Explain a letter of credit and how it works.
A core Corporate Treasury interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
A (documentary/commercial) letter of credit is a bank's undertaking to pay the seller on behalf of the buyer, provided the seller presents documents that strictly comply with the LC's terms — typically the invoice, transport document (bill of lading), and certificates (origin, inspection). It de-risks trade for both sides: the exporter gets a bank's payment promise independent of the buyer's creditworthiness once it ships and presents conforming documents, and the importer knows payment is released only against evidence the goods were shipped as specified. Key features: it's independent of the underlying sales contract (banks deal in documents, not goods — the 'autonomy principle'), strict documentary compliance governs payment (discrepancies are the usual dispute), and it's governed by UCP 600. Variants include confirmed LCs (a second bank adds its guarantee, useful for risky issuing-bank countries) and standby LCs (which act like a guarantee, paying only if the buyer defaults). Cost is typically a fee of around 0.5–2% p.a.
WHAT INTERVIEWERS LISTEN FOR
- ✓Bank pays seller against strictly-compliant documents on buyer's behalf
- ✓De-risks both sides: seller gets bank promise, buyer pays only vs shipping docs
- ✓Autonomy principle: banks deal in documents not goods; UCP 600; strict compliance
- ✓Variants: confirmed LC (second-bank guarantee), standby LC (guarantee-like)
COMMON MISTAKES
- ✗Thinking the bank assesses the goods, not the documents
- ✗Not knowing the autonomy/strict-compliance principle
- ✗Confusing a commercial LC with a standby/guarantee
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