A bank guarantee and a letter of credit, are financial instrument for mitigation of financial risks in trade contracts. Both instruments act as financial security to both parties in certain ways. Financial institutions and banks become facilitators of financial assurance to both parties in trade contracts.
A bank guarantee comes with more legal binding to both parties hence carries greater worthiness in trade contracts. A letter of credit works as a means of facilitating international payments and reducing the risk involved.
Here is our comparative guide on key similarities and differences in both instruments.
Definition – Bank Guarantee
A bank guarantee is a written order to make payments upon presentation of order or fulfillment of the contract. A bank covers the default risk of the applicant and obliges the beneficiary. The bank guarantee acts as a secondary financial security instrument and becomes payable if the buyer fails to make the payment.
Definition – Letter of Credit
A letter of credit is a promise by the bank to make a payment at a certain time and with the correct amount if the beneficiary faces a default risk from the applicant. It acts as a financial guarantee to the beneficiary of the LC for the payment.
Working Mechanism – Bank Guarantee and Letter of Credit
There are three parties involved in both instruments. A bank acts as the financial guarantor to both parties in both financial instruments. However, the working mechanism for both instruments varies slightly.
Bank Guarantee
A Bank Guarantee acts as a secondary financial obligation that becomes payable only if the buyer (drawee) fails to make the payment. It can include the financial and performance clause. It can secure the compliance interests of both parties by including the performance clause.
A bank guarantee is usually used in domestic large contracts between two parties. However, it can also be used along with letters of credit in international trade. Its prime function is to secure the beneficiary against the default risk of the issuing party.
Letter of Credit
A Letter of Credit is used as a financial instrument to settle international transactions. It serves as a financial guarantee from the issuing bank against the default risk of the buyer. LC also works as a means of payment. Unlike a bank guarantee, it acts as the primary obligation instrument.
A letter of credit ensures performance compliance by both parties in a trade contract. However, a letter of credit is a separate legal document from the trade contract itself. The documented terms and conditions dictate the obligation of the payment with a letter of credit.
Important Types – Bank Guarantee and Letter of Credit
Both types of instruments can take several forms and embed different features.
Some commonly used types of bank guarantees are:
Payment Guarantee: It is the default guarantee for the seller. If the buyer fails to make the payment, the bank will make the payment to the beneficiary directly.
Confirmed Payment Guarantee: It works as an irrevocable payment instrument. With the confirmed payment guarantee, the bank typically makes the confirmed payment to the beneficiary for the agreed amount on a set date.
Performance Guarantee: It secures the buyer’s interests against the non-performance of the supplier. The performance guarantee provides security to the buyer if the seller does not provide goods as agreed in the contract.
Rental Guarantee: It is issued against the default of rental payments of the tenant. The rental guarantee may include the rental amounts and the costs of damages to the property as well.
Warranty Bond: It serves the buyer as an assurance or warranty that the goods will be delivered on time as agreed in the contract terms.
Credit Guarantee: It is issued in favor of a third-party lender for the credit guarantee of the applicant. The credit guarantee serves as collateral for the repayment of the loan.
Some common types of Letters of Credit are discussed below.
Commercial Letter of Credit: It is a standard form of documentary letter of credit (DLC) in which the bank acts as a neutral facilitator to proceed with the payment if all conditions are fulfilled.
Standby Letter of Credit (SBLC): A standby letter of credit works as a backup plan for the seller if the buyer fails to make the payment on time with the first letter of credit. SLC is issued separately from the standard commercial DLC and provides additional security to the beneficiary.
Confirmed and Non-Confirmed Letter of Credit: In this form of a documentary letter of credit, a second bank acts as the confirming bank for the payment. The confirming bank is nominated by the seller. In case the buyer and the issuing bank fail to make the payment, the confirming bank takes the responsibility.
Sight Letter of Credit: In this arrangement, the bank must release the payment as soon as the seller presents the shipping documents. With the sight letter of credit, the bank can verify the document but needs to release the funds immediately.
Who Uses Bank Guarantee
A bank guarantee can be used by both parties in a trade contract to secure their financial interests. It is widely used in domestic contracts in real estate, construction, and other infrastructure development projects.
Bank guarantees are also used as credit guarantees by borrowers to secure debts from another financial institute. It is also used in international trade transactions.
Who Uses Letter of Credit
A letter of credit can also be used by both parties by including performance and payment clauses as per the needs. Both parties can agree to use it as means of payment as well.
Letters of credit are widely used in international contracts by importers and exporters.
Pros and Cons of a Bank Guarantee
A bank guarantee offers certain advantages and disadvantages to both parties in trade contracts.
Pros of using a Bank Guarantee:
- The bank guarantee legally provides greater financial security than a documentary credit.
- The bank guarantee assures the sellers of the payment confirmation in case of default of the buyer.
- It incurs lower costs than documentary credits.
- Buyers are, typically, able to secure the terms with a performance or advance payment guarantee as well.
- The bank guarantee reduces the trust deficit between both parties in a trade contract.
Cons of using a Bank Guarantee:
- The bank guarantee acts as the secondary payment obligation and enforces only on the non-performance of either party in the contract.
- The applicant of the bank guarantee may not possess sufficient creditworthiness or collateral to avail the bank guarantee.
Pros and Cons of a Letter of Credit
A letter of credit also provides similar financial security benefits to both parties.
Pros of using a letter of Credit:
- Letter of credit provides financial security to both parties in international trade.
- LC comes with several features and types making it a highly customizable instrument.
- LC acts as facilitating instrument for payment, working capital, and financial security simultaneously.
- It enables businesses to plan better for large cash flow projects.
Cons of using a Letter of Credit:
- Letter of credit does not remove the financial currency risk for the beneficiary.
- LC is a costly and sophisticated instrument that may not be accessible for small businesses easily.
- It cannot eliminate or reduce the financial risks due to political, geographical, or macroeconomic factors.
Conclusion
Both financial instruments act as financial risk mitigation tools. A bank guarantee comes as a secondary obligation instrument payable on default only. However, it is a legal securer instrument than a letter of credit. A letter of credit is a highly customizable and widely used instrument in international trade. Its flexibility appeals to both parties and also provides financial security.
