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Letter of credit vs Bank guarantees

Definition of Letter of Credit

A letter of credit is considered as a legal document in international trade. Lc is issued by a bank on behalf of the importer to the exporter. As per this legal document the bank is responsible for the drafts drawn on the importer, for the consignment being shipped, provided the terms and conditions written within lc are satisfied by the seller.

The supplier is supposed to comply with all the conditions described in the letter of credit, and are set by the buyer. Further, the supplier has to submit some documentary evidence along with the relevant shipping documents. As soon the terms and conditions are met by the supplier, the bank transfers the funds to the supplier.

Functions performed by letter of credit are:

  • Credit risk removal.
  • Provides reduction in uncertainty, as the exporter is aware about the conditions which have to be satisfied in order to receive payment.
  • Offers safety to the importer, as he can make payment after the consignment conditions mentioned in the L/C is met.

Various types of Letter of credit include Sight letter of credit, Usance letter of credit, Revolving letter of credit, Irrevocable and revocable letter of credit, Standby letter of credit, Confirmed letter of credit and much more.

Definition of Bank Guarantee

A bank guarantee is considered as a contract, in which the bank is supposed to provide the guarantee on customer’s behalf to the beneficiary that the bank will pay the seller the required payment, if in case customer defaults in discharging obligations. As per this agreement, the bank will act as a surety, to make the debt good within 3 working days, if not paid by the applicant.

Bank Guarantees are used for reducing the risk of loss that is attached to the commercial contracts. For providing such sureties so, the bank will get certain amount of commission which may vary as per the amount being guaranteed. Apart from this, the bank is not bound for making the payment, i.e. payment can be refused if the claim is not found genuine.

There are two types of bank guarantee:

  • Financial Guarantee
  • Performance Guarantee

Comparison Chart

Letter of credit Bank Guarantee
Letter of credit is a legal document for assured payments, i.e. an undertaking of the importer’s bank to make payment to supplier, against the mentioned documents. A bank guarantee is a surety which is given by the bank to its beneficiary on behalf of the applicant, for effecting payment, if the applicant fails to pay.
LC is considered as a primary liability. Bank guarantee is given secondary liability.
LC involves fewer risks for the trader and more on banks part. Bank guarantee involves more risks for trader and fewer on banks part.
Generally five or more parties are involved. Generally three parties are involved.
For invoking the undertaking, LC doesn’t wait for applicant’s default and beneficiary. Bank guarantee becomes active only if the applicant defaults to make payment.
Payment is made when the specified conditions are met. Non-fulfilment of obligation results in payment.
Usually, it is suitable for import and export business. Usually, it is suitable for government contracts.

Key Differences between Letter of Credit and Bank Guarantees

The below mentioned points are noteworthy, when difference between letter of credit and bank guarantee is concerned:

  • Letter of Credit can be seen as a commitment of importer’s bank to the exporter’s bank. As per LC bank is supposed to accept the invoices being presented by the seller and pay him for the consignment being sent subject to certain conditions. Whereas in Bank guarantee, a surety is given to the beneficiary by the bank on behalf of the applicant, to ensure payment, if in case the applicant defaults to make payment.
  • In case of LC, the primary liability lies only with the bank, which is responsible for collecting payments from the client afterwards. On the other hand, in the case of a bank guarantee, the bank assumes as a secondary liability, when the customer fails to make payment.
  • In terms of risk, the letter of credit is considered to be more risky for the bank but less to the traders. Whereas, the bank guarantee is termed to be more risky for the trader but less to the bank.
  • Usually, five or more parties are involved within a letter of credit transaction, such as applicant, beneficiary, issuing bank, advising bank, negotiating bank and confirming bank. On the other side, in bank guarantees only three parties are involved such as applicant, beneficiary and the banker.
  • In the case of LC, the payment is made by the bank, when the suppliers submit the documents regarding the delivery of consignment. It does not require any kind of undertaking or invoking for making the payment. Contrary, a bank guarantee comes into play, when the client or we can say the importer defaults in terms to make payment to the beneficiary.
  • A letter of credit provides surety that the desired amount will be paid when the services are performed as per the defined manner. Unlike bank guarantee mitigates loss, if and only if the parties to the guarantee satisfy the stipulated conditions.
  • A letter of credit is suitable for import and export business. In contrast, a bank guarantee is more suitable for government contracts.

Similarities between the Two

Both of these trade finance products ensure that the sellers will be paid for the associated goods and services. As a supplier or exporter, you can avail a letter of credit or bank guarantee for ensuring that you receive payment for the consignment you deliver. If you are a buyer or importer, the supplier will definitely expect direct payment from you. If in case you do not make payments on time then the seller can your bank to act as per the conditions on the letter of credit or bank guarantee to pay on your behalf.

Protection Difference

Although both these trade finance products serve as the primary purpose to ensure that the seller gets paid, but there is a legal difference in terms of protection they provide. A bank guarantee not only protects the supplier, but it also protects the importer. For sellers, it totally depends on the buyer whether your buyer chooses to avail a letter of credit or bank guarantee. However, when it comes to buyer, then a bank guarantee must be preferred. It can even protect you if the supplier fails to send your purchases or if the consignment arrived in damaged condition. A bank guarantee reimburses the amount you have sent to the non-performing seller.

Performance Difference

Letter of credit is preferred in terms of performance. When it comes to trade, after delivering the relevant product, seller can ask buyer’s bank to make payment for the exported products on presenting the required documents and meeting the terms and conditions being mentioned within the letter of credit. Whereas, a Bank guarantee will come into performance only in case of default payment i.e. if the buyer fails to pay for the goods and services being delivered, only then the bank guarantee comes into a role play.

LEGAL DIFFERENCE

There exists a major legal difference amongst these trade finance products. A bank guarantee can be seen as a simple obligation subject to the civil law whereas a letter of credit can be seen as a subject to banking protocols – UCP 500 and ISP 98.