Everything You Should Know About the Letter of Credit & Bank Guarantee

A bank guarantee and a letter of credit are both promises made by a financial institution that a borrower will be able to repay a debt to another party regardless of the debtor's financial situation.

While they differ, bank guarantees and letters of credit both assure the third party that if the borrowing party is unable to repay what it owes, the financial institution will step in on the borrower's behalf.

These promises serve to reduce risk factors by providing financial backing for the borrowing party (often at the request of the other party), thereby encouraging the transaction to proceed. However, they function in slightly different ways and in different situations.

Bank Guarantee vs Letter of Credit

Bank guarantees and letters of credit both work to reduce risk in a business agreement or transaction. When a letter of credit or bank guarantee is in place, the parties are more likely to agree to the transaction.

These agreements are especially important and useful in transactions that would otherwise be risky, such as certain real estate and international trade contracts.

Clients who are interested in one of these documents are thoroughly screened by banks. A monetary limit is placed on the agreement after the bank determines that the applicant is creditworthy and poses a reasonable risk.

The bank agrees to be obligated up to the limit but not beyond it. This protects the bank by setting a specific risk threshold.

Another significant distinction between bank guarantees and letters of credit is the parties who use them. Contractors who bid on large projects typically use bank guarantees. The contractor demonstrates its financial credibility by providing a bank guarantee.

In essence, the guarantee assures the entity behind the project that it is financially stable enough to take on the project from start to finish. Letters of credit, on the other hand, are commonly used by businesses that import and export goods on a regular basis.

Bank Guarantee

Bank guarantees are a larger contractual obligation for banks than letters of credit. A bank guarantee, like a letter of credit, ensures the payment of a sum of money to a beneficiary.

The bank only pays that amount if the opposing party fails to fulfill the contract's obligations. The guarantee can be used to protect a buyer or seller from loss or damage caused by the other party's failure to perform under a contract.

Bank guarantees shield both parties from credit risk in a contractual agreement. A construction company and its cement supplier, for example, may enter into a contract to build a mall. Both parties may be required to provide bank guarantees to demonstrate their financial standing and capability.

If the supplier fails to deliver cement within a certain time frame, the construction company would notify the bank, which would then pay the company the amount specified in the bank guarantee.

Bank Guarantees and their Varieties

Bank guarantees, like any other type of financial instrument, can take on a variety of forms. Banks, for example, issue direct guarantees in both domestic and international transactions. 

When the subject of the guarantee is a government agency or another public entity, indirect guarantees are commonly issued.

The following are the most common types of guarantees:

Letter of Credit

A letter of credit, also known as a documentary credit, is a promissory note issued by a financial institution, typically a bank or credit union. It ensures that a buyer's payment to a seller or a borrower's payment to a lender is received on time and in full.

It also states that if the buyer is unable to make a payment on the purchase, the bank will pay the entire or remaining amount owed.

A letter of credit is a bank's commitment to making a payment if certain conditions are met. The bank will transfer the funds once these terms have been completed and confirmed. The letter of credit guarantees payment as long as the services are performed.

The letter of credit effectively substitutes the bank's credit for the client's, ensuring correct and timely payment.

The purchasing company seeks a letter of credit from a bank where it already has funds or a line of credit (LOC).

The bank that issued the letter of credit holds the buyer's payment until it receives confirmation that the goods in the transaction have been shipped.

After the goods are shipped, the bank will pay the wholesaler its due as long as the terms of the sales contract are met, such as delivery by a certain time or buyer confirmation that the goods were received undamaged.

Types of Letters of Credit

Letters of credit, like bank guarantees, vary depending on the need for them. Some of the most common types of letters of credit are as follows: 

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