A:

A bank guarantee and a letter of credit are similar in many ways but they're two different things. Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction doesn't go as planned.

A letter of credit is an obligation taken on by a bank to make a payment once certain criteria are met. Once these terms are completed and confirmed, the bank will transfer the funds. This ensures the payment will be made as long as the services are performed.

A bank guarantee, like a line of credit, guarantees a sum of money to a beneficiary. Unlike a line of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.

For example a letter of credit could be used in the delivery of goods or the completion of a service. The seller may request that the buyer obtain a letter of credit before the transaction occurs. The buyer would purchase this letter of credit from a bank and forward it to the seller's bank. This letter would substitute the bank's credit for that of its client, ensuring correct and timely payment.

A bank guarantee might be used when a buyer obtains goods from a seller then runs into cash flow difficulties and can't pay the seller. The bank guarantee would pay an agreed-upon sum to the seller. Similarly, if the supplier was unable to provide the goods, the bank would then pay the purchaser the agreed-upon sum. Essentially, the bank guarantee acts as a safety measure for the opposing party in the transaction.

These financial instruments are often used in trade financing when suppliers, or vendors, are purchasing and selling goods to and from overseas customers with whom they don't have established business relationships. The instruments are designed to reduce the risk taken by each party.

For further reading, see What Is International Trade?

RELATED FAQS

  1. Can I have more than three original Bills of Lading?

    How many bills of lading copies are allowed when importing or exporting? Should I ship by air or sea? What type of bill of ...
  2. Is the banking sector subject to any seasonal trends?

    Explore the unexpected seasonal trends that can be discerned regarding the banking industry and the financial services sector ...
  3. What are some of the well-known no-load funds?

    Find out more about the capital to risk-weighted assets ratio, what the ratio measures and the formula used to calculate ...
  4. How do you calculate payback period using Excel?

    Understand the various fees that can be assessed on a personal or business checking account, and learn methods to avoid being ...
RELATED TERMS
  1. Debit Card

    An electronic card issued by a bank which allows bank clients ...
  2. Average Revenue Per User (ARPU)

    A measure of how much income a business generates, given the ...
  3. Money Market Account

    An interest-bearing account that typically pays a higher interest ...
  4. Compound Interest

    Interest calculated on the initial principal and also on the ...
  5. Straight Credit

    A type of letter of credit. A straight credit can only be paid ...
  6. Pirate Bank

    A type of offshore savings account used by a wealthy individual ...

You May Also Like

Related Articles
  1. Investing

    Can I have more than three original ...

  2. Entrepreneurship

    Technology, The Biggest Threat For Big ...

  3. Investing Basics

    An Investor's Guide To Bank Stress-Testing

  4. Stock Analysis

    How Wells Fargo Became The Biggest Bank ...

  5. Stock Analysis

    Why Wal-Mart Needs To Expand Into Financial ...

Trading Center