What Is The Difference Between A Letter Of Credit And A Bank Guarantee?

Being in international business, you might be very well aware of the concept of bank guarantee and letter of credit but sometimes, it becomes difficult to differentiate between these two as both the terminologies look similar but they are very different from each other. Both the financial instruments are the legal guarantees from the lending institution that the exporter will be paid on-time for delivered goods & services. Plus, both assure that the importer will be able to pay the debt, no matter what the financial circumstances are. But in case, if the buyer is unable to pay, the lending institution will step in and pay the amount. Both instruments provide financial assistance and reduce risk factors and grow global transactions.

Difference Between Bank Guarantee And Letter Of Credit

So, what is the difference? The key difference is that letters of credit are widely used in international trade & transactions due to the risk factors involved in global trade, for example, distance, different laws, and unfamiliarity of the parties to the contract towards one another, etc. While bank guarantees, on the other hand, are often used in real estate and infrastructure contacts to mitigate the credit risks in the domestic market.

Let’s understand the difference between their definitions.

What Is A Letter Of Credit?

A letter of credit is a legal document or guarantee issued by an importer’s bank on the behalf of the importer that the exporter will get the payment for their delivered goods & services after the fulfillment of Terms & Conditions mentioned in the contract. Every contract has predefined terms & conditions which are required to be fulfilled by both buyers & sellers and when they are met, the sellers can get their amount for their services provided to the buyers. Know More!

What Is A Bank Guarantee?

A bank guarantee is also a legal document where the bank or lending institution provides a guarantee to the exporter on the behalf of the importer to pay the full amount on-time for their delivered services in the event if the buyer defaults and fails to do it. In simple words, a bank guarantee takes place when there is a default or failure made by the customer ie. buyer. In this financial instrument, the bank acts as a guarantor and reduces the risks of loss involved in commercial transactions. It is commonly used by contractors in real estate or infrastructure projects in the domestic market.

Key Points Of Differences:

1. Use And Application – A LC is used in International markets to guarantee import/export while a BG is used in the domestic market to guarantee infrastructural projects.

2. Liability – In LCs, the bank bears the primary liability while in BG, it is secondary.

3. Risks Involved – LC brings lesser risks to the merchant, more to the bank while BG, it is more risks for the merchant, lesser for the banks.

4. Parties Involved – There are 5 or more parties involved in LC. These are the confirming bank, negotiating bank, advising bank, issuing bank, beneficiary, and applicant while bank guarantee has only 3. They are bankers, the beneficiary, and the applicant.

5. Default – LC does not wait for the buyer’s default while a BG becomes effective only after a default made by the applicant.

6. Recipient – In LC, it is the seller’s bank that receives the instrument while in BG, it is the beneficiary.

Finance-Opinions is a legal and private financial institution specializing in international trade finance services, import/ export, letter of credit, and other offshore banking services.

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