Difference Between Letter of Credit and Bank Guarantee

A letter of credit is a financial instrument that is issued out by one bank to another one. The receiving bank is often located in a foreign nation.

Its role is to guarantee the payments which are made to one person and is governed by a stringent set of rules and regulations.

A bank guarantee is similarly a financial instrument. This one is issued out by a bank or any other lending institution to a corporate entity.

Its role is to guarantee that the amounts borrowed will be repaid even if the debtor defaults on the repayment. Usually, it is the issuing authority that covers the debt.

Letter of Credit vs Bank Guarantee

The difference between Letter of Credit and Bank Guarantee is that a letter of credit is a document that a buyer’s bank gives to the seller with some conditions to supply the goods to the buyer, bank guarantee means the bank assures the seller that if the buyer fails to make the payment, then the bank will be responsible.

Letter of Credit vs Bank Guarantee

A letter of credit is risky for the bank, whereas a bank guarantee is risky for merchants.

Comparison Table

Parameters of ComparisonLetter of CreditBank Guarantee
ApplicationsA letter of credit is used to guarantee import businesses and is hence used to facilitate international trade.A bank guarantee is used to guarantee domestic trade and financial transactions. In many cases, it facilitates large infrastructural projects.
RisksThis instrument carries many risks to the bank but is nonetheless safer to the client.This one, on the other hand, carries many risks to the client but is safer to the issuing bank.
IssuerIt is issued out by a seller’s bank to the recipient’s bank which is often located in a foreign nation.Issued by a buyer’s bank to a corporate entity which in most instances is domiciled within the same nation or territorial jurisdiction.
PartiesFive parties are involved in drafting and executing this instrument. These are the confirming bank, negotiating bank, advising bank, issuing bank, beneficiary, and applicant.Three parties are involved in drafting and executing this instrument. These are banker, the beneficiary, and the applicant.
Conditions for PaymentsAll the laid down terms and conditions have to be met before the payments are released.The stipulated terms and conditions ‘have to be’ flouted before the instrument is invoked.

What is a Letter of Credit?

The letter of credit is a payment mechanism that is employed in international trade. Its role is to guarantee that the buyer of the merchandise concerned will pay for the goods and is hence creditworthy.

This letter goes by the names ‘banker’s commercial credit,’ ‘documentary credit’ or ‘letter of undertaking.’

Here is how it works: You order goods from country A, but you cannot pay up the dues in full for the time being.

You hence instruct your bank to issue out the ‘letter of credit’ to the bank of the foreign company. This company then gives you the goods and holds on for your payments later.

letter of credit

What is Bank Guarantee?

A bank guarantee is basically a promise from a lender, typically a bank or any other financial institution, to a corporate entity. It guarantees that should the lender in question default on remitting the dues, the issuing authority will step in to cover that debt.

This instrument is mainly used within the local borders.

Here is how it works: The company that intends to purchase the merchandise approaches its bank to ask for this instrument.

Its bank will draft it and send it out to the corporate entity which is about to sell its merchandises to the company concerned. The entity thereafter releases the goods and waits for the payments later.

bank guarantee

Main Differences Between Letter of Credit and Bank Guarantee

Use and Applications

The letter of credit is mainly used in global transactions such as in the import and exports of merchandises. Its primary role is to facilitate imports and exports of commodities.

The bank guarantees are most used domestically in funding large infrastructural projects which are costlier.

Recipient

In the case of a letter of credit, it is the seller’s bank that receives the instrument. The bank in question goes ahead to accept invoices that are drafted by the seller in anticipation of payments at a later date.

In the case of the bank guarantee, it is the beneficiary that receives the instrument. It assures the recipient of his dues no matter what.

Liability

This refers to how the risks of defaults are handled or taken care of. In the case of the letter of credit, the primary liability rests with the bank alone.

The case, however, differs from the bank guarantee in that it is the bank that takes care of this liability only if the client defaults. Simply put: the primary liability rests with the client.

Risks

All factors considered, the letter of credit is riskier for the issuing bank but safer for the merchant. The bank guarantee, on the other hand, is riskier for the merchant but safer for the issuing bank.

Parties Involved

To draft and implement the terms of a letter of credit, five parties are involved. These are the confirming bank, negotiating bank, advising bank, issuing bank, beneficiary, and applicant.

Only three parties are required though for the bank guarantee. These are the banker, the beneficiary, and the applicant.

Payer

The payment of the amounts owed is effected by different agents in both cases. In the case of a letter of credit, the payment is effected by the issuing bank as soon as it is due.

Conversely, the bank guarantee becomes only effective at such a time that the applicant defaults on remitting the dues.

Conditions for Payments

Before the amounts due may be remitted in either case, some conditions will have to be met. A letter of credit requires that the terms and conditions that are spelled out are met prior to the remittances of payments.

The bank guarantee, however, ‘requires’ that the party to the guarantee flouts the laid-down procedures before the document is honored.

Prioritization

Generally speaking, you have to prioritize the letter of credit if you happen to be an exporter. That is because the instrument protects the interest of both parties but tends to favor an exporter.

As for the bank guarantee, you have to prioritize it if you are an importer for the same reasons above.

Interventions

Though these documents are drafted and intended mostly to facilitate trade, they come to force under varying circumstances. The letter of credit only comes in when all the preconditions are met.

A bank guarantee will only be effected if a party to the agreement fails to meet his contractual obligations.

Users

Lastly, these two instruments are set apart by the kinds of users they might best serve. The letter of credit mainly favors those who engage in the export business.

These include the middlemen, agents, underwriters, and transporters. The bank guarantee, on the other hand, will mainly favor those domestic business people who handle large and often costly infrastructural projects.

Difference Between Letter of Credit and Bank Guarantee

References

  1. https://heinonline.org/HOL/LandingPage?handle=hein.journals/arz24&div=18&id=&page=
  2. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2460246
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