Letter of Credit vs Bank Guarantee: What is the Difference?

letter of credit vs bank guarantee
letter of credit vs bank guarantee

There is always a credit risk involved for both parties whenever two people engage in trade or business with one another, regardless of whether the transaction takes place domestically or globally. Buyers with credit issues can receive assistance through letters of credit and bank guarantees. But a letter of credit and a bank guarantee are different. When it comes to exporting and importing goods or working on real estate and infrastructure projects, both locally and internationally, they are frequently used in various ways that differ from one another.

Now that we have that out of the way, let’s compare and contrast a bank guarantee with a letter of credit. However, before we continue, let me clarify what a letter of credit and a bank guarantee are and what they are used for.

Letter of Credit and Bank Guarantee

A letter of credit, abbreviated “L/C,” is a type of financial instrument that banks or other financial institutions can provide with the promise that the obligations of the buyer or importer will be satisfied in accordance with the terms of the contract between the buyer and the seller.

During international trade or transactions, where the importer and exporter are unfamiliar with one another and the laws and regulations of two different nations are relevant, it is common practice to use a letter of credit (L/C).

On the other hand, a Bank Guarantee (BG) is a financial guarantee of payment issued by commercial banks on behalf of the buyer or tendering agencies assuring the payment mentioned if the buyer cannot perform contractual obligations. This occurs when the buyer cannot pay for their purchased goods or services.

It is common practice to use a bank guarantee in domestic transactions, infrastructure projects, real estate projects, and government tenders (in the capacity of a security instrument) to ensure that the trade or tender or project will be carried out in accordance with the agreement.

The difference between a Letter of Credit and a Bank Guarantee

Now that we’ve covered the similarities, let’s talk about the differences between bank guarantees and letters of credit based on the criteria listed below.

  1. Whereas bank guarantees are used in domestic trading, real estate and infrastructure projects (domestic or international), and government tenders, letters of credit are typically utilized in import and import of goods when the importer’s creditworthiness is unknown.
  2. The primary distinction between a letter of credit and a bank guarantee is that a letter of credit guarantees the performance of transactions while also covering the credit risk of sellers, whereas, in the case of bank guarantees, the issuing bank is only responsible for compensating if the debtor or buyer defaults on their payments.
  3. In layman’s terms, once the seller ships the goods, a letter of credit offers the guarantee of payment (buyer’s obligations), whereas a bank guarantee is claimed when the buyer cannot fulfill his commitments.
  4. The letters of credit (LC) help mitigate the risks inherent in international trade between countries that adhere to various legal frameworks. On the other hand, bank guarantees function more like an insurance policy because the bank will make good on any losses sustained if something untoward occurs.
  5. In the case of letters of credit, four parties are involved: the buyer, an advisory bank, a negotiable bank, the seller, and an optional confirming bank. In the case of bank guarantees, however, only three parties are involved, including the buyers or contractors, the banks, and the sellers or government agencies.
  6. In the case of letters of credit, the banks themselves pay the amount to the seller regardless of whether the buyer satisfies his financial responsibility or not. However, if the buyer fails to meet his financial commitment, the banks will make the payment to the seller.

Conclusion

I hope you understand the primary distinction between a bank guarantee and a letter of credit, but there are also some parallels between the two types of financial instruments.

  • Both letters of credit and bank guarantees are issued after assessing the creditworthiness of buyers and debtors.
  • Both LC and BG are issued against collateral.
  • The banks charge a fee for issuing both LC and BG.
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