What are Bank Guarantees? What is a Standby Letter of Credit? What are there functions? How do they differ from each other? These are questions that we are regularly asked to answer. Questions especially asked by those companies looking to monetise these bank instruments.
There is a simple answer to the difference between a Bank Guarantee and a Standby Letter of Credit. A bank guarantee as the name suggests is a guarantee of payment and a standby letter of credit is a means of payment. However, if a standby letter of credit is monetised it then becomes a guarantee of payment.
There are two forms of guarantees, a financial guarantee and a performance guarantee – both are bank instruments.
The performance guarantee covers any loss the beneficiary suffers from non-performance of contract. This contract will be between the beneficiary and the provider of the standby letter of credit
The financial guarantee covers the beneficiary in the event the provider fails to pay the beneficiary.
In both cases the provider is the counterparty who instructs their bank to issue the bank guarantee. The bank is known as the issuing bank and is the institution that pays any claims.
Standby Letters of Credit
The standby letter of credit is a bank instrument employed for trade finance. It is used globally to underpin trade contracts and is a contract between a buyer and a seller. The standby letter of credit is recognised as a payment of the last resort. So why are standby letters of credit utilised?
The answer is simple. Creditworthiness. A seller may feel the buyer might have a problem paying for the goods under contract. The seller therefore asks the buyer to open a standby letter of credit in the seller’s favour. The buyer requests their bank to issue the standby letter of credit. The buyer becomes the provider of the instrument and the seller becomes the beneficiary.
If the buyer pays the seller the standby letter of credit becomes superfluous. Accordingly the instrument will be cancelled. However if the buyer fails to pay, the standby letter of credit comes into its own.
The seller can now request their bank to claim monies owed against the standby letter of credit. They will claim from the issuing bank who have a legal responsibility to pay. The issuing bank will claim the same from the buyer.
To find out more information surrounding these banking instruments, get in touch or contact Finance-opinions.