Letter of credit: what it is, who is involved and what it costs

What is a letter of credit?

A letter of credit (LC) solves a simple trust problem. A seller does not want to ship goods and then chase the money. A buyer does not want to pay before the goods are on their way. So the buyer asks its bank to promise the seller payment, on conditions that can be checked on paper.

The International Chamber of Commerce (ICC) describes the instrument as "a written undertaking given by a bank (issuing bank) to the seller (beneficiary) on the instruction of the buyer (applicant) to pay at sight or at a determinable future date up to a stated amount of money" (International Chamber of Commerce). The promise holds only if the seller makes a "complying presentation" of documents, which means papers that match what the credit asks for.

In banking, an LC is a non-fund based facility. The bank lends no money on day one. It gives a promise, and it lends only if it has to pay out. RBI groups LCs with guarantees and co-acceptances under its Non-Fund Based Credit Facilities Directions, 2025 (RBI notification).

Who is involved in a letter of credit?

Every LC has at least three roles. Larger deals add more.

So, when people ask "letter of credit is issued by" whom, the answer is the buyer's bank, the issuing bank.

How does a letter of credit protect each side?

• The seller gets a bank's promise instead of the buyer's. The bank pays on documents, so a dispute over the goods does not hold up a correct presentation.
• The buyer gets control. The bank pays only if the papers match the terms, such as an invoice, a transport document and an inspection certificate. The buyer sees evidence of shipment before money leaves.
• A confirming bank adds comfort when the seller doubts the issuing bank or its country (International Chamber of Commerce).

The cost of this comfort is paperwork. Banks check documents strictly. A small mismatch, such as a wrong date or a different description of the goods, is a "discrepancy", and the bank may refuse to pay until it is fixed or the buyer waives it.

Which rules govern a letter of credit?

Most LCs in international trade follow the ICC's Uniform Customs and Practice for Documentary Credits, known as UCP 600. It has been in effect since 01-Jul-2007 and has 39 articles. It also gives a bank a maximum of five banking days to accept or refuse documents (International Chamber of Commerce).

Two points from UCP 600 matter in practice:

1. A credit is irrevocable by default. Even if the LC does not say so, the issuing bank cannot cancel it on its own. The idea of a revocable credit no longer exists in these rules (International Chamber of Commerce).
2. The bank deals in documents. It "honours" a complying presentation by paying at sight, by promising to pay at a later date, or by accepting a draft and paying it at maturity (International Chamber of Commerce).

Within India, a bank issuing an LC also follows RBI's directions. These apply to new and renewed facilities from 01-Apr-2026, or earlier if the bank's own policy says so (RBI notification).

Letter of credit and standby letter of credit

A normal LC pays when the seller performs, for example by shipping the goods. A standby letter of credit (SBLC) works the other way. It pays only if something goes wrong, such as the buyer failing to pay. ICC calls a standby "a secondary obligation covering default only" (International Chamber of Commerce). That makes it close to a bank guarantee. Standby credits and demand guarantees are covered by different ICC rules from a normal LC (International Chamber of Commerce). The types of letter of credit page covers the other kinds, and the letter of credit vs bank guarantee page sets the two promises side by side.

What does a letter of credit cost?

Banks price an LC as a commission for the promise, plus small fixed fees. Each bank sets its own card. To show the shape, here is one public sector bank's card for an inland LC where the borrower is not a large corporate. It was published by Bank of Baroda and shows an effective date of 10-Dec-2022 (Bank of Baroda).

"Sight" means the bank pays when it sees complying documents. "Usance" means it pays at a later date set in the credit, so the buyer gets time.

A worked example

These sums are arithmetic on the card above. They are not an offer from any lender, and your bank's card will differ.

For an inland LC of ₹10,00,000 for an unrated MSME priced as BBB (Bank of Baroda):

• Sight LC: 0.70% of ₹10,00,000 is ₹7,000.
• Usance LC of 120 days at 1.50% a year: about ₹4,932.
• Usance LC of 180 days at 1.50% a year: about ₹7,397.
• Adding confirmation at 0.20% a month for 4 months: ₹8,000.

ICICI Bank publishes a ceiling instead of a card. It says up to 2% a year, charged pro rata on the tenure and amount, for letters of credit and bank guarantees (ICICI Bank). The lender decides the final figure for your file.

Other charges can also arise. Bank of Baroda's card lists a standby LC against trade credits at 1% a year for amounts below ₹5,00,00,000, and a shipping guarantee, which lets the importer collect goods before the original bill of lading arrives, at 0.05% a month with a minimum of ₹1,000 in cases not under an LC (Bank of Baroda).

Who can get a letter of credit in India?

RBI's directions say a bank should issue a non-fund facility only for a customer that already has a funded credit facility from that bank. Three exceptions matter to small businesses (RBI notification):

• the facility is fully covered by eligible financial collateral, such as a deposit;
• the bank issues it against a no-objection certificate from the lender or lenders that fund the customer; or
• the customer has no fund-based facility from any lender in India.

In practice, a bank sanctions an LC limit with your working capital limits, asks for security or a cash margin, and looks at your repayment record. A business with clean GST returns, steady bank statements and a good CIBIL MSME Rank is easier to assess. CIBIL is TransUnion CIBIL, the credit bureau that scores business borrowers.

If the bank pays out under the LC and you cannot reimburse it, the LC becomes a loan. RBI treats a devolved non-fund facility as a fund-based one from that point (RBI notification).

Documents a bank usually asks for

The credit lists the documents the seller must present. Common ones are:

• a commercial invoice;
• a transport document, such as a bill of lading or airway bill;
• a packing list;
• an insurance document, where the terms ask for it;
• a certificate of origin or inspection certificate, where the terms ask for it.

Each credit sets its own list, so read the LC closely before you ship.

Before you apply

1. Decide whether you are the buyer or the seller. A buyer applies for the LC. A seller usually receives one.
2. Ask your bank for its LC commission card and margin rule.
3. Check that the documents the LC demands are ones you can produce on time.
4. Keep your financials and GST filings current, because the bank assesses the limit like a loan.

Capnix does not issue letters of credit. Banks do. Capnix can take your trade requirement to the lenders on our lender panel. See the trade finance product page, or run the free loan readiness check first to see your Capnix score from 0 to 100.