Documentary credit, which is also often referred to as a letter of credit, is a letter issued by a bank which serves as a guarantee to a seller that the items or products purchased will be paid for in full and in a timely manner. Should the buyer be unable to meet his obligation to make this payment, the bank will honor the guarantee it previously gave by covering the amount which needs to paid.
Documentary credit may come in handy for entities which conduct business internationally. A seller from one country may have some difficulties gauging the reliability of a buyer from another country. In this case, the buyer can request for documentary credit from his bank to assure the seller of payment. If the buyer is unable to pay, then the seller simply has to request the bank to issue the required payment. Since banks are much less likely to default on payments, the seller minimizes the level of risk being taken in the transaction. Of course, this translates into a higher risk for the bank.
However, the issuance of documentary credit does not just protect the seller, but the buyer, as well. If the buyer does not receive the goods as agreed on, then he simply needs to inform the bank of this, which ensures that the payment to the buyer will not be released. With the security that this provides to both parties involved, documentary credit has become helpful in facilitating international transactions.
In the process involving the issuance of documentary credit, the seller is also known as the beneficiary and his bank serves as the advising bank. On the other hand, the buyer is considered the applicant while his bank is known as the issuing bank.
