Letter of Credit vs Bank Guarantee

Introduction

If you are scouring the internet searching for answers in the comparison between a Letter of Credit and a Bank Guarantee, chances are you are in pursuit of a form of third-party guarantee for international trade. Furthermore, you are looking for any alternatives and the inherent costs of those guarantees. Here in this article, we have compiled all the necessary information to help you in your decision, and help you differentiate the difference between a Letter of Credit and a Bank Guarantee.

There are many forms that a Bank Guarantee can take, the general understanding is that a Bank Guarantee is issued by a financial institution (commonly the bank) that acts as a promise to make issue monetary payment to the beneficiary of the bank guarantee. A letter of credit or a documentary credit performs the same tasks of guaranteeing financial payment obligations to the beneficiary. The difference is that a Letter of Credit is a specific form of guarantee that solely assists in international trade, whereas a bank guarantee assists in undertaking any form of financial obligations according to the terms and conditions of the guarantee.

Key Differences between Letter of Credit and a Bank Guarantee

Letter of Credit

When an international trade occurs, where a commodity is shipped from a seller in one country to the buyer in another country, there is also a flow in money from the buyer to the seller. For an international shipment to be considered fully completed, there needs a trustworthy medium for money to flow.

This “trustworthiness” is supplied amply by a letter of credit, a form of documentary credit issued by a trustworthy medium (the bank), that undertakes the obligation to make payment to the seller/issuer.

Banks are well qualified to be a guarantor, but they are not qualified to ensure that the seller’s obligations are performed fully. Therefore, banks rely on documents as proof of contract performance.

If the documents meet all requirements drawn by the banks, seller, and buyer. The bank will issue the payment accordingly.

Otherwise, the bank reserves the right to refuse payment and will hold the document of title (Bill of Lading) as a lien. Since, unequivocally, if a letter of credit is involved in international trade, the bill of lading’s consignee is made to the order of the bank.

Letters of Credits are structured specifically for international trade, it is facilitated by the UCP guideline (Uniform Customs and Practice for Document Credits)

175 countries recognize the UCP 600 guidelines, which underlines the rules of an issue of a Letter of Credit.

This is the most pertinent feature in trade finance: the UCP guidelines. The guideline acts as a common language where banks from different countries can communicate with each other to draft the letter of credit.

This is because, not all banks have an international presence. Even if banks do have an international presence, both the exporter and importer rarely utilize the same bank.

Perhaps the illustration below provides a big picture understanding of how trade finance via a letter of credit is performed.

Letter of Credits are also flexible and are able to cater to each applicant’s requirements: –

1. Commercial Letter of Credit
2. Standby Letter of Credit
3. Confirmed/Unconfirmed Letter of Credit
4. Back to Back Letter of Credit
5. At Sight Letter of Credit
6. Deferred Payment Letter of Credit
7. Irrevocable Letter of Credit

More information: https://www.thebalance.com/types-of-letters-of-credit-315040

Bank Guarantees

Bank Guarantees, as compared to a Letter of Credit, is relatively straight forward.

However, the scope of a bank guarantee is much wider than the scope of a letter of credit, as there are many forms of bank guarantee.

 To simplify, it helps if we view that bank guarantees come in 2 major types.

1. Financial Bank Guarantees
2. Non-Financial Bank Guarantees

To illustrate the relationship between the bank, the buyer, and the seller, here is the graphical representation of a bank guarantee’s structure: –

Bank Guarantees should carry some of the details below: –

1. Principal or Applicant
2. Guarantor
3. Beneficiary
4. Purpose of the Bank Guarantee
5. Guaranteed amount and currency
6. Issue Date, Effective Date / “Expiry Date”
7. Claim Period

Financial Bank Guarantees

In simple terms, the bank pays the guaranteed contract amount once the contract has been performed. The payment is made to the third-party beneficiary of the guarantee.

The execution of a financial bank guarantee takes place when the document fulfills the requirements of the drawn bank guarantee.

In the event of a default in financial obligations by the buyer, the financial institution issuing the bank guarantee will step in and reimburse the amount payable per the contract drawn.

The performance of the goods or services rendered by the seller to the buyer is a separate issue altogether. This means that the bank does not get involved in ensuring that the goods or services performed are up to the buyer’s requirement or expectation. The bank only acts on the underlying documents involved.

Some define financial bank guarantees as “independent bank guarantees”, suggesting that the bank is independent of the performance of the contract.

There are many forms of Financial Bank Guarantees, of which the most common type of financial bank guarantee is the Letter of Credit. 

Non-Financial Bank Guarantees

In juxtaposition, non-financial bank guarantees take into consideration whether the underlying contract obligations are fulfilled.

In layman terms, “if you do good with your promise, I will pay the promised amount”. This adds an additional condition that a financial bank guarantee does not have.

In a non-financial bank guarantee, the condition of default is pre-determined per the contractual obligations set between the buyer and the seller. As opposed to a financial bank guarantee, where banks make the payments if the financial obligation of the buyer has defaulted. 

Which is why, some define non-financial bank guarantees as “performance guarantee”, suggesting that the payment by the bank is conditional to the performance of the contract.

There are many types of non-financial bank guarantee: –

1. Bid/Tender Guarantee;
2. Warranty Guarantee;
3. Performance Guarantee.

Letter of Credits and Bank Guarantees

Now to bring it all together, Letter of Credits and Bank Guarantees are not mutually exclusive. In fact, a letter of credit is a form of financial bank guarantee, just as we described above.

However, a Letter of Credit is a document of credit specific to finance international trade only.

Whereas, bank guarantees can be made to perform various financial guarantee or performance guarantees. Similar to what we have described above.

In actual fact, bank guarantees can be engineered to perform as an import/export guarantee as well.

More information: How does Bills of Exchange Work?

This graphical representation that gives us a top-level view of the different types of Bank Guarantees.

Conclusion

In essence, anything issued by the bank as a guarantor to perform financial obligations on behalf of the buyer is, in fact, a bank guarantee. And a letter of credit is a bank guarantee specifically engineered for international trade.