Letters of Credit Vs. Bank Guarantees – A 2022 Guide to Their Differences

Letters of Credit vs Bank Guarantees

Trade Finance Global / Introduction to Letters of Credit | 2022 Guide / Letters of Credit Vs. Bank Guarantees – A 2022 Guide to Their Differences

Bank Guarantee vs. Letter of Credit: What’s the difference?

Both the Bank Guarantee and a Letter of Credit (LCs) build trust between parties and reduce risks of non-payment between a buyer (importer) and the supplier (exporter). However there are slight differences in their purpose and use in international trade.

Letter of Credit

What is an LC?

An LC is a contract via a bank that helps guarantee the payment of a supplier as long as the supplier meets the conditions agreed upon in the LC.

In an LC, the buyer and seller will enter a sales contract, and the buyer (importer) will apply for a letter of credit with their bank (issuing bank),  which will be sent to the supplier’s bank (advising bank).

If accepted, the supplier will deliver goods that meet the requirements and standards made out in the LC and will send confirming documents to their advising bank.

The advising bank will pass this on to the issuing bank, and the buyer will examine and honour or refuse payment.

There are different types of letter of credit, which will you can see here. For more information on LCs please click here

Bank Guarantee (BG)

What is a bank guarantee?

Parties to a trade transaction can use bank guarantees to demonstrate the ability to perform duties in their transaction. The bank’s role can be characterised as minimizing the losses to parties if the counter-party is unable to fulfill their roles stipulated in the contract.

Both parties can apply for bank guarantees and the bank guarantees can come in multiple forms. Normally in the process, if one party fails, the other party can then invoke the bank guarantee by filing a claim with the bank and receiving the guaranteed amount.

Some umbrella examples are whether a bank guarantee is performance or financial-based.

Performance-based: If the supplier is unable to meet contractural obligations as pertains to the delivery of goods, for example, the quality or quantity of goods. The buyer can file a claim to the value of goods that is owed to the buyer or as agreed in the bank guarantee.

Finance-based guarantees: If a buyer (importer) is unable to pay the supplier (exporter), the supplier can file a claim, and the bank will pay the supplier.

The guaranteed amount and what constitutes a break in the contract will be stipulated in the bank guarantee. The agreed amount to be paid is referred to as the guaranteed amount and will always fall in favour of a beneficiary.

Bank guarantee, Letters of Credit, Shipping, Trade

Uses of LCs and BGs in international trade

Why would an Importer want an LC?

The LC has the outcome of providing confidence that the supplier (exporter) will send goods up to the standard and date required by the buyer (importer). If the correct documentation isn’t confirmed and accepted by the banks and the buyer, the supplier will not receive payment

Why would an exporter want an LC?

From the point of view of an exporter, it provides trust that the importer creditworthy because the importers issuing bank will have undergone due diligence to check the creditworthiness of the buyer.

Why would an importer want a bank guarantee?

Bank Guarantees may be used in international trade when bidding for commercial contracts.  An importer may ask for a bank guarantee from the exporter to secure a bid.

It provides the importer with confidence because a bank guarantee from the exporter can be tailored so that if the exporter fails to meet the contractual obligations of the bid then the importer can be reimbursed by the bank.

Furthermore, from the point of view of the importer, the fact that a supplier can take out a bank guarantee means the exporter has a relationship with a bank and is more trustworthy. 

Why would an exporter want a bank guarantee?

From an exporter’s point of view, the importers application for a bank guarantee helps protect exporters from non-payment and instills confidence in the transaction. This is because the importer’s bank will have completed due diligence on the importer before creating the bank guarantee, this means that the bank has checked the creditworthiness of the importer. 

The exporter can request a bank guarantee from the importer. This bank guarantee will mean that the supplier will receive payment from the bank if the buyer is unable to pay.

What are the critical differences?

In the case of late payments, with bank guarantees, the bank will only step in if the party is unable to meet obligations in the contract before the bank steps in, so can still lead to late payments. Whereas the date of payment is already set in an LC, so the issuing bank or confirming bank is more likely to pay on time.

For bank guarantees, because both parties can take out bank guarantees, both are protected if either party fails to meet their contractual obligations.

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.

Summary of types

Bank Guarantees

Bid Guarantee. In this case, the bid bond shows that the supplier is creditworthy and that if the buyer has paid for goods and the supplier fails to deliver on the contract, the buyer can be reimbursed through a guarantee. 

Performance Guarantees: If a supplier doesn’t meet obligations under the contract, the bank can step in a repay the buyer. 

Advance Payment Guarantee: The bank will pay the importer, if the exporter doesn’t meet contractual obligations, repaying the payments made by the buyer to the supplier.

Deferred Payment Guarantee: The payment is made at a set number of days after a defined event in the transaction, both the date and event being stipulated in the guarantee. 

Shipping Guarantee: This is most commonly taken out under an LC. In the event that an importer has not received the bills of lading (BL) when the goods have in the port. The importer can ask for a shipping guarantee issued by the bank. They can present this to move the goods out of port without presenting the BL. Increasing speed through the port, reducing costs from loss of perishable goods value and demurrage charges. 

Letter of Indemnity (LOI): This will be taken out in the event that bills of lading hasn’t been received before the arrival of goods at the port. Carriers will ask for LOI. Without an LOI carriers may not be covered by their Protection and indemnity insurance (P&I). An LOI can be obtained from a bank or insurance company. LOI does not remove carriers liability.

Letters of credit

Import LC: Secures the means of payment to the supplier through the issuing bank, and the buyer will only have to pay once the documents stipulated in the LC are presented by the supplier. You can negotiate longer terms of payments with the supplier, for example using a Usance LC.

Usance LC: Payment will be made by the buyer’s issuing bank to the supplier at a later date stipulated in the contract. This allows the buyer time to use the goods productively and send payment.

Export LC: Issuing bank, or the confirming bank will guarantee payments if the conditions in the LC are met and the exporter has provided the confirming document.s

Irrevocable LC: A buyer can cancel or amend the LC, as long as both parties agree. This allows them to enter into a new LC if the sales contract changes or the circumstances of the transaction. The LC also cannot be revoked by the issuing bank without the beneficiary’s consent.

Confirmed LC: The supplier can ask their bank to take on the risk of non-payment in the LC.

Once the bank has received the required documents to meet conditions in the LC, the bank will send money to the supplier. Even if the buyer or issuing bank is unable to pay the amount stipulated in the LC. This normally incurs a charge made by the bank to the supplier dependent on the credit risk of the issuing bank.

Unconfirmed LC: If conditions in the LC are met, payment to the supplier is the responsibility of the buyers issuing bank. The risk on non-payment is with the issuing bank, which is usually a foreign bank. This is cheaper than a confirmed LC.

 

A special thank you to Peter Sproston for his additional comments.

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About the Author

Marcus Lankford is a Policy Analyst at Trade Finance Global (TFG).

He holds a BA in Economics and Politics, with a core focus on International and Environmental Economics, Political Lobbying and Digital Information at Work.

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