Letters of Credit as Signals: Comments on Ronald Mann’s ‘The Role of Letters of Credit in Payment Transactions’

Why would buyers and sellers transact with each other through a third party that charges a significant fee for its services and that typically is authorized to make payment notwithstanding noncompliance with the very prerequisites that it has been engaged to monitor? This is the puzzle that Ronald Mann’s provocative and nuanced article purports to explain. Under the traditional story about the esoteric world of letters of credit, these transactions allow distant buyers and sellers to circumvent obstacles that would otherwise frustrate long-distance transactions. The traditional story explains that these credits induce buyers to approve payment prior to receiving conforming goods because the transactional structure provides buyers with documents that testify conforming goods are en route. Similarly, credits induce sellers to ship goods prior to payment because that same transactional structure assures that payment is forthcoming from a credible and creditworthy source. Mann suggests that the story is incorrect or at least incomplete. For him, the real function of the letter of credit is to solve informational asymmetries concerning the parties involved in the transaction by allowing an issuer with superior information to verify a buyer’s legitimacy to the distant seller or to the buyer’s government. I find the claim that letters of credit fill informational gaps highly plausible. Indeed, I take it to be wholly consistent with the traditional story that banks are asked to issue letters of credit because they have an informational advantage about the financial status of their customers, the applicants. It is less clear to me that what the beneficiary learns from the issuer’s conduct should be vaulted into a primary explanation for letters of credit. I want, therefore, to raise two issues with respect to the story that Mann tells us. One issue concerns his substantive claims about the role of letters of credit. The second is more directly related to the general theme of this conference and refleets on how Mann’s article may be refined, validated, or refuted by empirical work that has not yet been done.