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.
Letter of Credit vs Bank Guarantee
The main difference between Letter of Credit and Bank Guarantee is that a letter of credit is a document that a buyer’s bank gives to the seller with some conditions to supply the goods to the buyer, bank guarantee means the bank assures the seller that if the buyer fails to make the payment, then the bank will be responsible.
A letter of credit is risky for the bank, whereas a bank guarantee is risky for merchants.
Comparison Table Between Letter of Credit and Bank Guarantee
| 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.
Recipient
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.
Liability
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.
Risks
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.
Parties Involved
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.
Payer
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.
Prioritization
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.
Interventions
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.
Users
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.
Frequently Asked Questions (FAQ) About Letter of Credit and Bank Guarantee
Who pays for a Letter of Credit?
There are costs connected with letters of credit rating. Has it been agreed in between you and the purchaser who will pay these costs?
Remember, the letter of credit is an assurance from the bank of repayment; it will take place ONLY if:
1) All records exist in a timely manner, as well as in order
2) The guarantee originates from the issuing bank, the buyer’s financial institution, and only comes from your financial institution if you request for verification to be included.
Which documents are required for a Letter of Credit?
The documentation required in a letter of the credit depends on the degree of intricacy of the transaction.
Also, the degree of safety and security that the two parties desire to have on the transaction: security of payment, transparency pertaining to the description of the items, safety and security pertaining to the clearance of customs, transportation procedure, delivery promptly, as well as other sort of threats related to the deal.
Record conformity needs to be verified; this is one essential function of the endorsement/acceptance procedure for letters of credit score.
How much does a Letter of Credit cost?
Costs rates for a letter of credit coverage are based on issuing bank, as well as nation risks, the tenor(s) of the protected letter(s) of credit, as well as the guaranteed financial institution’s previous experience, if any, with the releasing bank and nation.
The letter of credit score cost is very affordable, typically dramatically much less than the expense of worldwide credit score costs for open-account international receivables.
A few underwriters set their costs rates based upon issuing banks, as well as country risks, while others examine costs as a portion of the insured financial institution’s confirmation charges or finance/discount spreads.
In all cases, the price of L/C costs can be passed to merchants or their foreign consumers.
What are the types of guarantees?
Direct Guarantee: The most typical means to issue a guarantee is by far the direct assurance and is issued by the count on the part of the principal for the recipient.
Indirect Guarantee: Occasionally, an indirect assurance may be stated as a problem in the underlying agreement.
In this plan, the bank initially issuing the guarantee, the advising financial institution, advises a neighborhood financial institution to issue the assurance in favor of the beneficiary in return for a counter-guarantee.
Under these situations, the instructing bank is bound to hold the local bank devoid of all risks, as well as duty in the status of the case under the guarantee.
What are the charges for Bank Guarantee?
Margin Money: This is a few percentages paid to the financial institution to proceed with the bank Guarantee.
Charges Sustained: Dealing With fees billed by the financial institution.
Fixed Deposit Number: In such cases, the offering event has any type of fixed deposits, it can be used for waging the financial institution assurance.
Conclusion
Now that you know the differences between these two commonly used financial instruments, we are pretty sure that you may now move on to find the right one for your use.
Just read through our explanations a second or third time to get to know their finer details. All the best now in your subsequent search and use.
References
- https://heinonline.org/HOL/LandingPage?handle=hein.journals/arz24&div=18&id=&page=
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2460246