Describe the concept of banking transaction and the letter of credit and its Consequential impact on world economy.

Before the topic can be discussed broadly the two key points (i) Banking transactions and; (ii) Letter of credit (LC) needs to be discussed to show the distinctions and also the similarities, that is jointly affecting the world economic market. The former goes on to explain that it is an agreement or movement carried out between a buyer and a seller to exchange an asset for payment. The buyer and seller are separate entities or objects, often involving the exchange of items of value, such as informationgoodsservices, and money. The latter simply means a letter addressed by the buyer’s bank to the seller’s bank stating that they could vouch for their good customer, the buyer, and that they would pay the seller in case of the buyer’s default. Letters of credit are used primarily in international trade for large transactions between a supplier in one country and a customer in another.

 INTRODUCTION: BANKING TRANSACTION

 In old days, non-financial transactions were commonly carried out through barter system, in which goods and services were exchanged directly, without a financial medium. This had certain disadvantages, including the requirements that traders or their intermediaries meet face to face and that transactions normally be completed in a single exchange. Then came the era where precious metals like gold and silver were exchanged. Gradually, introduction of fiat money took place with set values, permitting the growth of assets that would not deteriorate over time as goods might and that had the relatively secure backing of a government which could adjust value by producing more or less of the currency. As fixed currencies were gradually replaced by floating currencies during the 20th century, and as the recent development of computer networks made electronic money possible, financial transactions have rapidly increased in speed and complexity.

PRESENT SITUATION

  In the year 1997, billions of dollars were exchanged every day on Foreign exchange market.  The world financial transactions have jumped from $1,100,000 billion dollars in 2002 to $2,200,000 billion dollars in 2008 that is 95% of this global amount is only used for speculation. Some of the terms which are very important are discussed below.

  The Euro zone crisis is not only having a widespread impact on investor confidence, and therefore the number of new deals in the market, but also poses issues with regards to existing debt. And the other development is the tighter regulation facing banks and in particular, the increased regulatory capital which they must set aside before they can lend money. The result is that large syndicated loans are being arranged by a club of banks, rather than one or two banks, and borrowers also having to look at different sources for their borrowing requirements, such as the high yield bond market.

  Banks are in the money business; they accept our deposits, invest them in a wide range of financial products (for example, by making loans) and make both themselves and us a profit in the process. Every one of these banking activities is legally documented. For example, when one opened a bank account one will have signed a standard set of terms of conditions setting out one’s bank’s rights and obligations. Of course, one will not have had the ability to negotiate any of the terms of this contract, although they will have been scrutinized by a banking lawyer beforehand.  The commercial terms of the deal will be negotiated between the banks and the borrower, and it is the task of the banking lawyers to document what has been agreed between the parties and ensure documents work from a legal perspective.

  LETTER OF CREDIT

 Although a Letter of credit (LC) is considered one of the most secure means of obtaining quick payment for sale of goods, clients who are exporting should be made to understand that they can never totally control the payment process but the security provided by this device however does not extend to fraud risk. There are steps, however, that a prudent exporter can take to maximize his control of the LC process, thereby greatly increasing the likelihood of being paid under the LC. 

 Letters of credit are very common in international trade because the bank acts as an indifferent party between buyer and seller. For example, importers and exporters might use letters of credit to protect themselves. In addition, communication can be difficult across thousands of miles and different time zones.

TYPES OF LETTER OF CREDIT

  Letters of credit (LC) deal in documents, not goods. An LC can be irrevocable or revocable. An irrevocable LC cannot be changed unless both buyer and seller agree. With a revocable LC, changes can be made without the consent of the beneficiary.

  A sight LC means that payment is made immediately to the seller or exporter upon presentation of the correct documents in the required time frame. A time or date LC will specify when payment will be made at a future date and upon presentation of the required documents.

  Negotiation means the giving of value for draft and document by the bank authorized to negotiate, via the nominated bank. Mere examination of the documents and forwarding the same to the letter of credit issuing bank for reimbursement, without giving of value or agreed to give, does not constitute a negotiation.

  There are different kinds of payments that can be presented for payments. They are called shipping document, financial document, commercial document, official document, insurance document and so on.

 LEGAL PRINCIPLES REGARDING LC

  One of the primary peculiarities of the documentary credit is that the payment obligation is abstract and independent from the underlying contract of sale or any other contract in the transaction. Thus the bank’s obligation is defined by the terms of the credit alone, and the sale contract is irrelevant. The defensive of the buyer arising out of the sale contract do not concern the bank and in no way affect its liability.[1] Therefore, if the documents tendered by the beneficiary, or his or her agent, appear to be in order, then in general the bank is obliged to pay without further qualifications.

