Letters of credit and (LCs) and bank guarantees, both these financial instruments offer guarantees in trade transactions. This makes it possible for someone to use the two interchangeably and get confused. It is hence crucial that traders thoroughly understand each mechanism, the key differences between the two, and their use cases to decide which one to opt for.
What is a Bank Guarantee?
A bank guarantee is a contractual obligation stated by the bank that if the borrower fails to repay the debt, the bank will pay the money to the lender on the debtor's behalf. The bank acts as a guarantor for repaying the defaulted payments within three working days if the borrower doesn’t pay the same.
Bank guarantees are used to minimize the risks attached to commercial contracts and serve as a risk management tool to protect the parties involved from significant financial losses.
The different types of bank guarantees are either financial-based or performance-based.
1. Financial-based bank guarantees In financial-based bank guarantees, the bank guarantees that the debtor will repay all the debts owed to the beneficiary. If the debtor fails to do so, the bank will repay the amount on their behalf.
2. Performance-based bank guarantees In performance-based bank guarantees, the beneficiary can seek compensation for the failure of the other party to fulfill the performance obligations mentioned in the contract. For example, the bank can compensate a buyer for goods that weren’t delivered before a stipulated date as mentioned in the contract.
What is a Letter of Credit?
A letter of credit (LC), also called a credit letter, is a legal document assuring sellers that payments will be made by the buyer, in full and on time. It also mentions that the bank will cover the amount if the buyer fails to make the payment and acts as a cash equivalent for the parties involved.
An LC represents a commitment made by the bank that they will honor the payment after fulfilling the criteria in the agreement. Simply put, it substitutes the bank’s cash or credit for that of its client and ensures assured and timely payment.
An LC is usually used in the import and export business where parties aren’t familiar with each other, providing more confidence for the entities bound by the contract. Out of the many LCs, export LC is a popular documentary credit mechanism used in international trade to safeguard the interests of all parties. Banks and traders are also governed by the Uniform Customs and Practice for Documentary Credits (UCP) rules that pertain to the documentary credit.
Difference between Letter of Credit and Bank Guarantee
How do Bank Guarantees Work?
The following is a step-wise process explaining how a bank guarantee works.
- Firstly, the applicant (generally, the buyer) will ask the bank for a bank guarantee and submit the contract between him and the seller, outlining all the terms and conditions.
- The bank will carefully examine all aspects of the contract, including the terms, payment conditions, payment methods, payment defaults, performance obligations, etc.,
- Then, it will also look at the applicant’s financial track record, similar project outcomes, funds with the bank, and other details.
- If the bank feels that the applicant can honor the conditions mentioned in the contract, they will provide a bank guarantee.If they fail to do so, the bank will pay for the financial or performance-based shortcomings.
How do Letters of Credit Work?
The following is a step-wise process explaining an LC works.
- Firstly, the applicant (importer) approaches the bank (Bank 1 for reference) for an LC as requested by the other party (exporter) to execute a trade contract.
- Then, the bank analyzes the applicant’s financial track record and, if deemed fit, approves the issuance of an LC, after which it is submitted to the exporter.
- Once the exporter delivers the goods, he can submit the LC to a bank of their choice (Bank 2) by submitting the necessary documents.
- Bank 2 then pays the exporter the amount mentioned in the contract.
- Bank 2 then recovers the amount from Bank 1, which, in turn, recovers the amount from the importer.
Bank Guarantees Examples
A construction firm planning to build a residential building and a brick supplier enter into a contract. They both have to issue bank guarantees to the other party to prove their financial credibility. If the construction company fails to pay the brick supplier, the bank will pay the supplier on behalf of the construction company. Or, the bank guarantee can also be performance-based, where the bank will have to pay the construction company on behalf of the brick supplier if they fail to supply the agreed number of bricks within a specified time. These clauses can be included in the same bank guarantee contract, which is typically the case, or can be divided into separate contracts.
Letters of Credit Examples
A company (A) from China exports mobile phones to a company (B) in the US, where both parties are relatively unknown to each other. Company A isn’t sure that the Company B will make the payment. Similarly, company B is uncertain if the company A can deliver the agreed volume of mobile phones. The company A asks for an LC from the US buyer to ensure that they are serious about the transaction and to protect its own interests. The company B then requests an LC from a US bank. The LC is then sent to the company A. As soon as the company A receives the bill of lading for their goods, they approach a bank where they hold funds and submit the LC. The bank then makes the payment on behalf of the US company.
The Chinese bank then recovers the money from the US bank, which then recovers it from the US company.
Difference between Standby Letter of Credit and Bank Guarantee
A standby LC differs from a standard LC as the former is commonly used when there is a breach of contractual obligation. While it may seem similar to a bank guarantee in many ways, especially as a standby LC can also be performance or financial-based, there are some key differences.