Letter of Credit (L/C) is a financial instrument, used as an evidence of creditworthiness, issued by the bank of the buyer, concerning his credit history. L/C is often confused with a bank guarantee, as they share some common characteristics like both play a significant role in trade financing when the parties to the transactions don’t have established the business relationship.
Nevertheless, the two differs, in the bank’s position vis-à-vis buyer and seller of goods and services. A bank guarantee is a guarantee given by the bank to the seller, that if the buyer defaults in making payment, the bank will pay to the seller. Hence, to understand the terms better, all you need to know is the difference between letter of credit and bank guarantee, so take a read.
Content: Letter of Credit
|Basis for Comparison||Letter of Credit||Bank Guarantee|
|Meaning||Letter of credit is an financial document for assured payments, i.e. an undertaking of the buyer's bank to make payment to seller, against the documents stated.||A bank guarantee is a guarantee given by the bank to the beneficiary on behalf of the applicant, to effect payment, if the applicant defaults in payment.|
|Risk||Less for merchant and more for bank.||More for merchant and less for bank.|
|Parties Involved||5 or more||3|
|Default||Doesn't wait for applicant's default and beneficiary to invoke undertaking.||Becomes active only when the applicant defaults in making payment.|
|Payment||Payment is made only when the condition specified is fulfilled.||Payment is made on the non-fulfillment of obligation.|
|Suitable for||Import and Export business||Government contracts|
Definition of Letter of Credit
A letter of credit is a formal document, which a bank issues on behalf of the buyer to the seller. The document states that the bank will honour the drafts drawn on the buyer, for the goods supplied to him, provided the conditions written on the document are satisfied by the supplier (seller).
The seller had to comply with all the terms and conditions set by the buyer and stated in the letter of credit. Further, he has to prove the conformity with conditions, by producing documentary evidence along with the relevant shipment documentation. Once the terms and conditions are met, the bank will transfer the funds to the seller. The functions performed by the letter of credit are:
- Removal of credit risk if the bank has good standing.
- Reduction in uncertainty, as the merchant is aware of the conditions which are to be satisfied to receive payment.
- Offers safety to the buyer, who want to make payment only if the conditions mentioned in the L/C is met.
Various types of Letter of credit include Sight L/C, Usance L/C, Revolving L/C, Irrevocable L/C, Standby L/C, Confirmed L/C and so on.
Definition of Bank Guarantee
A bank guarantee refers to a contract, wherein the bank gives the guarantee on behalf of the customer to the beneficiary, that the bank will be responsible for payment, in case if the customer defaults in discharging obligations. In this agreement, the bank acts as a surety, for making the debt good within three working days, if it is not paid by the applicant.
These are used to reduce the risk of loss that is attached to the commercial contracts. For doing so, the bank gets a certain amount of commission based on the sum guaranteed. Further, the bank is not bound to make payment, i.e. it can refuse to make payment if the claim is found unlawful. There are two types of bank guarantee:
- Financial Guarantee
- Performance Guarantee
Key Differences Between Letter of Credit and Bank Guarantee
The points given below are noteworthy, so far as the difference between letter of credit and bank guarantee is concerned:
- Letter of Credit is a commitment of buyer’s bank to the seller’s bank that it will accept the invoices presented by the seller and make payment, subject to certain conditions. A guarantee given by the bank to the beneficiary on behalf of the applicant, to effect payment, if the applicant defaults in payment, is called Bank Guarantee.
- In a letter of credit, the primary liability lies with the bank only, which collects payment from the client afterwards. On the other hand, in a bank guarantee, the bank assumes liability, when the client fails to make payment.
- When it comes to risk, the letter of credit is more risky for the bank but less for the merchant. As opposed, the bank guarantee is more risky for the merchant but less for the bank.
- There are five or more parties involved in a letter of credit transaction, as in applicant, beneficiary, issuing bank, advising bank, negotiating bank and confirming bank (may or may not be). As opposed, only three parties are involved in a bank guarantee, i.e. applicant, beneficiary and the banker.
- In a letter of credit, the payment is made by the bank, as it becomes due, such that it does not wait for applicant’s default and beneficiary to invoke undertaking. Conversely, a bank guarantee becomes effective, when the applicant defaults in making payment to the beneficiary.
- A letter of credit ensures that the amount will be paid as long as the services are performed in a defined manner. Unlike, bank guarantee mitigates loss, if the parties to the guarantee, does not satisfy the stipulated conditions.
- A letter of credit is appropriate for import and export business. In contrast, a bank guarantee suits government contracts.
A letter of credit is widely used in the international trade, but with the passage of time, its usage in domestic trade has also started. Whether its a global market or a local one, as a buyer you always need to pay for your purchases, which is facilitated by letter of credit. On the other hand, bank guarantee is used to fulfil various business obligations, whereby the bank acts as a surety and guarantees beneficiary, that is needed to meet the business requirements.