Introduction: Two widely utilised financial instruments are the Bank Guarantee (BG) and the Letter of Credit (LC). Although both are designed to safeguard the interests of the parties in a transaction, they have distinct purposes, functions, and applicable scenarios. This blog delves into the main differences between a Bank Guarantee and a Letter of Credit, providing insights on when and how to use each one effectively.
What is a Bank Guarantee?
A Bank Guarantee is a financial instrument given by a bank that promises to reimburse a loss or debt if the applicant (the party requesting the guarantee) fails to meet their contractual commitments. Essentially, it serves as a safety net for the beneficiary (the person to whom the guarantee is granted), ensuring that they will be reimbursed if the application defaults.
What is a Letter of Credit?
A Letter of Credit is a document issued by a bank to a buyer (importer) to secure payment to a seller (exporter) if certain terms and circumstances are satisfied. Payment is made when the seller provides the relevant documentation, such as shipping paperwork, invoices, and certificates of origin, indicating that they have met their contractual responsibilities.
Differences Between Bank Guarantee and Letter of Credit
Purpose and Function
Bank Guarantee (BG):
- The primary purpose of a BG is to provide assurance to the beneficiary that they will be compensated if the applicant fails to meet their obligations. It is often used in construction contracts, lease agreements, and other long-term contracts where performance or payment may be in question.
Letter of Credit (LC)
- An LC is primarily used in international trade to ensure that the seller will receive payment once they have shipped the goods and met all the required conditions. It facilitates trade by reducing the risk of non-payment for the seller.
Nature of Commitment
Bank Guarantee (BG)
- A BG serves as a secondary obligation. The bank only pays if the applicant fails to meet their obligations, making it a contingent liability. The bank steps in to fulfill the financial commitment only if the applicant defaults.
Letter of Credit (LC)
- An LC serves as a primary obligation. The bank is directly liable for paying the seller after the requirements of the LC have been met, regardless of the buyer’s financial status or desire to pay.
Risk Distribution
Bank Guarantee (BG)
- The risk in a BG is primarily on the beneficiary, as they depend on the applicant to fulfil their obligations. The bank only steps in if the applicant defaults.
Letter of Credit (LC)
- The risk is shared between the bank and the buyer. The bank takes on the responsibility of payment, ensuring that the seller receives their money as long as they meet the LC’s conditions.
Use Case Scenarios
Bank Guarantee (BG)
- BGs are commonly used in situations where performance or payment needs to be guaranteed, such as in construction projects, tender bidding, advance payment guarantees, and loan guarantees.
Letter of Credit (LC)
- LCs are primarily used in international trade to ensure payment for goods shipped across borders. They are suitable for circumstances in which the buyer and seller do not know each other well and the seller requires payment security.
Involvement of Documents
Bank Guarantee (BG)
- A BG often does not need the provision of documentation to initiate payment.The beneficiary simply needs to provide proof that the applicant has defaulted.
Letter of Credit (LC)
- An LC is a documentary credit, meaning that payment is made against the presentation of specific documents. For the seller to obtain payment, these papers must adhere to the requirements outlined in the letter of credit.
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Financial Impact on the Bank
Bank Guarantee (BG)
- A BG is a contingent liability for the bank, meaning that it only becomes a financial obligation if the applicant defaults. The bank’s balance sheet is not immediately impacted when issuing a BG.
Letter of Credit (LC)
- An LC represents a direct liability for the bank, as it is obligated to pay the seller once the conditions are met. This can have an immediate impact on the bank’s balance sheet.
Beneficiary’s Assurance
Bank Guarantee (BG)
- The beneficiary is assured of compensation only in the event of a default by the applicant. The BG provides security but is contingent on non-performance.
Letter of Credit (LC)
- The beneficiary (seller) is assured of payment as long as they fulfill the LC’s conditions. This provides a higher level of security for the seller, particularly in international trade.
Revocability
Bank Guarantee (BG)
- A BG is generally irrevocable, meaning it cannot be cancelled or altered without the consent of all parties involved. This provides stability and security to the beneficiary.
Letter of Credit (LC)
- An LC may be either revocable or irrevocable. Most LCs used in international trade are irrevocable, meaning they cannot be changed or cancelled without the agreement of all parties.
Cost Efficiency
Bank Guarantee (BG)
- The cost of a BG is normally determined by the amount guaranteed and the bank’s appraisal of the applicant’s creditworthiness. It may be less expensive than an LC because the bank’s duty is contingent.
Letter of Credit (LC)
- An LC can be more expensive since it places a direct financial obligation on the bank and requires meticulous document verification. The cost includes issue costs, advisory fees, and possible confirmation expenses.
Bank Guarantee (BG)
- Because BGs are contingent liabilities, they often have little influence on the applicant’s cash flow. The applicant may be required to submit collateral or margin money, although this does not result in an immediate financial outflow.
Letter of Credit (LC)
- An LC can impact the buyer’s cash flow, as it requires the buyer to have sufficient funds to cover the payment. The bank may also require the buyer to deposit the full amount or provide collateral.
Conclusion:
Both Bank Guarantees and Letters of Credit are essential tools in business transactions, especially in the realm of international trade. Despite their importance, they have distinct functions and are applicable in various situations. A Bank Guarantee acts as a safety net, ensuring that a loss will be compensated if the applicant does not meet their obligations. In contrast, a Letter of Credit guarantees payment to the seller once certain conditions are satisfied.
To gain insights on key trade finance instruments, read our article on the Characteristics and Benefits of a Letter of Credit to understand what makes LCs distinctly beneficial in securing international transactions. For understanding how performance bonds work to manage all types of risks and secure contracts, click Performance Bond and How Does it Work.