Letter of Credit vs Bank Guarantee
Letter of Credit and Bank Guarantee are financial instruments and almost similar to each other. It serves as a promise from the financial institutions and a guarantee to the seller that the borrower or buyer irrespective of his financial situation will repay the third party’s debt. It assures the third party since the financial institution will step in if the borrower cannot repay its debt. Hence, it not only encourages further transactions but also reduces the risk factors.
Here is an easy example for a better understanding of the Letter of Credit and Bank Guarantee. Suppose A from India purchased some material from another seller B living in the USA. The material will come for a month continuously. Now A can get a bank to issue a letter of credit for giving to B and ensure that B will receive the payments regularly. Hence B is more likely to believe in the letter of credit issued from a financial institution. The same example can be taken for the bank guarantee also wherein A will give a bank guarantee letter to B stating that the bank will make the payment if A cannot give it in time.
Key Differences between Letter of Credit and Bank Guarantee
Below stated are some of the significant differences between the Letter of Credit and Bank Guarantee.
- A letter of credit is an undertaking by the bank for making payments to the third party by the conditions stipulated in the document. Whereas, a bank guarantee is a form of assurance to the third party on behalf of the applicant for effecting the payment in case the applicant defaults.
- A letter of credit is mostly used in the case of international trade transactions and assuring the business of imports. In contrast, a bank guarantee is mostly used in financial transactions, large infrastructural projects, and domestic trade.
- A letter of credit is safer for the clients but carries risks for the banks. Whereas, bank guarantee carries risks for the clients but is safer for the issuing banks.
- A letter of credit has five parties involved in the drafting and execution of the instrument. In contrast, a bank guarantee involves only three parties for drafting and execution.
- The primary liability in the letter of credit falls on the bank alone. Whereas, the primary liability in the bank guarantee falls on the client and the bank intervenes only when the client defaults.
Hence, there are many differences between the letter of credit and bank guarantee despite both being financial documents issued by the bank only. The instruments come into effect under different situations and have its use for different purposes.