Bank guarantees are similar to letters of credit in that they both instill confidence in the transaction and the parties involved. The main difference, however, is that the letter of credit ensures that the transaction goes smoothly, while the bank guarantee reduces any losses that arise if the transaction does not go as planned.
Letter of Credit - Reduce Risk
A letter of credit is a financial institution's commitment to fulfill a buyer's financial obligation, thereby eliminating any risk that the buyer will not perform payment. Therefore, it is often used to reduce the risk of non-payment after delivery.
In addition, a letter of credit is issued to the buyer after the necessary due diligence has been carried out and sufficient collateral has been collected to cover the secured amount. The letter is then submitted to the seller as proof of the buyer's credit quality.
Types of Letters of Credit
Just like bank guarantees, letters of credit vary according to need. Here are some of the most commonly used letters of credit:
- An irrevocable letter of credit ensures that the buyer is obligated to the seller.
- The confirmed letter of credit is from the second bank, which guarantees the letter of credit when the credit of the first bank is in question. If the company or the issuing bank fails to meet its obligations, the confirming bank will ensure payment.
- An import letter of credit allows importers to make immediate payments by giving them a short-term cash advance.
- An export letter of credit lets the buyer's bank know that it must pay the seller, provided that all the conditions of the contract are met.
- A revolving letter of credit allows customers to make withdrawals within a certain range within a certain period of time.
Bank Guarantee – Failure to perform contractual obligations
Bank guarantees help companies mitigate any risk arising from both sides of a transaction and play an important role in facilitating high-value transactions. The agreed-upon amount is called the guaranteed amount and will always benefit the beneficiary.
In venture capital, both parties are obligated to perform certain duties in order to successfully complete a transaction, and both parties often use bank guarantees as a way to demonstrate their creditworthiness and financial standing.
Also, if one party fails, the other party can invoke the bank guarantee and get the guaranteed amount by filing a claim with the lender. Unlike a LOC, a bank guarantee protects the parties involved.
Types of Bank Guarantees
Bank guarantees are just like any other type of financial instrument - they can take a variety of different forms. For example, banks provide direct guarantees in both domestic and foreign operations. Indirect guarantees are usually issued when the subject of the guarantee is a government agency or other public entity.
The most common types of guarantees include:
- Shipping Guarantee: This guarantee is provided to the carrier for shipments that arrive before any documentation has been received.
- Loan Guarantee: An institution that issues a loan guarantee promises to assume financial obligations in the event of a borrower default.
- Advance Payment Guarantee: This guarantee is used to support the performance of the contract. Basically, this security is a form of security to repay the advance payment if the seller does not deliver the goods specified in the contract.
- Confirmed Payment Guarantee: With this irrevocable obligation, the bank pays the beneficiary a specific amount on behalf of the customer by a specific date.
Summary: What is the difference between a bank guarantee and a letter of credit?
Letter of Credit (LC)
A letter of credit is a promise by a bank to pay the beneficiary after certain conditions are met.
Often used by merchants engaged in the import and export of goods.
Protects both sides of the transaction, but benefits the exporter.
Example: A letter of credit can be used to transport goods or complete services.
Bank Guarantees (BGs)
A bank guarantee is a promise by the bank to pay the beneficiary in the event that the counterparty does not fulfill its contractual obligations.
Typically used by contractors to bid on large projects, such as infrastructure projects.
Protects both parties to the transaction, but benefits the beneficiary (usually the importer).
Example: A bank guarantee is used when a buyer buys an item from a seller, then the seller is in financial difficulty and cannot pay.
