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.
- A letter of credit is a financial instrument that guarantees payment to a seller when certain conditions are met. In contrast, a bank guarantee is a promise by a bank to cover a loss if a borrower defaults on a loan or fails to fulfill contractual obligations.
- Letters of credit are commonly used in international trade to mitigate risk, while bank guarantees are used in various situations, including construction projects, loan agreements, and service contracts.
- Both instruments assure parties in a transaction but differ in their primary purpose and the types of risk they address.
Letter of Credit vs Bank Guarantee
When buyer’s needs to show he can pay the seller for the goods he is buying he shows a letter of credit or means he has credit to pay for the goods he is buying issued by a bank and mostly used in international exchange. On the other hand, if the buyer is unable to pay for the goods the bank is going to pay instead of him so the bank guarantees that the seller will get payment in every condition either he is going to pay or else the bank will pay.
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A letter of credit is risky for the bank, whereas a bank guarantee is risky for merchants.
|Parameters of Comparison||Letter of Credit||Bank Guarantee|
|Applications||A 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.|
|Risks||This 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.|
|Issuer||It 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.|
|Parties||Five 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 Payments||All 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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.