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MGT604 - Management of Financial Institutions - Lecture Handout 30

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Letter of Credit and International Trade

A letter of credit is a document issued mostly by a financial institution which usually provides an irrevocable payment undertaking (it can also be revocable, confirmed, unconfirmed, transferable or others e.g. back to back: revolving but is most commonly irrevocable/confirmed) to a beneficiary against complying documents as stated in the Letter of Credit. Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply as credit (as in the UCP 500 and UCP 600). Once the beneficiary or a presenting bank acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any, within the expiry date of the LC, comprising documents complying with the terms and conditions of the LC, the applicable UCP and international standard banking practice, the issuing bank or confirming bank, if any, is obliged to honor irrespective of any instructions from the applicant to the contrary. In other words, the obligation to honor (usually payment) is shifted from the applicant to the issuing bank or confirming bank, if any. Non-banks can also issue letters of credit however parties must balance potential risks.

The LC can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. Letters of credit are used nowadays primarily in international trade transactions of significant value, for deals between a supplier in one country and a wholesale customer in another. They are also used in the land development
process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Since nowadays almost all letters of credit are irrevocable, (i.e.
cannot be amended or cancelled without prior agreement of the beneficiary, the issuing bank, and the confirming bank, if any). However, the applicant is not a party to the letter of credit. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheque. Typically, the documents a beneficiary has to present in order to avail him of the credit are commercial invoice, bill of lading, insurance documents. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped.

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MGT604 - Management of Financial Institutions - Lecture Handout 16

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ROLE OF COMMERCIAL BANKS

Types of investment banks

  1. Investment banks "underwrite" (guarantee the sale of) stock and bond issues, trade for their own accounts, make markets, and advise corporations on capital markets activities such as mergers and acquisitions.
  2. Merchant banks were traditionally banks which engaged in trade financing. The modern definition, however, refers to banks which provide capital to firms in the form of shares rather than loans. Unlike Venture capital firms, they tend not to invest in new companies

Banks in the Economy

Role in the money supply

A bank raises funds by attracting deposits, borrowing money in the inter-bank market, or issuing financial instruments in the money market or a capital market. The bank then lends out most of these funds to borrowers. However, it would not be prudent for a bank to lend out all of its balance sheet. It must keep a certain proportion of its funds in reserve so that it can repay depositors who withdraw their deposits.

Bank reserves are typically kept in the form of a deposit with a central bank. This is called fractional-reserve banking and it is a central issue of monetary policy.

Note that under Basel I (and the new round of Basel II), banks no longer keep deposits with central banks, but must maintain defined capital ratios

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