Topic #5: LETTER OF CREDIT FINANCING,

BANK RESERVES and BANK REPORTS

How to Apply for a Letter of Credit

The letter of credit (LC) or credit letter represents a bank’s commitment to substitute its
credit to an applicant after due investigation and analysis of the credit risk and is used for
domestic financing. Its acceptance involves other banks in the international network for foreign
financing.

It is a letter from a bank to another bank guaranteeing that a buyer's payment to a seller will be
received on time and for the correct amount under specified conditions. Its purpose is to give
payment security to the beneficiary subject to documents and compliance of requirements
presented under the LC. In case when the buyer is unable to make a payment on the purchase,
the bank will be required to cover the full or remaining amount of the purchase.

Also known as a documentary credit, banker’s commercial credit, or letter of undertaking, it is

further defined as a payment mechanism used in international trade to provide an economic
guarantee from a creditworthy bank to an exporter of goods.

Letters of credit are indispensable for international transactions

since these ensure that payment will be received. Using
documentary letters of credit allows the seller to significantly reduce
the risk of non-payment for delivered goods by replacing the risk of
the buyer with that of the banks.

To obtain a letter of credit, the buyer simply applies through his company’s bank. It is always
preferable to request a letter of credit from a bank with which a buyer has an established
relationship, as opposed to applying at a new bank. This is especially true for new companies
that don’t have an established credit history with excellent scores.

The bank generally requires full documentation of the agreement in question, as well as
whatever application documents it uses for internal processing. If the cash is present in the
company’s account, the bank will require the buyer to remit those funds up front or it may
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alternatively reserve a margin amount for use in satisfying the
buyer’s obligations. The margin amount varies from buyer-to-
buyer, depending on credit score and history, transaction history
and how well-established the company is, among other factors.
Risky buyers may be required to put up 100 percent of the
purchase price to secure a letter of credit; while established buyers
with excellent credit may be required to front as little as 1 percent
of the total sales price.

Once the LC is produced, there are other documents related to the LC that may need to be
arranged and filed. It is important to clarify what other requirements must be met in addition to
the LC itself and at what point in time they need to be filed.

❖ Preparing a Letter of Credit (LC)

When arranging for a letter of credit for a purchase, the bank or financial institution provides a
guarantee to the seller it will be paid in full or receive the remaining balance of the purchase
regardless of the buyer’s ability to pay. Because of this guarantee, Letters of Credit are most
widely used in international transactions.

➢ Research and single out financial institutions that provide

Letters of Credit to businesses and individuals. Qualifications for a
Letter of Credit are based on many factors but the principal factors
are the individual or business’ creditworthiness; all of the liabilities
and assets; the legitimacy of the product/goods; as well as the
seller’s ability to deliver said goods in a timely manner and in good
condition for the purpose it is intended - such as a car that is
mechanically sound or furniture that is usable.

➢ When arranging for a Letter of Credit, carefully review all terms and
conditions. In most cases, the institution issuing the LOC will place deadlines
and terms on the sale, such as a delivery date and the product or goods are
as described.

➢ Determine the practicability and necessity of the goods or product

being purchased. Because Letters of Credit are typically used for international transactions, the
buyer is obliged to find out if the goods or product being purchased can be acquired locally or
within the country as this will permit him to see and inspect the product or goods before the
issuing institution extends a Letter Of Credit. If the product or goods are available locally or
within the company but are more expensive, it might be prudent to buy the domestic product or
goods as their condition and value can be confirmed.

➢ Place an application for a Letter of Credit. Put first a request on

application packet from the selected bank or financial institution to do
business with. The application packet will include the actual Letter of Credit
application as well as general terms and conditions related to extending LOC.

➢ Complete the application and submit it to the bank or financial

institution. The buyer/applicant must provide personal and/or business
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information on his application, such as his full legal name; his
company’s name; Employer Identification Number (if
applicable); Social Security Number; date of birth; residential
address and/or business address; the seller’s full name and
address; description of the product or goods; the seller’s
banking information; and any other information required for
obtaining his LC.

