Letter of Credit vs Bank Guarantee: Difference and Comparison

A letter of credit is a financial instrument that guarantees payment to a seller on behalf of a buyer for goods or services. In contrast, a bank guarantee is a promise by a bank to cover the financial obligations of a debtor to a third party if the debtor defaults.

Key Takeaways

1. 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.
2. 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.
3. 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 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.

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

Comparison Table

Aspect	Letter of Credit (LC)	Bank Guarantee (BG)
Purpose	Facilitates international trade by providing a guarantee of payment to the seller (beneficiary) from the buyer’s bank (issuer) upon compliance with specified terms and conditions.	Provides a financial guarantee to the beneficiary (a seller or supplier) that the obligor (the applicant or buyer) will fulfill its contractual or financial obligations.
Parties Involved	Three main parties: Applicant (buyer), Beneficiary (seller), and Issuing Bank (applicant’s bank). In some cases, there may be confirming banks and advising banks.	Three main parties: Beneficiary (seller or supplier), Applicant (buyer or obligor), and Issuing Bank (the applicant’s bank). May also involve confirming banks and advising banks.
Purpose of Issuance	Ensures that the buyer makes payment to the seller as per the terms of the sales contract.	Ensures that the obligor fulfills its contractual obligations, such as payment, performance, or completion of a project.
Payment Guarantee	Provides a guarantee of payment to the beneficiary upon presentation of compliant documents or fulfilling specific conditions outlined in the LC.	Serves as a guarantee of payment to the beneficiary if the obligor defaults on its obligations as specified in the BG.
Types	Different types include commercial LCs (for trade), standby LCs (as backup or performance assurance), and revolving LCs (reusable for multiple transactions).	Various types, such as performance guarantees, payment guarantees, bid bonds, advance payment guarantees, and financial guarantees.
Conditional Payment	Payment is conditional upon the beneficiary complying with the terms and conditions outlined in the LC, including presenting compliant documents.	Payment is made upon default or non-performance of the obligor’s obligations, as stipulated in the BG.
Termination	LCs expire upon completion of the transaction or on a specific maturity date, whichever occurs first.	BGs expire upon fulfillment of the obligor’s obligations or the expiration of the guarantee period, whichever comes first.
Usage in Trade Finance	Commonly used in international trade to facilitate secure transactions and build trust between buyers and sellers across borders.	Less common in trade finance but may be used in specific situations where performance or payment assurances are necessary.
Risk Allocation	Shifts risk from the buyer (applicant) to the issuing bank, which undertakes to make payment to the seller upon compliance.	Shifts risk from the beneficiary to the obligor’s bank, which commits to paying the beneficiary if the obligor defaults on its obligations.
Cost	LC charges include issuance fees, confirmation fees (if applicable), and document examination fees.	BG costs include issuance fees and annual fees, which can vary depending on the nature and duration of the guarantee.
Document Presentation	LC requires the beneficiary to present specific documents that comply with the LC’s terms to receive payment.	BG does not require document presentation; payment is triggered by the obligor’s default.
Use in Construction	LCs may be used to secure payments in construction projects, but they are more common in trade finance.	BGs are frequently used in construction contracts as performance guarantees and payment guarantees.

What is Letter of Credit?

A Letter of Credit (L/C) is a financial document commonly used in international trade transactions. It serves as a guarantee from a bank to the seller that the buyer will fulfill their payment obligations, providing a secure and reliable method for conducting cross-border business.

Mechanism

1. Initiation and Agreement
   • The buyer and seller agree on the use of a Letter of Credit in their transaction. The buyer then approaches their bank to issue the L/C in favor of the seller.
2. Issuance by the Bank
   • The buyer’s bank issues the L/C, specifying the terms and conditions agreed upon. This document assures the seller that they will receive payment if they fulfill the requirements outlined in the L/C.
3. Presentation of Documents
   • Upon completing the shipment or fulfilling the terms, the seller presents the required documents (such as invoices, shipping documents, and certificates) to their bank.
4. Examination by the Bank
   • The seller’s bank reviews the documents to ensure they comply with the L/C terms. If everything is in order, the bank forwards the documents to the buyer’s bank.
5. Payment to the Seller
   • The buyer’s bank releases payment to the seller, completing the transaction. In case of discrepancies, the banks may resolve issues through negotiation.

Types

• Revocable vs. Irrevocable:
  • Revocable L/C can be modified or canceled by the buyer without notice, whereas an irrevocable L/C cannot be altered or revoked without the consent of all parties involved.
• Confirmed vs. Unconfirmed:
  • A confirmed L/C involves an additional guarantee by a second bank (in the seller’s country), providing extra security compared to an unconfirmed L/C.
• Transferable vs. Back-to-Back:
  • Transferable L/C allows the seller to transfer the credit to another party, while back-to-back L/C involves the issuance of a second L/C based on the original credit.

