What is a Confirmed Letter of Credit?

A confirmed letter of credit is a way for banks to guarantee payments in international trade deals. It’s an extra layer of security on top of a regular letter of credit. With a confirmed letter of credit, a second bank steps up and says, “We’ve got your back.” They promise to pay the seller (the “beneficiary”) if the first bank issuing the original credit letter doesn’t come through.

Why Would You Need a Confirmed Letter of Credit?

International trade can be risky business. You’ve got companies and banks in different countries trying to do deals. They might not know each other well. There could be worries about whether everyone can be counted on to hold up their end of the bargain. That’s where a confirmed letter of credit comes in handy.

Concerns About the Issuing Bank

The seller might think, “I don’t know this bank that issued the letter of credit. What if they flake out on me?” The seller gets nervous if the issuing bank is small or not super financially stable. They want extra assurance that they’ll get paid for sure.

Sovereign Risk Jitters

Or maybe the issuing bank is in a country that’s politically or economically shaky. Even if the bank itself is ok, there’s a chance the whole country could have problems that keep the bank from paying. This is called “sovereign risk” – the risk that a government could interfere with the deal.

How Does a Confirmed Letter of Credit Work?

Here’s the step-by-step of how it goes down:

The buyer goes to the bank and asks them to issue a letter of credit.
The issuing bank sends the letter of credit to the seller’s bank.
The seller looks at the letter of credit and says, “Hmm, I’m not comfortable with this issuing bank. I want my bank to confirm the letter of credit.”
The seller’s bank, now called the confirming bank, looks at the deal and decides whether to confirm the letter of credit. If they do, they’re saying they’ll guarantee payment to the seller.
The confirming bank tells the issuing bank, “We’re confirming this letter of credit. We’ll pay the seller if you don’t.”
The seller is happy because now they have two banks on the hook to pay them.
The seller ships the goods.
The seller gives the shipping documents to their bank, the confirming bank.
The confirming bank checks that all the documents are in order. Then they pay the seller according to the terms of the letter of credit.
The confirming bank sends the documents to the issuing bank.
The issuing bank checks the documents and then pays back the confirming bank.
The issuing bank gives the documents to the buyer so they can pick up their goods.

The Confirming Bank Takes on Risk

When a bank confirms a letter of credit, they’re taking on the risk of the issuing bank not paying up. They’re saying, “We believe this other bank is good for the money. But if they’re not, we’ll step in and pay.”

The confirming bank is betting that the issuing bank and the country it’s in will stay financially stable long enough for the deal to go through. If something goes wrong and the issuing bank can’t pay, the confirming bank has to pay the seller out of their own pocket.

The Seller Pays for the Confirmation

Because the confirming bank is taking on extra risk, they charge a fee for this service. Usually, the seller has to pay this fee. For the seller, it’s the cost of peace of mind. They’re willing to take a little less profit to know they’ll definitely get paid.

The fee for a confirmed letter of credit is usually a percentage of the amount being paid in the deal. The riskier the confirming bank thinks the deal is, the higher the fee will be.

When is a Confirmed Letter of Credit Used?

Confirmed letters of credit are common when:

The seller doesn’t have a long-term relationship or experience with the issuing bank.
The issuing bank is small or not well-known internationally.
The issuing bank is in a developing country.
The issuing bank is in a country with economic or political instability.

Basically, any time there’s a higher than usual risk that the issuing bank might not be able to pay, a confirmed letter of credit can help the deal move forward.

Confirmed Letters of Credit Facilitate International Trade

By adding an extra layer of security, confirmed letters of credit help companies feel more comfortable doing business across borders. The seller knows they’ll get paid, even if something happens to the issuing bank. The buyer knows the seller will ship the goods because they trust the confirming bank.

This trust is the grease that keeps the wheels of international trade turning. Without tools like confirmed letters of credit, many companies would be too nervous to do business globally. They’d stick to dealing with companies they know in countries they’re familiar with.

The Downsides of Confirmed Letters of Credit

While confirmed letters of credit can be very useful, they’re not perfect:

They add costs to the trade deal. The confirming bank’s fee cuts into the seller’s profits.
They can slow down the deal. The confirming bank has to review all the documents and make sure everything is in order before they’ll pay.
If something goes wrong, it can get complicated figuring out who’s responsible. The seller, the buyer, the issuing bank, and the confirming bank could all get tangled up in a dispute.

Despite these drawbacks, for many international deals, the benefits of a confirmed letter of credit outweigh the costs. The added security and peace of mind is worth a little extra time and money.

Real World Examples

Let’s say a company in the United States is buying electronics from a manufacturer in Indonesia. The U.S. company asks their bank to issue a letter of credit. But the Indonesian manufacturer isn’t familiar with the U.S. bank. They worry that if something goes wrong with the U.S. economy, the bank might not be able to pay.

The Indonesian manufacturer asks their local bank to confirm the letter of credit. The Indonesian bank, familiar with the manufacturer and comfortable with the risk, agrees to confirm. Now the manufacturer knows they’ll get paid, even if something happens to the U.S. bank.

Or imagine a British company buying textiles from a supplier in Bangladesh. The Bangladeshi supplier has had trouble in the past with foreign buyers not paying. They insist on a confirmed letter of credit from a major international bank. The British company agrees to pay the extra fee to get their bank to confirm the letter of credit. The deal goes through smoothly, and both parties are happy.