❖ Parties to a Letter of Credit, Essential Features and Required

Documents

The letter of credit is a bi-partite agreement for it represents a

debtor-creditor relationship. During its transmission and negotiation,
other parties are involved. Creating duties and obligations for each
party requires explanation of different treatments.

The parties involved to a letter of credit are:

♦ The accredited buyer is the applicant/importer/account/consignee or debtor. He is the party

who opens the Letter of Credit as per his instruction. Necessary payment is arranged to open
LC with his bank. He arranges to open the letter of credit with his bank as per the terms and
conditions of purchase order and business contract between himself and the seller.

In its original form on a merchant-to-merchant basis, a third party acts as the intermediary in
settling the exchange transactions. Within the banking system, banks serve as the link between
buyers and sellers, especially with international transactions, and substitute credit as an
importer to enhance the accredited buyer’s credit reputation in foreign trade.

♦ The beneficiary is the person receiving the proceeds of a letter of credit. He

is also the seller/exporter or the consignee of goods shipped to the importer.
He follows the conditions and submits requirements set in the LC to obtain
payment; avoid litigation from non-compliance; and makes use of the
contingency clause. The LC is opened on the beneficiary’s favor.

♦ The opening or issuing bank opens the letter of credit, substituting its credit to that of the
accredited buyer. It is responsible in paying the amount on receipt of documents from supplier
of goods. This bank must possess a credit standing of “par excellence” as the exporter is more
concerned with the bank’s reputation at the international
market rather than with the buyer.

♦ The notifying or advising bank sends the documents of

the Letter of Credit to the opening bank. It is responsible in
communicating with the necessary parties under letter of
credit and other required authorities.

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 ♦ The confirming bank confirms and guarantees payment or
negotiation acceptance under the credit.
♦ The negotiating bank verifies the documents and confirms the
terms and conditions under LC on behalf of the beneficiary to avoid
discrepancies.

♦ The reimbursing bank authorizes the reimbursement claim of negotiation/ payment/

acceptance.

♦ The second beneficiary represents the first or original beneficiary in his absence. The credit
belonging to the original beneficiary is transferable to the second beneficiary under certain
terms.

Remember:
When the bank notifies and assumes the negotiation of drafts, the bank is
both a notifying and negotiating bank. Usually, the negotiating bank is not
a correspondent of the opening bank.

❖ Some essential features of a letter of credit are:

➢ Advice Number. Each LC is given an advice number

for ready reference and identification.

➢ Issuing Bank. The name of the issuing bank is stated

to know who is indebted to the advising and confirming
banks.

➢ The amount is clearly stated and not exceeding nor below the actual amount of goods.

➢ The name of importer is specifically stated in the letter of credit.

➢ Tenure of the letter of credit. The LC specifies how it is paid and the duration of
payment.

➢ Types of the letter of credit which are specified as:

• Advised Letter of Credit is a notice by an advising bank of the issuance of a

letter of credit. It is a communication from a bank informing a party that such bank or its
correspondent bank has opened a letter of credit in favor of him/her.

• Confirmed Letter of Credit. A confirmed letter of credit is a guarantee a

borrower gets from a second bank in addition to the first letter of credit. The confirmed
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 letter decreases the risk of default for the seller. By issuing the confirmed letter, the
second bank promises to pay the seller if the first bank fails to do so.

• Unconfirmed Letter of Credit is a letter of credit which has not been

guaranteed or confirmed by any bank other than the bank that opened it. The advising
bank merely informs the beneficiary of the letter of credit terms and conditions.

• A revocable Letter of Credit is a credit, the terms and conditions of which can
be amended/ cancelled by the Issuing Bank. This cancellation can be done without prior
notice to the beneficiaries.

