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. What is a bank's legal liability when issuing a letter of credit?

    Learn the responsibility of banks that issue letters of credit Letters of credits ensure payment on transactions between ... Read Answer >>
  2. When is it necessary to get a letter of credit?

    Capitalize on assets and negate risks by using a letter of credit. Letters of credit are often requested for buying, selling ... Read Answer >>
  3. When are you legally required to get a letter of credit?

    Learn how exporters or importers who deal in international trade use letters of credit to ensure that transactions are safe, ... Read Answer >>
  4. Can entities other than banks issue letters of credit?

    Obtaining a letter of credit from a non-bank is legally acceptable according to the ICC, but companies tend to prefer to ... Read Answer >>
  5. How would a standby letter of credit be used during an export transaction?

    Learn what a standby letter of credit is and how it works, as well as how a standby letter of credit is typically used for ... Read Answer >>
  6. How legally binding is a letter of intent?

    Find out when a letter of intent is binding and when it is not. Understand the roles of drafting language, relationships ... Read Answer >>
Related Articles
  1. Small Business

    Letter of Credit

    A letter of credit is a document from a bank promising to pay the holder a certain amount if the holder fulfills certain obligations. Sellers in commercial transactions often require buyers to ...
  2. Investing

    What's Trade Finance?

    Essentially, trade finance makes it possible and easy for exporters and importers to trade, and its expansion has accommodated a massive international trade growth.
  3. Managing Wealth

    Letter Of Instruction - Don't Leave Life Without It

    This simple document can take the guesswork and headache out of settling your estate.
  4. Investing

    Financial Analyst Cover Letters That Get You Hired

    Crafting a strong cover letter for a job can increase your chances of standing out from the crowd and landing an interview. Some techniques that help.
  5. Personal Finance

    The Basics Of Lines Of Credit

    Lines of credit are potentially useful hybrids of credit cards and normal loans. Learn how a line of credit can help (and hurt) your finances, and how to find the best one to suit your needs. ...
  6. Investing

    Are Hedge Fund Letters More Valuable Than 13Fs?

    13F filings can be a useful way to track hedge fund investment strategies, but sometimes it pays to go directly to the fund leaders themselves.
  7. Small Business

    How To Increase Your Appeal To Prospective Lenders

    Making a business eligible for loans/credit cards at the best possible rates requires crafting an excellent credit profile through the smart use of credit.
  8. Personal Finance

    6 Ways To Build Credit Without A Credit Card

    It's definitely possible – if a bit more complicated – to build a credit history without traditional credit cards. Just follow these steps.
  9. Personal Finance

    Retail Banking Vs. Corporate Banking

    Retail banking is the visible face of banking to the general public. Corporate banking, also known as business banking, refers to the aspect of banking that deals with corporate customers.
  10. Investing

    The Ins And Outs Of Seller-Financed Real Estate Deals

    There's more than one way to buy or sell a house. Seller financing presents yet another unique option.
RELATED TERMS
  1. Letter Of Credit

    A letter from a bank guaranteeing that a buyer's payment to a ...
  2. Confirmed Letter Of Credit

    A second guarantee, in addition to a letter of credit, that commits ...
  3. Bank Confirmation Letter - BCL

    A letter confirming that a line of credit has been secured from ...
  4. Sight Letter Of Credit

    A letter of credit that is payable once it is presented along ...
  5. Assignment Of Proceeds

    A document transferring all or part of the proceeds from a letter ...
  6. Interpretive Letter

    A letter issued by banking regulators that interprets the banking ...
Trading Center