A bank guarantee and a letter of credit are both promises from a financial institution that a borrower will be able to repay a debt to another party, no matter what the debtor's financial circumstances. While different, both bank guarantees and letters of credit assure the third party that if the borrowing party can't repay what it owes, the financial institution will step in on behalf of the borrower.
By providing financial backing for the borrowing 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 meeting in person. While letters of credit are primarily used in global transactions, bank guarantees are often used in real estate contracts and infrastructure projects.
- A bank guarantee is a promise from a lending institution that ensures the bank will step up if a debtor can't cover a debt.
- Letters of credit are also financial promises on behalf of one party in a transaction and are especially significant in international trade.
- Bank guarantees are often used in real estate contracts and infrastructure projects, while letters of credit are primarily used in global transactions.
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. The bank only pays that amount if the opposing party does not fulfill the obligations outlined by the contract. The guarantee can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.
Bank guarantees protect both parties in a contractual agreement from credit risk. For instance, a construction company and its cement supplier may enter into a 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.
Types of Bank Guarantees
Bank guarantees are just like any other kind of financial instrument—they can take on a variety of different forms. For instance, direct guarantees are issued by banks in both domestic and foreign business. Indirect guarantees are commonly issued when the subject of the guarantee is a government agency or another public entity.
The most common kinds of guarantees include:
- Shipping guarantees: This kind of guarantee is given to the carrier for a shipment that arrives before any documents are received.
- Loan guarantees: An institution that issues a loan guarantee pledges to take on the financial obligation if the borrower defaults.
- Advanced payment guarantees: This guarantee acts to back up a contract's performance. Basically, this guarantee is a form of collateral to reimburse advance payment should the seller not supply the goods specified in the contract.
- Confirmed payment guarantees: With this irrevocable obligation, a specific amount is paid by the bank to a beneficiary on behalf of the client by a certain date.
Bank guarantees are commonly used by contractors while letters of credit are issued for importing and exporting companies.
Letter of Credit
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 guarantees a buyer's payment to a seller or a borrower's payment to a lender will be received on time and for the full amount. It also states that if the buyer can't make a payment on the purchase, the bank will cover the full or remaining amount owed.
A letter of credit 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. The letter of credit basically substitutes the bank's credit for that of its client, ensuring correct and timely payment.
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 is 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.
Types of Letters of Credit
Just like bank guarantees, letters of credit also vary based on the need for them. The following are some of the most commonly used letters of credit:
- An irrevocable letter of credit ensures the buyer is obligated to the seller.
- A confirmed letter of credit comes from a second bank, which guarantees the letter when the first one has questionable credit. The confirming bank ensures payment in the event the company or issuing bank default on their obligations.
- An import letter of credit allows importers to make payments immediately by providing them with a short-term cash advance.
- An export letter of credit lets the buyer's bank know it must pay the seller, provided all the conditions of the contract are met.
- A revolving letter of credit lets customers make draws—within limits—during a certain time period.
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 determines that the applicant is creditworthy and has 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.
Another key difference between bank guarantees and letters of credit lies in the parties that use them. Bank guarantees are normally used by contractors who bid on large projects. By providing a bank guarantee, the contractor provides proof of its financial credibility. In essence, the guarantee assures the entity behind the project it is financially stable enough to take it on from beginning to end. Letters of credit, on the other hand, are commonly used by companies that regularly import and export goods.