What a Letter of Credit Buys—and What It Costs
This chapter examines the letter of credit as a way of reallocating the risks between an importer, an exporter, and their banks. The practical question is not whether a letter of credit is “safe,” but what it makes safer, what the bank must verify, and when the resulting cost is worth paying. That distinction helps explain why the instrument can be valuable for a risky transaction yet difficult for a small or inexperienced firm to use.
Three ways to divide the risk
International trade usually requires one party to trust the other before the transaction is complete. Goods take time to produce and ship; payment may be due before the buyer can inspect them or after the seller has already surrendered control. A seller that ships first risks non-payment. A buyer that pays first risks non-delivery, delay, or goods that do not meet the agreement. The two parties are not facing the same exposure, and the payment term decides who carries more of it.
With cash in advance, the importer pays before the exporter sends the goods. This protects the exporter’s cash flow and reduces the exporter’s fear of non-payment. It does the opposite for the importer: money leaves before delivery is secure. The importer may accept that risk when the supplier has bargaining power, the goods are scarce, or the relationship is not yet strong enough for credit.
With open-account trade, also called trade credit, the exporter sends the goods and waits to be paid. That arrangement gives the importer time to sell or use the goods before cash is due. The exporter, however, becomes the creditor. If the importer diverts funds, fails, or simply refuses to pay, the exporter must rely on private enforcement, commercial pressure, or a legal system that may be slow or weak across borders.
A letter of credit places a bank between those two promises. The importer commits to paying the bank, perhaps by depositing cash, providing collateral, or relying on an established banking relationship. The exporter is paid when the agreed documentary conditions are met, typically by presenting evidence connected to shipment or delivery. The bank’s role is to monitor the transaction and settle payment against a fee. It does not make the underlying commercial relationship risk-free; it changes who verifies the promises and when payment is released.
The choice is therefore not between risk and no risk. It is between different risk allocations. Cash in advance protects the exporter at the importer’s expense. Open account protects the importer’s liquidity at the exporter’s expense. A letter of credit asks a bank to absorb and manage part of the commitment problem, while charging for the work and risk involved.
That last feature is easy to miss. A letter of credit can be most useful precisely when the importer and exporter know little about each other. But limited information is also what makes the bank’s job demanding. The bank must decide whether the parties, documents, country, currency, and transaction are sufficiently credible. A firm that cannot demonstrate a reliable record may need intermediation more than an established firm while being more expensive to serve.
What the bank actually does
The bank-mediated arrangement can be understood as a sequence of commitments rather than as a general insurance policy. The importer begins by asking an issuing bank to support the purchase. The bank assesses the requested transaction and the importer’s ability to meet the commitment. If it agrees, the letter of credit states the conditions under which payment will be made.
The exporter then ships the goods and presents the required documents. The bank checks those documents against the agreed conditions. When they comply, the bank arranges payment to the exporter and seeks payment from, or enforces the commitment against, the importer. Each step turns an uncertain private promise into a condition that another institution can inspect.
The sequence also shows where failure can occur. The exporter may not ship, the documents may not satisfy the stated conditions, the importer may lack the funds or collateral to honor the commitment, or the bank may decide that the transaction is outside its risk appetite. Bank intermediation reduces the risk that one party can simply disregard the other’s promise, but it cannot eliminate production failure, documentary discrepancies, currency shocks, or the cost of resolving a dispute.
The bank’s contribution has two sides. First, it supplies a credible commitment: the exporter does not have to rely only on the importer’s promise to pay. Second, it supplies monitoring. The documents and conditions give the bank a structured way to determine whether the payment obligation has been triggered. That structure is valuable when private information is scarce, but it is not free. Reviewing documents, maintaining controls, assessing counterparties, and managing cross-border exposure consume staff time and balance-sheet capacity.
The price of replacing trust
The CESifo model represents the cost of a letter of credit as a variable component tied to the payment amount plus a fixed monitoring component. The variable part grows with the value of the transaction. The fixed part represents the work of setting up and monitoring the instrument. In practice, some of that burden appears as a fee; some may appear as collateral requirements, time spent preparing documents, or the need for a long-standing banking relationship. The model also notes that exporters can face negotiation or confirmation fees, although the importer typically bears the main issuance cost.
This cost structure creates a tension between protection and affordability. If a bank charges too much, the risk reduction no longer compensates the firm for the fee and effort. If the firm’s transaction is small, the fixed burden takes a large share of the expected margin. If the firm is young or unfamiliar to the bank, the bank may need more verification and may demand more security. The firm can then face a double disadvantage: the transaction is hard to execute without protection, and the protection is expensive because the firm is hard to assess.
