Difference between a Bank Guarantee and a Letter of Credit

Bank guarantees and Letters of Credit(LC) are both used in international transactions, however, the market for Bank Guarantees is much larger than that of LC’s. Bank Guarantees are often used in real estate to mitigate credit risks, whereas Letters of Credit are frequently used in commodity markets.

Merchants involved in the exports and imports of goods will choose Letters of Credit to ensure delivery and payments. In contrast, Contractors bidding for infrastructure projects will prove their financial credibility through Bank Guarantees.

Another distinctive difference between the two instruments is that Bank Guarantees are more costly than their counterpart. This is due to its ability to protect both parties in the transaction, and also due to the Bank Guarantee covering a wider range of higher value transactions.

Other Differences

As they are tailored instruments, Bank Guarantees can come in different forms:

? Advanced Payment Guarantee – Typically ensures the performance of a commercial contract.

? Loan Guarantee – Promises to assume the debt obligation of the borrower if they face default.

? Performance Guarantee – Ensures the full and due performance of the contract in line with the original contract.

? Deferred Payment Guarantee – A promise for a payment that has been postponed.

? Shipping Guarantee – A written guarantee which will be presented to the carrier in the event of goods arriving before the arrival of the shipping documents.

? Trade Credit Guarantee – This covers the providers of a good/ service against the risk of non (or late) payment.

Similarly, lending institutions issue different forms of Letters of Credit:

? Import LC & Export LC – A document containing instructions to the buyer’s bank that they must pay you on the condition that the agreed specifications are met. 

? Revocable LC – Uncommon due to the fact these LC’s can be cancelled by the bank at any time, for any reason.

? Irrevocable LC – This guarantees a buyer’s obligations to a seller.

? Confirmed LC – Present when the issuing bank may have a questionable quality of credit.

? Unconfirmed LC – A letter of credit that does not have the confirmation of any bank.

Therefore, a Letter of Credit is a promise to honor the financial obligations of the buyer, and this then eliminates any risk of the buyer not fulfilling the payments. As a result, it is often used to mitigate the risk of not being paid post-delivery.

Furthermore, an LC is issued by the buyer’s bank after carrying out the necessary due diligence, other procedures, and collecting sufficient collateral to cover the guaranteed amount. After which the Letter is presented to the seller as proof of the buyer’s credit quality.