What is the difference between a Bank Guarantee and a Letter of Credit?
Bank Guarantees and Letters of Credit (LCs) are used in trade to carry out international transactions. LCs are frequently used in international transactions compared with bank guarantees. However, bank guarantees are often used in real estate and infrastructure development to mitigate credit risks. When comparing the two instruments, the market for bank guarantees is much bigger than that for LCs.
Letters of Credit reduce the risks of not getting paid after the product has been delivered
An LC is a promise by a financial institution to honour the financial obligations of the buyer due to the risk of the buyers failure to pay the seller. It is often used in a transaction to mitigate the risk of not getting paid post-delivery of the products. An LC is issued to the buyer after carrying out the necessary due diligence and collecting sufficient collateral. The letter is then shipped to the seller as a proof of the buyer’s credit quality.
Bank Guarantees are used if the contractual obligations are not met by the other party
Lending institutions issue bank guarantees as tailored financial instruments to carry out international transactions efficiently and these contracts help companies mitigate credit risks arising from inaction of a party in a project or a transaction. The agreed amount is referred to as the guarantee 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 obligations.
In ventures where two parties are obliged 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 partners. 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 in a project or a transaction.
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 exports and imports 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.
The critical difference between LCs and guarantees lie in the way these financial instruments are used. Merchants involved in exports and imports 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. 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 whereas bank guarantees can be tailored to cover quality of performance by the parties.
Bank Guarantees are costlier than letters of credit due to its ability to protect both parties involved in the transaction. Also, bank guarantees usually cover a wide range of transactions.
Summary: 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 projects.
- 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. (Payment is guaranteed to the seller.)