Both a letter of credit and a bank guarantee are promises from a financial institution that a borrower can repay a debt to another party, irrespective of what the debtor’s financial circumstances are. Although there are some differences, both of these assure the third party that in case the borrowing party cannot repay what it owes, the financial institution will invariably step in on behalf of the borrower.
Simply by providing financial backing for the borrowing party, these promises serve to reduce risk factors, thereby, encouraging the transaction to proceed further. However, they tend to work in slightly different ways in different types of situations.
Letters of credit are particularly significant in international trade, owing to the distance involved, the remarkably differing laws in the countries of the businesses involved, as well as the difficulty of the parties meeting in person. While letters of credit are primarily used in global transactions, bank guarantees are, more often than not, used in real estate contracts as well as infrastructure projects.
Bank guarantees usually showcase a more important and professional contractual obligation when it comes to banks than letters of credit usually do. To be precise, a bank guarantee guarantees a sum of money to a beneficiary. The bank only pays that amount if the opposing party fails to fulfil the obligations by the contract. Additionally, the bank guarantee can also be used to effectively insure a buyer or seller from either loss or damage due to non-performance by the other party in a particular contract.
In addition to this, bank guarantees to protect both parties in a contractual agreement from credit risk. Let’s say, for instance, a construction company and its cement supplier may sign a contract to build a mall. Both of these parties may have to issue bank guarantees to prove their financial capability and credibility. Therefore, in a situation where the supplier fails to provide cement within a specified time, it is upon the construction company to notify the bank, which then pays the company the specified amount in the bank guarantee. While letters of credit are issued for importing as well as exporting companies, bank guarantees are most typically used by many contractors.
Letter of Credit
Also known as a documentary letter of credit, it assures that a buyer’s payment to a seller or a borrower’s payment to a lender will be received right on time and for the entire amount as a whole, thus acting as a promissory note.
In addition to this, it also states that if the buyer fails to make the full payment while purchasing, the bank will cover the whole or remaining amount owed. However, before making any purchase, it is also important to ensure that your trade partner is legitimate. To do so, the best way is to use the services such as business vetting to ensure a more transparent trade. From company status and registration details to shareholder information and much more, you can rely on Tazapay to download specialized reports on any company right away, to grow your business with utmost confidence.
A letter of credit process involves an obligation that is taken on by a bank to make a payment, considering certain criteria are met. Once these terms are completed and confirmed, the bank will make it a point to transfer the funds. The letter of credit also ensures that the payment will be made as long as the services are performed properly. The letter of credit, all in all, substitutes the bank’s credit for that of its client, thus, making it a point to ensure correct, proper, and timely payment.
Summary of Key Differences between Letter of Credit and Bank Guarantee
Listed below are the key points of
● Use & Application – A letter of credit is used in International markets to
guarantee import as well as export. On the other hand, a bank guarantee is used
in the domestic market and guarantees infrastructure projects.
● Liability – When it comes to a letter of credit, the bank bears the primary liability.
However, in bank guarantee, it is secondary.
● Risks Involved – The letter of credit brings lesser risks to the merchant and a lot
more to the bank. However, bank guarantees have more risks for the merchant and
less for banks.
● Parties Involved – There are about five or more parties involved in a letter of credit.
These are the confirming bank, advising bank, issuing bank, negotiating bank,
beneficiary, and applicant while a bank guarantee only has three – the bankers,
beneficiary, and the applicant.
● Default – A letter of credit does not wait for the buyer’s default. However, a bank
guarantee becomes all the more effective when the applicant defaults.
● Recipient – When it comes to a letter of credit, it is the seller’s bank that receives
the instrument. However, in bank guarantees, it is the beneficiary.
The purchasing company has to apply for a letter of credit at a bank where it already has some funds or a line of credit, also referred to as LOC. The bank that is issuing the letter of credit can hold payment on behalf of the buyer until it receives confirmation that the goods in the transaction have been shipped. Once the goods are shipped, the bank pays the wholesaler its due amount only if the terms of the sales contract are met. Tazapay’s Escrow Services is an alternative that is cheaper and much simpler than LOC. It reduces risk for both the parties involved in a transaction and releases amount only upon the completion of the set milestones.