Letter of Credit and Bank Guarantee are two financial instruments that are very helpful to buyers and suppliers, especially when they are not too well known to each other or are just starting out on a venture. These two financial instruments are issued by banks to buyers and sellers and have many common features. However, there are many differences that will be highlighted in this article.
What is Bank Guarantee?
Bank Guarantee is like a financial cover to the supplier for recovering losses or damages. It is issued by the bank on the request of the buyer and given to the supplier. When the buyer defaults on payments or there is any dispute between the two parties, the buyer can instruct the bank to invoke the bank guarantee and recover the payment mentioned in the instrument. A bank guarantee is an assurance of a sum of money to the beneficiary in the event of default from the buyer. It insures the supplier against losses if the buyer fails to fulfill his part of the obligation.
When the buyer fails to pay the seller for goods he has supplied, the seller can ask the bank for the amount mentioned in the BG and the bank is obliged to pay the beneficiary the aforesaid amount. Similarly if the seller fails to supply the goods or does not fulfill the terms of contract, the buyer can ask the bank to cancel the Bank Guarantee. A bank guarantee is used in situations where the two parties are relatively unknown and are entering upon a contract. Banks issue bank guarantee when the buyer produces FD, LIC certificates or deposits cash for it.
What is Letter of Credit (LC)?
A Letter of Credit (LC) is more commonly used in international trade where the supplier is in one country and the buyer is in another. Suppliers are known to request buyers to arrange for a Letter of Credit to feel comfortable before proceeding with the supplies. This is a financial instrument that guarantees a supplier that he will receive payment for the goods in time and for correct amount. If the buyer does not pay in full, or makes delays, the bank undertakes to pay the difference or the full amount to the supplier. LC is a safeguard in international trade where non payments and delayed payments are common these days. Even a buyer can ask the issuing bank not to pay the supplier until he is sure of the goods having been shipped.
What is the difference between LC and Bank Guarantee?
Major difference between a LC and a BG is that the issuing bank does not wait for a default from the buyer unlike BG where a formal request is made by the supplier to this effect. In this sense, a BG is more risky for the supplier as he has to wait till the bank clears his dues. Bank is liable to pay in the case of a BG in case of a default by the buyer whereas an LC is a direct responsibility of the issuing bank. BG is therefore called a second line of defense while LC guarantees timely payments for the supplier. LC is more of an obligation on the part of the issuing bank that has to transfer the funds once criterion mentioned in the contract are fulfilled. LC is thus more for ensuring timely and correct payments.