• The Irrevocable Letter of Credit cannot be

changed, amended nor cancelled without authorization
from all parties involved. Almost all letters of credit today
are irrevocable because revocable letters of credit
simply do not provide the security that most beneficiaries
want.

❖ The letter of credit is also known as documentary credit because in

a letter of credit, documents are its driving force. The performance of the
seller/exporter is tied to the documents requested in the LC as the
payment from a bank to a seller/exporter is conditional upon the ability of
the latter to produce the requested documents by the buyer/importer.

♦ In a letter of credit, the buyer/importer generally requests

documents from the seller. However,
the list and form of documents are open to negotiation and might contain requirements to
present documents issued by a neutral third-party evidencing the quality of the goods shipped,
or their place of origin or place. Typical types of documents in such contracts may include:

➢ Financial documents (bill of exchange, co-accepted draft);

➢ Commercial documents (orders; invoices; shipping
documents; packing list; transport papers; certificates of origin);
➢ Shipping documents (bill of lading - ocean or multi-modal or
charter party -; airway bill; lorry/truck receipt; railway receipt;
CMC other than mate receipt; forwarder cargo receipt)
➢ Official documents (license, embassy legalization, origin
certificate, inspection certificate, phytosanitary certificate); and
➢ Insurance documents (insurance policy or certificate and not
a cover note)

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❖ Bank’s Position Before and After Acceptance

In nature, the letter of credit is a contractual relationship between the bank and the person
addressed to. On the other hand, acceptance is a negotiable instrument, which, in the hands
of a holder, is precisely categorized as a negotiated promissory note.

In assuming the obligation to honor the drafts at maturity, banks add

to the acceptability of the draft or bill of exchange. Between the
positions of a bank as an issuer of the LC and as an acceptor of a
draft drawn under LC’s terms is the fact that the letter of credit is not
negotiable – only the acceptance is effectively negotiable.

❖ The Trust Receipt

The trust receipt is one of the most important documents used in

the letter of credit financing. It is a notice of release of merchandise
to a buyer from a bank retaining the ownership title of the released
assets. In an arrangement involving a trust receipt, the bank
remains the owner of the merchandise but the buyer is allowed to
hold the merchandise in trust for the bank for manufacturing or
sales purposes.

The trust receipt serves as a promissory note to the bank that the
loan amount will be repaid upon sale of the goods.

Although the bank has a security interest in the goods under the
standard terms of a trust receipt, the customer takes possession of
the goods and may do what he wants with them as long as he does
not violate the terms of his contract with the bank. If he decides to
terminate the bank’s security interest and tie to the inventory, he may
tender the amount advanced on the goods; thus, giving him total
ownership of the goods.

Extending short-term financing through a trust receipt requires

the customer or borrower to be in good standing with the bank.
The bank and the customer also have to agree to the terms of
the trust receipt, including such conditions as the maturity date,
interest charge, and financing amount.

Maturity dates under trust receipts are short-term and range

from 30 to 180 days. At the time of maturity, the customer must
repay the loan to the lender with interest stipulated under the
terms of the trust receipt. The bank must be repaid at the time
of maturity or after the sale of the goods, whichever comes
earlier. If after the maturity date, no payment has been received
by the bank or the business defaults in paying its advances, the bank could repossess and
dispose of the merchandise.

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Under a typical trust receipt transaction, the business has little to
none of its own assets invested in the particular goods financed.
The bank bears the majority of the credit risk prevalent in the
transaction. The business keeps any profits made from the
resale of the goods but also bears the business risk.

If the goods get damaged, lost, or deteriorate in quality or value,

the loss is solely the burden of the business and it remains liable
for repaying the full loan amount to the bank. In addition, any
business expense (such as manufacturing costs, freight, custom
dues, storage, etc.) is the responsibility of the business, not the
lending institution.

Bank Reserves

Bank reserves are the cash minimums that must be kept on hand by
financial institutions in order to meet central bank requirements. The
bank cannot lend the money but must keep it in the vault, on-site or at
the central bank, in order to meet any large and unexpected demand
for withdrawals.

