Letters of Credit (L/C)

Letters of Credit (L/C) are commonly used documents in international trade. L/C is a form for guarantee by the bank to the exporter or seller that an importer or buyer will meet its obligations of trade. The bank assumes the risk of default by the buyer in case it does not meet its financial obligation of payment for the trade transaction. The bank assures the credit rating of the buyer by checking past history or by requiring a full or partial security deposit in the amount of transaction. Islamic banks usually issue an L/C for a fee to cover their expenses, however, some L/Cs might require financing by the bank. Since the banks can not charge interest, they issue the L/Cs as a Wakalah, Musharakah, or Mudarabah contract.

In Wakalah (Agency) contract L/C the importer assigns the banks as an agent to open an L/C in favor of an exporter. The importer would deposit the entire amount of transaction with the bank. After ascertaining the shipment of goods, the bank makes the payment to the exporter. When goods arrive the importer will take delivery of the goods. The bank charges a commission for this service.

L/C is also formed under Murabaha or cost-plus-sale contracts. The customer would ask the bank to open an L/C and buy the goods from the exporter. Under this contract, the customer agrees to purchase the goods from the bank with agreed upon profit for the bank for financing the deal. Once the goods are shipped the bank uses its own funds to make payment to the exporter. When goods arrive at the port of destination either the bank or the customer acting as the bank’s agent takes delivery. The customer then takes ownership of the goods at the agreed Murabaha price with the bank’s profit built in. The price would be paid on deferred basis as per the contract.

Islamic banks also make L/Cs based on Musharakah (partnership) contracts. The customer deposits his share of the partnership amount with the bank and the bank opens the L/C according the customer’s request. Upon verification of shipment the bank would pay full payment to the seller. The bank or the customer acting as an agent takes delivery of the goods. The goods are sold in the market on fair price basis. The profit is split between the bank and customer according to the contract. The customer could also purchase the entire inventory and pay off the bank’s share at the market price. When customer later sells the goods the entire profit or loss belongs to the customer.
Since there is no concept of time value of money in Shari’ah, the banks can not charge interest in L/C business. However, they can charge a commission or fee for processing and documentation which is usually a fixed fee based on the service and amount of the transaction but not tied to the time. These fees include fixed amount for opening or issuing of L/C; advising cost for nominated ban; confirmation fee to guarantee payment which is a percentage of L/C amount; charges for amendments to the contract; commission for shipment verification for Sight L/C; negotiation of exporter documents under Usance L/C; foreign exchange charges; etc.