What is Bank Guarantee?

A bank guarantee is a financial instrument provided by a bank on behalf of a customer, ensuring that specified financial obligations will be met. This commitment serves as a form of security for the recipient in case the customer fails to fulfill their contractual or financial obligations. Bank guarantees are commonly used in various business transactions to build trust between parties and mitigate risks.

Types of Bank Guarantees

1. Performance Guarantee:
   • Issued to assure the satisfactory completion of a project or contract. It safeguards the beneficiary in case the contractor fails to meet agreed-upon performance standards.
2. Payment Guarantee:
   • Ensures that the buyer will make payment for goods or services as per the terms of the agreement. This type of guarantee protects the seller from non-payment risks.
3. Bid Bond:
   • Submitted by a contractor along with a bid to guarantee that, if awarded the contract, they will enter into a contract and provide the required performance and payment guarantees.
4. Advance Payment Guarantee:
   • Issued to the buyer’s bank on behalf of the seller, ensuring the proper utilization of advance payments. It provides the buyer with a level of assurance that the funds will be used for the intended purpose.

Process of Obtaining a Bank Guarantee

1. Application:
   • The customer (applicant) submits a formal request for a bank guarantee to their bank, providing details such as the type and amount of the guarantee, as well as the terms and conditions.
2. Bank Assessment:
   • The bank evaluates the customer’s creditworthiness and assesses the risks associated with issuing the guarantee. This may involve collateral or a cash margin.
3. Issuance:
   • Upon approval, the bank issues the guarantee in favor of the beneficiary (the party receiving the guarantee), clearly specifying the conditions and terms.
4. Expiration and Renewal:
   • Bank guarantees have a predetermined validity period. If needed, the customer may request an extension or renewal before the expiration date.

Main Differences Between Letter of Credit and Bank Guarantee

1. Purpose:
   • Letter of Credit (LC): LC is primarily used to facilitate international trade by ensuring that the seller (exporter) will receive payment once they meet the specified conditions, related to the quality and delivery of goods or services.
   • Bank Guarantee (BG): BG guarantees that the party for whom it is issued will fulfill a specific obligation or contract. It is not directly related to trade but can be used in various contexts, including construction projects, bid bonds, and payment guarantees.
2. Party Involvement:
   • Letter of Credit (LC): Involves three parties: the buyer (importer), the seller (exporter), and the issuing bank. The LC ensures that the seller receives payment from the buyer’s bank once the terms and conditions are met.
   • Bank Guarantee (BG): Involves two parties: the beneficiary (party receiving the guarantee) and the issuing bank. BGs guarantee the beneficiary that a specific obligation will be fulfilled.
3. Financial Obligation:
   • Letter of Credit (LC): LC represents a financial commitment to make a payment to the seller once the seller complies with the terms of the LC.
   • Bank Guarantee (BG): BG represents a financial promise to pay a specified amount to the beneficiary if the party for whom the BG was issued fails to fulfill their obligation.
4. Payment Trigger:
   • Letter of Credit (LC): Payment is triggered by the seller’s compliance with the terms and conditions outlined in the LC.
   • Bank Guarantee (BG): Payment is triggered by the failure of the party for whom the BG was issued to fulfill their obligation.
5. Types:
   • Letter of Credit (LC): There are different types of LCs, including revocable and irrevocable LCs, confirmed and unconfirmed LCs, and standby LCs.
   • Bank Guarantee (BG): BGs come in various forms, such as bid bonds, performance guarantees, financial guarantees, and advance payment guarantees.
6. Use in Trade:
   • Letter of Credit (LC): LCs are widely used in international trade to provide assurance to both buyers and sellers that the terms of the trade agreement will be honored.
   • Bank Guarantee (BG): While not directly related to trade, BGs are commonly used in construction contracts, real estate transactions, and other situations where financial security is required.
7. Cancellation and Amendment:
   • Letter of Credit (LC): LCs can be amended or canceled with the consent of all parties involved, including the buyer, seller, and issuing bank.
   • Bank Guarantee (BG): BGs are irrevocable and cannot be canceled or amended without the beneficiary’s consent.
8. Cost:
   • Letter of Credit (LC): Banks may charge fees for issuing and administering LCs, which can vary depending on the complexity of the LC.
   • Bank Guarantee (BG): Banks charge fees for issuing BGs, and the cost may vary based on factors like the amount and duration of the 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