What Is a Letter of Credit?
A letter of credit (LC or LOC) solves a trust problem: a seller wants assurance of payment before shipping goods, while a buyer wants assurance the goods ship before paying. The issuing bank steps between them, committing to pay the seller if the documented conditions are satisfied. The arrangement involves the applicant who requests the LC, the issuing bank, the beneficiary who gets paid, and often an advising or confirming bank in the beneficiary's home country.
Because the bank's obligation is independent of the underlying commercial contract, the seller no longer needs to assess a foreign buyer's creditworthiness — only the bank's. That substitution of credit is what makes letters of credit so powerful in cross-border trade, where enforcing a contract against a distant counterparty can be slow and uncertain.
How Letters of Credit Work
In a commercial (documentary) LC, the exporter ships the goods and presents documents such as the bill of lading and commercial invoice to the bank. If the documents conform exactly to the LC's terms, the bank pays — banks deal in documents, not in the goods themselves, a principle codified in the ICC's UCP 600 rules that govern most LCs worldwide. Even small discrepancies in the paperwork can delay or void payment.
A standby letter of credit works differently: it is a safety net drawn only if the applicant fails to perform, functioning much like a bank guarantee. Landlords, project owners, and trading counterparties often require standbys as performance assurance. Banks charge issuance fees that commonly run 0.75% to 1.5% of the face amount annually, with higher rates for weaker credits, and they may require cash collateral from riskier applicants.
Why Letters of Credit Matter
Letters of credit grease trillions of dollars of global trade that would otherwise require prepayment or open-account risk. Inside corporate finance, they also interact with a company's credit facilities: LCs are typically issued under a revolver sublimit, so every dollar of outstanding LCs reduces the borrowing capacity available for cash draws. Credit analysts treat outstanding LCs as contingent liabilities when sizing a company's true leverage and liquidity.
For candidates heading into credit-focused roles — leveraged finance, corporate banking, restructuring, or ratings work — knowing how LCs consume revolver availability is a practical detail that shows up in real capital structure analysis. In interviews, being able to distinguish a documentary LC used to settle a trade from a standby LC used as a performance backstop signals genuine familiarity with how companies actually operate.