  The reason behind adopting the policies is the abstraction principle which is purely commercial, and reflects a party’s expectations. First, if the responsibility for the validity of documents was thrown onto banks, they would be burdened with investigating the underlying facts of each transaction, and would thus be less inclined to issue documentary credits as the transaction would involve great risk and inconvenience. Second, documents required under the credit could in certain circumstances be different from those required under the sale transaction. This would place banks in a dilemma in deciding which terms to follow if required to look behind the credit agreement. Third, the fact that the basic function of the credit is to provide a seller with the certainty of payment for documentary duties suggests that banks should honor their obligation notwithstanding allegations of misfeasance by the buyer. Finally, courts have emphasize that buyers always have a remedy for an action upon the contract of sale, and that it would be a calamity for the business world if, for every breach of contract between the seller and buyer, a bank were required to investigate said breach.

The principle of strict compliance also aims to make the bank’s duty of effecting payment against documents easy, efficient and quick. Hence, if the documents tendered under the credit deviate from the language of the credit the bank is entitled to withhold payment even if the deviation is purely terminological.[2]

LEGAL BASIS

The bank is the only party in the transaction chain that determines whether or not the presentation complies with the terms and conditions of the LC based on the International Standard Banking Practice (ISBP)[3] and the Uniform Customs and Practice for Documentary Credits (UCP)[4]. Significantly, the UCP provides relevant provisions relating to documents presented by the seller under LC transaction. Obviously, the requirement of strict compliance is highlighted by Article 18(c) relating to the description of the goods in a commercial invoice. The above provision expressly maintains the requirement of strict compliance in commercial invoice where it should comply with the terms and conditions of LC. Similarly, the reflection of strict compliance was developed in 1927 by Lord Sumner in the case of Equitable Trust v Dawson Partners[5].

Customs and Practice for Documentary Credits (UCP)

  Although documentary credits are enforceable once communicated to the beneficiary, it is difficult to show any consideration given by the beneficiary to the banker prior to the tender of documents. In such transactions the undertaking by the beneficiary to deliver the goods to the applicant is not sufficient consideration for the bank’s promise because the contract of sale is made before the issuance of the credit, thus consideration in these circumstances is past. In addition, the performance of an existing duty under a contract cannot be a valid consideration for a new promise made by the bank: the delivery of the goods is consideration for enforcing the underlying contract of sale and cannot be used, as it were, a second time to establish the enforceability of the bank-beneficiary relation.

 RISKS OF LC

Fraud Risks– The payment will be obtained for nonexistent or worthless merchandise against presentation by the beneficiary of forged or falsified documents.

Sovereign and Regulatory Risks– Performance of the Documentary Credit may be prevented by government action outside the control of the parties.

Legal Risks– Possibility that performance of a Documentary Credit may be disturbed by legal action relating directly to the parties and their rights and obligations under the Documentary Credit

Risks to the Nominated Bank– Nominated Bank has made a payment to the Beneficiary against documents that comply with the terms and conditions of the Credit and is unable to obtain reimbursement from the Issuing Bank

Risks to the Confirming Bank– If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may not be able to obtain reimbursement from the Issuing Bank because of insolvency of the Issuing Bank or refusal of the Issuing Bank to reimburse because of a dispute as to whether or not payment should have been made under the Credit

.CONSEQUENTIAL IMPACT ON THE WORLD ECONOMY

  The financial crisis– Between the second semester of 2008 and the first semester of 2009, the financial crisis worsened and spread around the globe, causing the deepest and broadest recession since the 1930s and triggering a simultaneous plunge in production and international trade. This crisis is unprecedented in terms of its scope, its origin in the world’s dominant economy (specifically in investment banking, the most dynamic segment of the United States economy), and the simultaneity and speed with which it was transmitted to every corner of the globe. In a context marked by turbulent financial markets, limited access to credit, rising unemployment and a substantive devaluation of assets, the world economy will contract in 2009 for the first time since the Second World War.

  One of the main consequences of the crisis has been the drastic decline of world trade, generated largely by the sharp drop in lending for trade transactions and the greater vulnerability of traded goods to the fall in worldwide demand. As a result, global trade is expected to shrink by about 10%. The previous contraction in world trade occurred in 1982 and was less severe. Not since the 1930s has the world experienced a trade slump of this magnitude.

The onset of this recession signaled the end of the most expansionary cycle in 40 years: the growth period that stretched from 2003 to mid-2008. One unique feature of this cycle was that the savings surpluses of the South, mainly through the current account surpluses of China, the other Asian economies and the oil-based economies, financed the real-estate and stock market bubbles of the North. This enabled the United States to grow beyond its potential, without inflationary pressure and with low interest rates, which resulted in a large current account deficit and soaring debt levels among families, businesses and government alike. The bursting of these bubbles shook the United States economy, the very heart of the world financial system, as well as the Japanese and European economies, and did not spare the developing countries as many were unprepared from 20 Economic Commission for Latin America and the Caribbean (ECLAC)a financial viewpoint.

