A bank guarantee and a letter of credit are both promises from a financial institution issued on behalf of one of the parties in a transaction. By providing financial backing for this party (often at the request of the other one), these promises serve to reduce risk factors, encouraging the transaction to proceed. But they work in slightly different ways and in different situations.

Letters of credit are especially important in international trade due to the distance involved, the potentially differing laws in the countries of the businesses involved, and the difficulty of the parties to meet in person. While letters of credit are used mostly in global transactions, bank guarantees are often used in real estate contracts and infrastructure projects.

How a Letter of Credit Works

Sometimes referred to as a documentary credit, a letter of credit acts as a promissory note from a financial institution, usually a bank or credit union. It represents an obligation taken on by a bank to make a payment once certain criteria are met. After these terms are completed and confirmed, the bank will transfer the funds. The letter of credit ensures the payment will be made as long as the services are performed.

For example, say a U.S. wholesaler receives an order from a new client, a Canadian company. Because the wholesaler has no way of knowing whether this new client can fulfill its payment obligations, it requests a letter of credit be provided in the purchasing contract.

The purchasing company applies for a letter of credit at a bank where it already has funds or a line of credit (LOC). The bank issuing the letter of credit holds payment on behalf of the buyer until it receives confirmation that the goods in the transaction have been shipped. After the goods have been shipped, the bank would pay the wholesaler its due as long as the terms of the sales contract are met, such as delivery before a certain time or confirmation from the buyer that the goods were received undamaged.

Basically, the letter of credit substitutes the bank's credit for that of its client, ensuring correct and timely payment.

How a Bank Guarantee Works

Bank guarantees represent a more significant contractual obligation for banks than letters of credit do. A bank guarantee, like a letter of credit, guarantees a sum of money to a beneficiary; however, unlike a letter 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 ensure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.

Bank guarantees ensure both parties in a contractual agreement from credit risk. For instance, a construction company and its cement supplier may enter into a new contract to build a mall. Both parties may have to issue bank guarantees to prove their financial bona fides and capability. In a case where the supplier fails to deliver cement within a specified time, the construction company would notify the bank, which then pays the company the amount specified in the bank guarantee.

The Bottom Line

Both bank guarantees and letters of credit work to reduce the risk in a business agreement or deal. Parties are more likely to agree to the transaction because they have less liability when a letter of credit or bank guarantee is active. These agreements are particularly important and useful in what would otherwise be risky transactions, such as certain real estate and international trade contracts.

Banks thoroughly screen clients interested in one of these documents. After the bank has determined that the applicant is creditworthy and 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. 

One might say letters of credit ensure a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction doesn't go as planned.