Bank reserves are divided into the required

reserve and the excess reserve. The required
reserve is that minimum cash on hand; while
the excess reserve is any cash over the
required minimum that the bank is holding in the vault rather than putting
it to use as loans.

Usually, banks have little incentive to maintain excess reserves because cash earns no return
and can even lose value over time due to inflation. Thus, banks normally minimize their excess
reserves and lend out the money to clients rather than holding it in their vaults.

Bank reserves decrease during periods of economic expansion and increase during recessions.
That is, in good times, businesses and consumers borrow more and spend more. During
recessions, they cannot nor would not take on additional debt.

In general, banks do not earn any interest on their reserves. Funds in banks
that are not retained as a reserve are available to be lent with interest.

→Primary Reserves are the minimum legal amount of

reserves that a bank is required to hold against its deposits. The
amount of reserves that banks hold helps determine the total
supply of money and credit in the economy. These include the
bank's vault cash and checkable deposits held with other banks
or any other funds that are accessible immediately to meet
demands for liquidity made against the bank.
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 When a customer deposits money in a bank, the bank is required
to keep a certain fraction held in reserve. A portion of deposits are
held in reserve as liquid funds; while the rest is lent to borrowers or
invested in less liquid assets.

• Primary reserves are kept to cover normal day-to-day withdrawals, especially unexpected
major withdrawals or runs of withdrawals. These serve as a defense against a substantial
reduction in liquidity. These reserves must be kept more liquid than secondary reserves which
may be invested in marketable securities such as treasury offerings.

• A bank keeps primary reserves in the form of

cash in its vaults; deposits in the central bank (legal
reserves); deposits with other banks; exchange for the
clearing house; and checks for collection. These items
are classified under excess reserves and working or
legal reserves.

❖ Factors Affecting Size of Primary Reserves Requirements

➢ The number of depositors and the diversity of their interests;

➢ Public confidence on banks;
➢ Nature of a bank’s deposits;
➢ Percentage of legal reserve requirements;
➢ Percentage and quality of secondary reserves;
➢ Demand for loans;
➢ Community habits and customs; and
➢ Other factors such as holidays, paydays, first day of the week

♦ Reserve requirements are the amount of funds that a bank holds in reserve to
ensure that it is able to meet liabilities in case of sudden withdrawals.

♦ Reserve requirements are used by the central bank to increase or decrease

the money supply in the economy and influence interest rates.

♦ Reserve requirements today are currently set at zero as a response to the

COVID-19 pandemic.

→Secondary Reserves are bank assets (as government securities and bank acceptances)
readily convertible into cash to replenish primary reserves, consisting of earning assets easily
converted to cash without loss and delay in order to meet unanticipated obligations. These
reserves’ principal feature is ready marketability.

• The presence of highly-liquid earnings not only enhance the banks’ earnings; but also
presents a veritable source of cash to meet depositors’ demands.

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• Secondary reserves keep a maximum percentage of the
banks’ funds invested in earning assets if cash is not needed.

• Secondary reserves, like primary reserves, does not

appear in a bank’s balance sheet but is expressed in the form of
loans and investments in short-term maturities. The assets meet
the test of shiftability as a theoretical aspect of investment in bank
assets.

→Investment Reserves
Assets not qualified as liquid or primary nor secondary
reserves are termed as investment reserves. These are
items with longer maturities spaced at even intervals to
allow the continuous intake and reinvestment of funds, such
as stocks and bonds.

Its purpose is to earn and meet any unanticipated major

losses resulting from bank failure.

Bank Reports

• Commonly referred to as bank statements, a bank report is issued

by a bank to its depositors. Banks usually issue reports each month for the
depositors listing the detailed activity on their bank accounts or to
summarize the transaction activity during the period. Since the bank
doesn’t own the money in the account, it must act as a fiduciary and report
the balances and transactions to the depositor.

