Letters of credit vs Bank guarantees The Definition and the Key differences
A Bank guarantee or a letter of credit are very similar. Both are essentially the assurance that borrowers will repay a debt to third parties irrespective of their financial circumstances.
If borrowers are unable to pay, they must still repay their lenders. Both sources of finance facilitate trade by backing the borrower financially. They significantly reduce transaction risks and speed up the trade process.
However, there are underlying differences between the two. Letters of credit are widely used in global transactions. This is due to the variation of laws in different countries, especially when it is difficult for both parties to meet in person.
Letters of credit are more widely used in international trade. A bank guarantee can be a better option in real estate contracts and infrastructure projects.
Bank Guarantee
A lending institution makes a promise that a bank will pay on behalf of a debtor if they are unable to pay. A bank guarantee generally imposes more contractual obligations than a letter of credit.
A Bank guarantee fundamentally protects both parties from credit risk. This is the most important factor in the trade.
For example, a construction company enters a contract with a cement supplier. They go to the bank for the contractual agreement. Both parties must prove their financial capabilities to meet the terms and conditions of the contract, which are primarily financial.
If the supplier fails to deliver the cement on time, the construction company notifies the bank. The bank will then pay the company on behalf of a supplier as part of the bank guarantee.
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Types of bank guarantee
Bank guarantees are similar to other financial instruments. There are two types:
- Direct bank guarantee – Issued by banks for domestic and international businesses.
- Indirect bank guarantee – Issued for government projects or those related to a public entity.
Other types of bank guarantees:
- Shipping guarantee: Given to the carrier of a shipment arriving before documents are received.
- Loan guarantee: A financial obligation of the bank to pay the money if a borrower defaults.
- Advance payment guarantee: This guarantees the payment in advance even if a seller does not supply goods within a specified time.
- Confirmed payment guarantee: This guarantee is irreversible. It compels the bank to pay to a beneficiary within a certain defined date.
Letters of credit
A Letter of credit [LC] is a financial instrument that proves creditworthiness. It is also referred to as documentary credit. An LC is often confused with bank credit as they both share certain common characteristics.
A Letter of credit guarantees payment to a seller from a buyer within a specified time. If a buyer fails to pay, the bank will pay on his behalf the full amount to a seller.
However, they have pre-defined terms and conditions. Once these criteria are met, the bank will release the funds to the seller. Let’s understand it with a simple example:
A UK-based wholesaler orders goods from a French company. Both parties have no previous business relationship. There is a risk of non-payment as the wholesaler has inadequate information about a new company with which he wants to trade. They then request a letter of credit to ensure the payment.
The buyer applies for a letter of credit to a bank where they have sufficient funds for a line of credit. The bank then issues a letter of credit on behalf of the buyer. The LC guarantees the payment, provided certain conditions met by the seller.
The seller has specific criteria to comply with also, which are specified in the LC. Furthermore, they must meet all the terms and conditions with documented evidence. The bank will transfer the funds only after all terms and conditions are met.
An LC facilitates international trade with secure transactions. It accelerates trade and creates new opportunities for businesses.
Similar to a bank guarantee, there are various types of letters of credit:
- An irrevocable letter of credit – The buyer is obliged to pay the seller for the goods.
- A confirmed letter of credit – Guarantee from the second bank. It issues the letter in case of questionable credit from the first bank. It basically confirms the payment if the issuing bank defaults on the payment
- An import letter of credit – Enables importers with finance to pay in advance
- An export letter of credit – Obliges Obligation to the buyer’s bank to make the payment given all terms and conditions are met
- A revolving letter of credit – Allows both parties to withdraw from the contract within a specific period
Underlying differences
Both reduce payment risks, secure transactions, and work as a catalyst to increase trade.
Letter of credit Vs Bank guarantee – comparison
| # | Letter of credit | Bank guarantee |
|---|---|---|
| Definition | A Letter of credit is a financial instrument to guarantee payment. | A Bank guarantee is an assurance given by the bank on behalf of a buyer to the beneficiary. |
| Liability | Primary | Secondary |
| Risk levels | Lower for traders, higher for the bank. | Higher for traders, lower for the bank. |
| Parties | Generally 5 or more – applicant,beneficiary, issuing bank, negotiating bank, confirming bank. | 3 – applicant, beneficiary and bank |
| Payment terms | Payment is transferred upon the fulfillment of all conditions. | Payment is made even if the obligation is not fulfilled. |
| Preferred for | Import and Export business. | Government projects. |
Final words:
A Letter of Credit is widely used in international trade. They are becoming increasingly popular in domestic business as well. It is owing to the assurance of payment.
The seller must be paid. The buyer must pay on time. A letter of credit serves both purposes. A bank guarantee is usually preferred to fulfill certain obligations. It helps meet requirements and assures payment to the beneficiary.
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