What is the difference between a Bank Guarantee and a Letter of Credit?

Bank Guarantees (BGs) and Letters of Credit (LCs) are financial instruments which are key components in international trade and trade finance. LCs are used more frequently in international transactions in comparison to bank guarantees. However, bank guarantees are often used in real estate and infrastructure projects to reduce credit risks. When comparing the two instruments, the market for bank guarantees is much larger than that for LCs.

Bank Guarantees are used if the contractual obligations are not met by the other party

A Bank Guarantee is different from a Letter of Credit; it’s a promise from a financier or bank that if a borrower (or buyer) defaults on a loan, the loss will be covered by the funder.

Financial institutions issue bank guarantees to assist international trade transactions and help reduce credit risk (including the risk of a company defaulting). The agreed amount is referred to as the guaranteed amount. Bank guarantees play a vital role in the forfaiting market and also in high value transactions.

A bank guarantee is issued to the applicant for carrying out a transaction after necessary due diligence and is always given in favour of a beneficiary who would be affected in a case where the applicant fails to honour their contractual obligations (or in the case of default).

In ventures where two parties are obligated to perform certain duties for successfully completing a transaction or a project, both parties often prove their credibility and financial health by issuing bank guarantees to the other partner. When one party fails, the other party can invoke the bank guarantee by filing a claim with the lending institution and receive the guaranteed amount. Unlike LCs, Bank Guarantees protect both the parties involved.

Example of a Bank Guarantee

Let’s say the beneficiary ‘Example Incorporated’ is a boutique clothing manufacturer, looking to purchase £500k worth of garments and materials from a reputable factory in India. The vendor of the the garments might ask for a Bank Guarantee to ensure they receive payment from Example Incorporated, so that they can be sure of payment (as Example Incorporated are not very well known and a small trader in the market).

Example Incorporated would approach a lender who might be able to provide this guarantee, which is essentially like having a co-signee on the contract with the Indian factory.

Letters of Credit reduce the risks of not getting paid after the product has been delivered

A Letter of Credit is a ‘promise’ by a financial institution to honour the financial obligations of the buyer. It is used to mitigate the risk of the buyer failing to pay a seller.

It is often used in a transaction to reduce the risk of not being paid once the products have been delivered. An LC is issued to the buyer after carrying out any necessary due diligence and collecting sufficient collateral or security. The letter is then presented to the seller as a proof of the buyer’s credit quality.

Letters of Credit are governed by a set of rules, the UCP 600 (Uniform Customs and Practice for Documentary Credit), which were established by the International Chamber of Commerce.

Example of a Letter of Credit

Imagine ‘Telephone Equipment Limited’ sells telephones to big corporates in the USA, and needs to purchase £5 million in equipment from a Chinese manufacturer. However, the Chinese manufacturer are concerned about Telephone Equipment Limited’s ability to pay for the goods, and need some form of security or guarantee.

Telephone Equipment Limited can request a Letter of Credit (deferred payment) to be issued from its lender or bank, which will confirm payment to the Chinese manufacturer 90 days after the goods arrive at the agreed destination. Proof of goods being shipped through an Airway Bill or a Bill of Lading are required in order for payment to be released, and the security is often the goods themselves.

Letter of Credit: Explainer Video

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LCs and BGs are instruments to reduce payment risks to both parties

The critical difference between LCs and guarantees lie in the way these financial instruments are used. Merchants involved in the export and import of goods on a regular basis choose LCs to ensure delivery and payments, whereas contractors bidding for infrastructure projects prove their financial credibility through guarantees.

As tailored financial instruments, bank guarantees come in different forms such as an Advance Payment Guarantee, Loan Guarantee, Performance Guarantee, Deferred Payment Guarantee, Shipping Guarantee and Trade Credit Guarantee. Similarly, Lending institutions issue LCs in forms such as Import LCs, Export LCs, Revocable LCs, Irrevocable LCs, Confirmed LCs and Unconfirmed LCs.

Another striking difference between LCs and Guarantees are the way contracts are crafted. In LCs, the payment obligation is independent of the underlying contract of sale. It is widely understood that an LC (after issue) will be used to advance funds, but a BG is posted to display financial standing (not to be called upon).

Bank Guarantees are costlier than Letters of Credit due to their ability to protect both parties involved in the transaction. Also, Bank Guarantees usually cover a wide range of transactions.

Summary: what’s the difference between BGs and LCs?

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 fulfil their contractual obligations
    • Often used for contractors bidding on larger projects such as infrastructure contracts
    • Protects both parties in the transaction but favours the beneficiary (usually the importer)
    • Example: A BG could be used when a buyer purchases goods from a seller then runs into cash flow problems and cannot pay the seller (i.e. payment is guaranteed to the seller)

NEXT >> Standby Letters of Credit

Summary
Letter of Credit versus Bank Guarantee - What is the Difference?
Article Name
Letter of Credit versus Bank Guarantee - What is the Difference?
Description
A letter of credit is a commitment taken on by a bank to make a payment to a beneficiary once certain criteria are met whereas a Bank Guarantee is a bank's commitment to honour payment to a beneficiary if the opposing party does not fulfil their contractual obligations. Read our free LC 2017 guide
Author
Trade Finance Global
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