• Bank reports are needed to meet the requirements of the supervisory and regulatory
agencies (bank directors and officers, stockholders, depositors, potential investors and the
general public).

→A bank report usually lists the following:

˃The depositor’s beginning balance;
˃Checks, withdrawals, and debits decreasing the balance
during the month;
˃Deposits and credits increasing the account balance
during the month;
˃Photocopies of cancelled checks cleared during the
month; and
˃The ending balance of the bank account

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❖ Types of Bank Reports

➢ Condensed Bank Statement

The accounts in this statement appear in condensed or abbreviated form. This is usually issued
for publication or is sent to depositors and stockholders to inform them. The frequency of
publication depends on the requirement of the supervisors and regulatory agencies.
Stockholders are furnished reports annually.

→Also called as a condensed financial statements,

these are additional documents or precise
supplementary papers essential during the auditing
procedure. It is further defined as the brief version of a
bank or a business’ income statement, cash flow
statement and balance sheet - all collectively put into a
particular financial document. These brief reports are
made to deliver a rapid outline of the financial
institution’s position with appropriate detail, usually for
internal procedures.

→Financial data, with usually several dedicated lines in a full financial statement, only receives
a single line to represent that data in the condensed form. Therefore, a representative
condensed financial/bank statement normally comprise of one line for expenses, financing
income, revenues, cost of goods sold and net income. Only relevant pieces of financial data are
included, forming a summary version of the information presented on a complete financial
statement with detail. It documents and calculates assets and liabilities for temporary recording,
using the financial data available on a year-to-date basis.

➢ Real Bank Statement

This statement is arranged in a more detailed form for the regulatory and supervisory agencies
as the basis for preparing other reports.

→Also known as an account statement, it lists all transactions for a bank account over a set
period, usually on a monthly basis. Account-holders generally review their bank statements
every month to help keep track of expenses and spending, as well as monitor for any fraudulent
charges or mistakes.

➢ Annual Reports

An annual report (also called as progress report) is a corporate document

disseminated to shareholder that spells out the bank's financial condition
and operations over the previous year. It is prepared in a brochure form
and is made available for the public as a means of advertisement.
However, it does not contain the “focal points” in the bank’s progress. The

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addition of a new building, the bank’s opening of new branches and the like can be included in
the brochure through write-ups or a pictorial reporting. An income statement, as well as the
reconciliation of the bank’s capital can also be featured.

❖ Bank Resources or Assets and Liabilities

→Bank Resources or Assets

• For a bank, the assets are the financial instruments that either the
bank is holding (its reserves) or those instruments where other parties
owe money to the bank.

• The most common bank assets or resources are:

➢ Cash on Hand represents the bank’s notes and coins that meet the depositors’
withdrawals and other cash needs – all kept in the bank’s vaults and/or in the hands of tellers.

➢ Other Cash Reserves are comprised of exchanges for the clearing house; collections in
transit; and other cash items. These detailed classifications reflect the different aspects of
liquidity relative to the bank’s immediate cash needs.

▪ Exchanges for the clearing house consist of checks deposited or cashed by the bank
which prepares the statement during the day’s course. These are drawn from member
banks of the clearing house that are located within the city.

Remember:

In the Philippines, all commercial banks are members of the clearing house.

▪ Collections in transit consists of “out-of-town” cheques or drafts drawn on banks outside

the city. Banks receiving this account for deposit and/or collection usually credit the
depositor’s or customer’s account pending receipt of the proceeds. In either case, the
entry on the bank’s books is on a deferred basis and subject to final payment or receipt
of the proceeds.

▪ Other cash items include miscellaneous items such

as bond coupons in which the depositor has been
credited pending coupon collection.

In case where not all banks are members of the

clearinghouse, cheques or drafts represent claims
against non-member banks.
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 ➢ Due from Banks are deposits carried to other banks,
usually in the form of demand deposits. Depositing banks
usually keep these in the reserves as time deposits to earn
interest. In the Philippines, these bulk deposits are in the
form of legal reserves kept at the Bangko Sentral ng
Pilipinas (BSP) by private banks.