The cost is not merely a price attached after the useful part has happened. It changes the set of transactions that can be attempted. An importer may have a willing supplier and a profitable order, but still lack the cash deposit, collateral, records, or banking relationship needed to make the bank comfortable. The exporter may accept the bank’s involvement but require confirmation from another institution, adding another layer of assessment. From the bank’s perspective, country and counterparty risk affect the work required to verify payment and delivery; from the firm’s perspective, that same work appears as a fee, a condition, or a delay. The parties are looking at one process from different balance sheets.
Consider a hypothetical importer with two possible orders. The first is a small shipment from a new supplier. The supplier will not ship without bank-backed assurance, but the order’s margin is too narrow to absorb a substantial fixed monitoring burden. The second is a much larger shipment with the same unfamiliar supplier. The underlying counterparty risk has not disappeared, yet the value at stake may now justify paying for independent verification. If the two parties later trade repeatedly and learn that the supplier delivers reliably, an open-account arrangement may become attractive. The relevant question changes over time: first, whether the order can be trusted at all; later, whether continued bank monitoring is worth its cost.
The comparison should also be made against the best available alternative, not against an imaginary transaction with no risk. A firm may compare a letter of credit with cash in advance, open-account trade, documentary collection, or another loan. The value of the letter of credit depends on how risky those alternatives are for the particular counterparty and corridor. If a buyer and seller have traded repeatedly and can enforce their agreement, open account may be safer and cheaper than adding a bank. If the importer has no established relationship and the exporter will not ship without assurance, a letter of credit may be the only arrangement that makes the order possible.
The same firm characteristic can therefore push use in opposite directions. A larger firm may receive better bank terms because the bank can spread its monitoring cost over more business. That lower cost makes a letter of credit more attractive. But the same firm may possess better market intelligence, more experienced staff, or alternative sources of finance. Those capabilities make direct trade safer and reduce the need for a bank-backed instrument. Whether the firm uses more or less depends on which effect is stronger.
Why scale and repetition matter
A fixed cost favors transactions large enough to absorb it. The CESifo model predicts that the net gain from a letter of credit, measured relative to transaction value, improves as revenue rises because the monitoring burden is spread over a larger base. This is not a claim that large shipments are always safer. It is a claim about the arithmetic of intermediation: a fee that is tolerable on a major order can consume the margin on a small one.
The data are consistent with a second effect. For importers, letter-of-credit use rises with the value of a product-and-country transaction but falls with the number of months in which the same relationship is repeated. A large, occasional shipment may justify setting up bank monitoring. Repeated transactions with one partner may create enough knowledge and trust for the parties to use a cheaper direct arrangement, even though the total annual value is high. For exporters, both transaction value and frequency are positively associated with letter-of-credit use in the study, consistent with a different distribution of costs: exporters may bear processing or confirmation costs, while importers generally pay for issuance.
This helps explain why the instrument cannot be evaluated by asking only whether the firm is “risky.” The relevant question is whether the incremental security is worth the full cost in this transaction. A small importer may face serious non-delivery risk but have too little scale to justify the bank’s fixed work. An established importer may face the same nominal country risk but possess relationships that make open-account trade acceptable. A large transaction with an unknown supplier may support a letter of credit because the value at stake is high enough to pay for independent monitoring.
Selected market studies summarized by ADB illustrate the pressure created by these costs. In the emerging markets covered by those studies, a letter of credit averaged around 2%–5% of transaction value, while working-capital loans often used as a substitute averaged about 15% annually. Those figures are not a universal price list: they come from particular markets and instruments, and a loan rate is not identical to a letter-of-credit fee or the time spent complying with documentary conditions. They do show why firms may seek protection and still find formal finance unaffordable.
The boundary of the guarantee
A letter of credit does not turn every commercial disagreement into a bank obligation. Its force depends on the terms written into the instrument and on the parties’ ability to satisfy them. The bank monitors an agreed documentary process; it does not replace the exporter’s production capability, the importer’s solvency, or the legal and logistical institutions around the trade. The model abstracts from some residual bank exposure, and real transactions can involve confirmation, negotiation, and enforcement costs beyond the simplified fee.
For that reason, the letter of credit should be understood as a conditional bridge between two parties, not as a universal solution to weak trade relationships. It is attractive when the benefit of reducing payment or delivery risk exceeds the cost of bank intermediation. That balance changes with information, transaction scale, repeated dealings, currency, collateral, and the quality of alternatives.
The mechanics make the access paradox visible. Bank involvement substitutes institutional verification for private trust. But the need for verification is greatest where information is weakest, and the cost of verification is then hardest for a small or inexperienced firm to bear. To understand how large that problem is, the next question is not simply how often letters of credit are used. It is what the available numbers count—and which firms disappear before they can be counted.