Informality as a Bilateral Assurance Mechanism: Comments on Ronald Mann's The Role of Letters of Credit in Payment Transactions

Abstract:     
This paper comments on Ronald Mann's article "The Role of Letters of Credit in Payment Transactions." In that article, Mann shows that beneficiaries of letters of credit routinely fail to present complying documents and that the applicants and issuing banks just as routinely waive the resulting documentary defects. Based on this finding, he argues that, contrary to traditional understandings, beneficiaries do not in practice rely on letters of credit as a guaranty of payment, but rather as a signalling device. On his view, the willingness of a bank to issue a letter of credit serves as a credible signal, enforced by an implicit reputational bond, of the issuer's private information that the applicant is a reliable creditor; and this signal is more important to the beneficiary in practical terms than is any legal right to collect directly from the bank.

In this paper, I argue that Mann's account does not explain why parties would want to use a commercial letter of credit as their mechanism for verifying creditworthiness, or why, given that the parties have chosen to use a letter of credit to signal the buyer's reliability, they would avoid the presumably stronger signal of making the letter legally binding. The reason why Mann's explanation is incomplete, I suggest, is that he focuses on only half of the incentive problems inherent in the stereotypical commercial letter of credit transaction. When the bilateral nature of the risk is taken into account, the use of letters of credit, as well as the fact that in most instances they are honored despite technical noncompliance with their documentary conditions, becomes substantially more understandable.

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