➢ Balances with Foreign Banks consist of deposits or funds

held abroad to fill foreign exchange demands.

➢ Loans and Discounts comprise all promissory notes and

bills of exchange held by the bank – all evidencing the existence of
indebtedness fully guaranteed by the Republic of the Philippines in
the form of bonds and other instruments of similar nature.

➢ Other Securities represent stocks and bonds or short-term

investments that are not fully-guaranteed by the Philippine government.
These securities belong to private corporations.

➢ Bank Building, Furniture and Fixtures are the monetary value of the properties
owned by a bank to ensure its functionality.

➢ Other Real Estate Owned is stated when banks accept real estate as security for
unpaid loans.

➢ Customer Liability under Letters of Credit is an account that represents the

customer’s obligation to pay the bank back by virtue of the bank’s commitment to substitute
credit for the borrowers through honoring drafts.

➢ Customer’s Liability under Acceptance is similar to the customer’s liability under

letters of credit – except that the bank’s obligation is to pay drafts upon presentation.

➢ Income Accrued but not yet Collected. When a

bank grants loans with interests collected upon maturity, it
gains future earnings which has not yet been collected.
Interests run during the entire period. In the case of bonds,
interest payments accrue but are not yet collectible. Such
accruals are considered as bank reserves.

➢ Other Assets serve to “round-up” any or all other assets not described in detail.
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❖ Stockholders’ Equity

→Stockholders’ equity, sometimes called as the bank’s capital accounts

or owners’ equity, is the remaining amount of assets available to
shareholders after all liabilities have been paid. It is calculated either as a
bank's total assets less its total liabilities or alternatively as the sum of
share capital and retained earnings less treasury shares. Stockholders'
equity might include common stock, paid-in capital, retained earnings
and treasury stock.

→If equity is positive, the bank has enough assets to cover its liabilities; while a negative
stockholders' equity may indicate an impending bankruptcy.

→Because a bank trades on equity, its net worth represents the amount
that depositors and stockholders could possibly recover, in case of loss.
Thus, the state sets the capital-to-deposit ratio and tabs strict surveillance
on every weakening of the bank’s capital.

→The stockholders’ equity is comprised of capital stocks; surplus; and undivided profits.
▪ Capital Stock is the number of shares issued times par value per share of a bank.

▪ Surplus comprises earnings from sale of stock above par; or

earnings retained by the management from operations.

• Surplus may also be obtained by the sale of “obsolete

assets.”

• It acts as the “shock absorber” for incurred losses.

▪ Undivided Profits are earnings from current operations that are not yet paid-out as
dividends. Thus, this account, which is transitory in nature, may be allocated for
different purposes, such as payment of dividends; to cover certain expenses; offset
losses; or it may be added to the surplus account.

❖ Minimum Capital Requirements

♦ The combined capital accounts of each commercial bank is not

less than an amount equal to 15% or its total assets, excluding
cash on hand; amounts due from banks (here and abroad) which
includes all deposits with the Bangko Sentral ng Pilipinas; and
evidences of indebtedness of obligations (servicing and
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repayment) fully guaranteed by the Republic of the Philippines and the Bangko Sentral ng
Pilipinas.

♦ The Mandatory Board prescribes the manner of determining the

total assets of banking institutions, including total assets.

❖ Criticisms on Published Statements

➢ Published statements are much abbreviated so as

to give any significant detail to banking operations.

➢ People without professional or specialized knowledge in

banking functions nor with banks would not understand the
significance of the accounts appearing in the statements.

➢ Assets and liabilities are combined, making it impossible to

understand the nature of the bank – not unless a person is
knowledgeable in financial statement analysis.

➢ The nature of the bank’s financial position, as reflected at

the financial reports, largely depends on the accountant’s
estimation on the valuation of assets and liabilities. For
example, some accountants resort to secret reserves.

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