Difference between Letter of Credit and Bank Guarantee

Difference between Letter of Credit and Bank guarantee

There is always a credit risk for both buyers and sellers during domestic or international trade/ transaction between two parties. The letters of credit and bank guarantees, both are utilised to mitigate the credit risks of buyers. However, letter of credit and bank guarantee are not similar and often used (domestic and international) in different circumstances during the export and import transaction or performance of real sates and infrastructure projects.

Hence let us discuss the difference between a letter of credit and bank guarantee. But before we go ahead let me explain what does it mean by a bank guarantee and letter of credit.

Letter of Credit And Bank Guarantee:

A letter of credit (L/C) is a financial instrument issued by the banks or other financial institutions promising the buyer/ importer’s obligations will be fulfilled as per the contract between buyer and seller.

An L/C is frequently used during cross border trade or transactions where the importer and exporter are unknown to each other and rules and regulations of two different countries are applicable.

On the other hand, a Bank Guarantee (BG) is a financial guarantee of payment issued by the commercial banks on behalf of the buyer or tendering agencies assuring the payment mentioned if the buyer is unable to perform contractual obligations.

A bank guarantee is frequently used in domestic transactions, infrastructure projects, real state projects, Government tenders (as security) to ensure the performance of trade or tender/ projects according to the agreement.

Difference between Letter of Credit and Bank Guarantee:

Now let’s discuss what are the difference between bank guarantee and letters of credit based on the following parameters.

  1. The letters of credit are usually used in import & import of goods in which the creditworthiness of importer is uncertain, whereas, bank guarantees are used in domestic trading, real state and infrastructure projects (domestic or international), Government tenders.
  2. The major difference between a letter of credits and bank guarantee is that a letter of credit ensures the performance of transactions covering the credit risk of sellers, however, in case of bank guarantees, the issuing bank is responsible to compensate only if the debtor/ buyer defaults.
  3. In simple words, a letter of credit promises the guarantee of payment (buyer’s obligations) once the seller ships the goods, whereas a bank guarantee is claimed when the buyer unable to fulfil his obligations.
  4. The letters of credit (LC) reduces the risk involved during international transactions where the trades are done between two different countries having different rules and regulations, on the other hand, bank guarantees work as an insurance cover, such as if anything happens, the bank will compensate the loss occurred.
  5. There are four parties involved in letters of credit eg. buyer, advisory bank, negotiable bank, seller and confirming bank (optional), on the other hand, in case of bank guarantees, there are only three parties involved buyers/ contractors, banks and sellers/ government agencies.
  6. In case of L/C, the banks itself pay the amount to the seller whether buyer fulfils his financial obligation or not, however, the banks do the payment to the seller only when the buyer defaults.

Conclusion:

Hope you have understood the key difference between a letter of credit and bank guarantee, however, there are some similarities between LC and BG as well.

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

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References: tradefinancegloble.com (source)

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