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Letters of Credit vs Bank Guarantees
1 | Introduction to the Letter of Credit
2 | Different types of Letter of Credit
3 | UCP 600 and the Letter of Credit
4 | Problems with Letters of Credit
5 | Restricted Letters of Credit
6 | Letters of Credit vs Bank Guarantees
7 | Standby Letters of Credit
What is the difference between a Bank Guarantee and a Letter of Credit?
Bank guarantees and Letters of Credit are both used in international transactions, however the market for Bank Guarantees is much larger than that of LOC’s. Bank Guarantees are often used in real estate and infrastructure to mitigate credit risks, whereas Letters of Credit are frequently used in commodity markets other international markets.
A Bank Guarantee is similar to a Letter of credit in that they both instil confidence in the transaction and participating parties. However the main difference is that Letters of Credit ensure that a transaction goes ahead, whereas a Bank Guarantee reduces any loss incurred if the transaction does not go to plan.
Letters of Credit – Reducing the Risk involved
A Letter of Credit is a promise from a financial institution to honour the financial obligations of the buyer, and this then eliminates any risk of the buyer not fulfilling the payments. As a result, it is often used to mitigate the risk of not being paid post-delivery.
Furthermore, a LC is issued to the buyer after carrying out the necessary due diligence and collecting sufficient collateral to cover the guaranteed amount. The Letter is then presented to the seller as proof of the buyer’s credit quality.
Bank Guarantees – Failure of Contractual Obligations
Bank Guarantees help companies mitigate any risk arising from either side of the transaction, and play a large role in facilitating high-value transactions. The agreed amount is referred to as the guaranteed amount and will always fall in favour of a beneficiary.
In Ventures where two parties are obligated to perform certain duties in order to successfully complete a transaction, both parties often use Bank Guarantees as a way of showing their credibility and financial health.
Moreover, if one party fails, the other party can then invoke the bank guarantee by filing a claim with the lending institution and receive the guaranteed amount. Unlike LOC’s, Bank Guarantees protect both parties involved.
The Critical Difference
Merchants involved in the exports and imports of goods will choose Letters of Credit to ensure delivery and payments. In contrast, Contractors bidding for infrastructure projects will prove their financial credibility through Bank Guarantees.
Furthermore, another distinctive difference between the two instruments is that Bank Guarantees are more costly than their counterpart. This is due to its ability to protect both parties in the transaction, and also due to the Bank Guarantee covering a wider range of higher value transactions.
As they are tailored instruments, Bank Guarantees can come in different forms:
- Advanced Payment Guarantee – Typically ensures the performance of a commercial contract.
- Loan Guarantee – Promises to assume the debt obligation of the borrower if they face default.
- Performance Guarantee – Ensures the full and due performance of the contract in line with the original contract.
- Deferred Payment Guarantee – A promise for a payment which has been postponed.
- Shipping Guarantee – A written guarantee which will be presented to the carrier in the event of goods arriving before the arrival of the shipping documents.
- Trade Credit Guarantee – This covers the providers of a good/ service against the risk of non (or late) payment.
Similarly, lending institutions issue different forms of Letters of Credit:
- Import LC – Short-term cash advance that enables an importer to meet immediate payments.
- Export LC – A document containing instructions to the buyer’s bank that they must pay you on the condition that the agreed specifications are met.
- Revocable LC – uncommon due to the fact these LoC’s can be canceled by the bank at any time, for any reason.
- Irrevocable LC – This guarantees a buyer’s obligations to a seller.
- Confirmed LC – Present when the issuing bank may have a questionable quality of credit.
- Unconfirmed LC – A letter of credit that does not have the confirmation of any bank.
Summary: the difference between Bank Guarantees and Letters of Credit?
Letters of Credit (LCs)
- A letter of credit is a commitment taken on by a bank to make a payment to a beneficiary once certain criteria are met.
- Used more commonly by merchants involved in imports and exports of goods on a regular basis.
- Protects both parties in the transaction but favours the exporter.
- Example: A LC could be used in the shipment of goods or for the completion of a service.
Bank Guarantees (BGs)
- A Bank Guarantee is a bank’s commitment to honour payment to a beneficiary if the opposing party does not fulfill their contractual obligations.
- Often used for contractors bidding on larger projects such as infrastructure projects.
- Protects both parties in the transaction but favours the beneficiary (usually the importer).
- Example: A Bank Guarantee is used when a buyer purchases goods from the seller, who then encounters financial difficulty and cannot pay.