Banking Exam Question - What are the Major Risks in Letter of Credit? How can be Mitigate it? Describe it.

What are the major risks in LC? How can be mitigate it? Describe it.

A letter written by one bank or financial institutions to another bank or financial institution authorizing the letter to accept cheques, drafts, hundies or bill of exchange of a specific person within the limit of the amount is called letter of credit. Letter of credit is common in both national and international trade where the banks act as intermediary between the two parties, like buyer and seller. Major risks in LC are as follows:

1Risk in letter of credit transaction

• Credit risk
• Fraud risk
• Exchange rate risk
• Sovereign rate risk
• Legal risk
• Force majeure risk
• Other risk (Caused by a difference in law, language or culture)

2. Risk to the applicant

• Non-delivery of goods
• Short shipment
• Inferior quality
• Early or late shipment
• Damaged in transit
• Foreign exchange
• Failure of bank, issuing bank/collecting bank

3.  Risk to issuing bank

• Insolvency of the applicant
• Fraud risk, sovereign and regulatory risk and legal risk

4.  Risk to beneficiary

• Failure to comply with credit conditions
• Failure of or delays in payment from the issuing bank
• Fraud credit – credit issued by party other than issuing bank

5.  Risk to the advising bank

• LC advised without proper authentication

6.  Risk to the nominated bank/confirming bank/reimbursing bank

• Insolvency of issuing bank
• Refusal of reimbursement by issuing bank because of a dispute

The following are the main points should be considered to mitigate the risks in letter of credit transaction:

• Know your customer
• Know your correspondent bank
• Credibility of beneficiary
• Confirmed LC
• Forward contract
• Be clear in terms and conditions of LC
• Ask for amendment, if necessary
• Sufficient insurance coverage
• Check documents properly
• Advice discrepancy in time