The primary difference between a letter of credit and bank guarantee is the level of responsibility assumed by the bank. The two also differ in their purpose, the frequency of their use, and the parties involved. A letter of credit is generally used in international trade to assure that transactions proceed as planned. Bank guarantees helps assure that financing will be available for a project should one of the parties involved become insolvent. This arrangement is often seen in construction projects and infrastructure development.
In international trade, the seller wants to make certain that payment is forthcoming, and the buyer wants to make sure that the order has been shipped. LC (letter of credit) facilitates this process and gave guaranty to both sides. Buyer will enter in contact with his bank to issue an LC (credit letter) under the agreed terms between him and his seller. Buyer bank will state between the two parties to control the execution of the signed agreement (goods delivery and after this money transfer to the seller).
The issuing bank sends LC (letter of credit) to the seller stating the fixed terms in the agreement (signed between seller and buyer) and the letter of credit text. Typically, this involves presenting a standard shipping document, such as a bill of lading (some times can be used a scan copy to gain time but all original document must be send as agreed). The seller is paid by the bank upon presentation of this document and after full verification of its authenticity. The bank then forwards the bill of lading to the buyer, who would present it to the carrier and receive shipment of the order. The buyer then repays the bank.
The only responsibility of the issuing bank is to make payment when presented with the agreed upon documents. A letter of credit depends on the contractual arrangement between the issuing bank and the buyer. It is not the bank’s responsibility to oversee the contract between the buyer and seller. Any violation of the terms of that contract would have nothing to do with the handing of a LC. For example, if the seller presented the proper documentation and was paid, but had shipped a defective product, the buyer would still have to repay the issuing bank. This problem can happen when buyer didn’t fix in the agreement(export import contract) a third party control (inspection organization in the exporting port to fix the conformity of shipped goods to the agreed quality and quantity)
The issuing bank assumes a greater liability with a bank guarantee. In this situation, the bank accepts liability for the payment of the debt or performance of some duty for a party to an agreement. If the party becomes insolvent, or fails to complete contractually obligated requirements, then the bank assumes responsibility and must make good on the terms of the contract. Such a guarantee is often necessary when public bonds are to be issued.
The usage disparity between a letter of credit and bank guarantee can be seen in the underlying roles they play. A LC facilitates trade without becoming directly involved in the contractual obligation between the parties. In a bank guarantee, the issuer is intimately involved in the contractual terms and the performance of the parties involved. Both work to lessen risk, but the depth of involvement and liability accepted by the issuing bank distinguishes the two.
Letters of Credit (LCs)
In simple words LC (letter of credit) a money transfer (or payment) under terms. Seller must fulfill all agreed terms in the contract to get paid.LC is more commonly by merchants involved in imports and exports of goods on a regular basis under ICC Incoterms.
Letters of credit protect the two parties involved but favor the exporter.
Bank Guarantees (BGs)
A Bank Guarantee is a bank’s commitment to honor payment to a beneficiary if the opposing party does not fulfill their contractual obligations.
Often used for contractors bidding on larger projects such as infrastructure projects.
Bank Guarantees (BGs) protects both parties in the transaction but favors’ the beneficiary (usually the importer).
A BG could be used when a buyer purchases goods from a seller then runs into cash flow problems and cannot pay the seller. (Payment is guaranteed to the seller.)