A:

Bank guarantees represent a more significant contractual obligation for banks than letters of credit do. A letter of credit from a bank assures that the seller will receive the correct payment amount at the correct time, and promises that the bank will cover the cost of the liability to the seller if the buyer fails to deliver the payment. These are commonly used in international trade, and only involve the bank in a contract with the buyer. Bank guarantees agree to cover the liability and involve the bank directly in the contract between the buyer and the seller by obligating the bank to cover the debts incurred by the buyer if the buyer fails to deliver payment.

Both of these agreements work to reduce financial risk. The seller takes on less risk when a letter of credit or bank guarantee is active, and would be more likely to agree to the transaction. These agreements are particularly important and useful in what would otherwise be risky transactions for the seller, such as certain real estate and international trade contracts. Banks, since they are agreeing to take on risk, thoroughly screen buyers interested in one of these transactions. After the bank has determined that the buyer is a reasonable risk, a monetary limit is placed on the agreement. The bank agrees to be obligated up to, but not exceeding, the limit. This protects the bank by providing a specific threshold of risk. Creditworthy buyers are then issued a letter of credit or bank guarantee.

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