  The crisis also severely affected several small and open emerging countries, which are more reliant on the European and United States markets and in whose national economy manufacturing exports play a larger role. This accentuated some of the trends seen prior to the crisis: the shift from the Atlantic to the Pacific of the driving force of the global economy; and the growing weight of China and the increasing number and strength of its ties with the other Asian economies. The recessionary shock rocked the foundations of the most buoyant segment of the world’s predominant economy, the United States financial sector, and its most dynamic element, investment banking, in particular. The bankruptcy of Lehman Brothers and the bail-out of American International Group Inc. (AIG) in October 2008 marked the start of the second phase of the financial crisis. The demise of two of the financial sector’s most influential institutions had a devastating effect on financial markets. Prior to the folding of Lehman Brothers, the action taken by the authorities had suggested that efforts would focus on stemming systemic risk, in other words, on preventing the failure of large financial establishments that could cause the credit markets and economic activity to tumble with them.

Uncertainty about the health of other banking and non-banking institutions produced a widespread plunge in demand for debt instruments, and hence the total collapses of their prices and market. This forced credit rating agencies to lower the ratings of several prestigious institutions that had operations all over the world.

The financial crisis has provided a number of lessons on the limitations of self-regulation in financial markets with high levels of international interdependence. The global recession, set in motion by the bursting of the property bubble in the United States (the subprime mortgage crisis), revealed the structural disequilibria in the global economy and uncovered the flaws in domestic financial systems- particularly in Europe and the United States. The imbalances vary in nature: (a) the excess borrowing in the United States and the excess saving in China; (b) the developing countries’ tendency to build up international reserves, which generates a recessionary bias in the global economy since the flawed international monetary system is unable to provide stability among the main international reserve currencies; and (c) an international financial system that has turned out to be ineffective in terms of reducing the volatility of financial instruments, anticipating and averting the increasingly frequent financial crises, and opportunely supplying the financing needed to prevent balance-of-payments crises and the contagion of economies that are on sounder footings.

CONCLUSION

  The function of a letter of credit is to ensure function of remote purchases not only within countries but also in order to export goods to retailers in other countries. Necessary parties in a transaction carried out using a letter of credit. And due to banking transaction and LC, the effects of the financial crisis are increasingly evident. It is the most worrisome for Asia’s export-oriented economies, global shipping has been hit as exporters and importers struggle to secure letters of credit. This credit crisis has prevented banks from lending credit to investors. For which trade has fallen by a significant amount. Many countries have gone into recession. There has been a decline in the overall economic growth globally.

 BIBLIOGRAPHY

Pritchard. J (2012). New York Times.  Letters of credit: how letters of credit work    http://banking.about.com/od/businessbanking/a/letterofcredit.htm (Accessed on 18 July 2012).

Bnak of Maharashtra (2011).http://www.bankofmaharashtra.in/internet_banking.asp (Accessed on 18 July 2012).

Bank Transactions, (2012) http://www.turtlesoft.com/goldenseal-software-reference/Banking-Transactions.htm (Accessed on 16 July 2012).

Banking Transaction Services, (2011). http://www.postmasters.ie/services/financial/banking-transaction-services.html (Accessed on 16 July 2012).

Impact of crisis of World Trade. http://www.eclac.org/publicaciones/xml/7/36907/The_crisis_and_its_future_impact_chapter_I.pdf (Accessed on 20 July 2012)

Fraud Aid, (2008). http://www.fraudaid.com/dictionary-of-financial-scam-terms/letter_of_credit.htm (Accessed on 20 July 2012).

Economic Impact of the Financial Crisis, (2009). http://www.afdb.org/fileadmin/uploads/afdb/Documents/Policy-Documents/AfDB%20Response%20to%20the%20Crisis%20_%20web.pdf (Accessed on 20 July 2012).


[1] Article 4(a) UCP states this principle clearly. Article 5 the UCP further states that banks deal with documents only, they are not concerned with the goods (facts).

[2] The general legal maxim de minimis non curat lex has no place in the field of documentary credits.

[3] ISBP is issued in January 2003, reflected the best practices used by banks in determining compliance of stipulated documents

under LC. Its function is to serve as a guideline to practitioners dealing with documentary compliance

[4] The UCP is a body of Articles which regulate the implementation and operation of LC. The latest version is the UCP 600 which

has been implemented from 1st July 2007. Even though UCP has no force of law, it has been applied in almost transaction

involving LC.

[5] (1926) 25 LIL Rep 90; In this case, LC called for a certificate to be signed by experts, the bank paid against a document signed

by only one expert. The bank was not entitled to reimbursement.