A letter of credit is an agreement or commitment by a bank (issuer) made at the request of a customer (account party) that the bank will honor drafts or other demands of payment from third parties (beneficiaries) upon compliance with the conditions specified in the letter of credit. Through the issuance of its letter of credit, the bank agrees to pay the sellerís draft, thereby substituting the bankís credit for that of the buyer. This often takes the form of a letter from a bank in one area of the country to a bank or merchant in another area introducing the person names, vouching for the customer and specifying a sum of money to be extended.
A bank charges a small annual fee for issuing a letter of credit, which is issued only to customers with the highest credit ratings. Unlike direct loans, the bank need not report obligations under letters of credit as liabilities in its financial statements, nor is the bank required to maintain a certain amount of bank reserves to back up its letter of credit obligations.