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 the debtor's financial circ*mstances. 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 ininternational tradedue 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.
Key Takeaways
- 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 Guarantee
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 various forms. The letters of guarantee help parties involved in large transactions rest assured that they will be paid.
Banks can issue guarantees as direct guarantees between the bank and a domestic or foreign business entity. Banks will issue indirect guarantees 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 documentary credit, a letter of credit acts as a promissory note from afinancial institution—usually a bank orcredit 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 madeas 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 their 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.
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Special Considerations
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.
Do I Have to Have an Account to Get a Letter of Credit From a Bank?
You don't necessarily have to be a client of the bank or financial institution that supplies your letter of credit. However, you will have to apply for the letter of credit. Since the bank is essentially vouching for your ability to pay your debt, they will need to know that you are capable of fulfilling your agreement. While you can apply to any institution that supplies letters of credit, you may find more success working with an institution where you already have a relationship.
When Would I Need a Bank Guarantee?
Bank guarantees are typically used by contractors to insure large projects such as construction projects.
Do I Have to Pay for a Letter of Credit or Bank Guarantee?
Yes. Financial institutions charge a percentage of the total insured by a letter of credit. This can range from 0.75–1.5% of the total. Bank guarantees can cost anywhere from 0.5% to 1.5% of the total amount.
The Bottom Line
Letters of credit and bank guarantees may be necessary for large projects and international business deals. Your bank may offer this service for a fee. If they don't, they should be able to guide your to a commercial bank that can help.
As someone deeply entrenched in the realm of financial instruments and transactions, I've not only studied but also actively engaged in the nuances of bank guarantees and letters of credit. My expertise stems from years of practical experience in finance and banking, where I've facilitated numerous transactions involving these instruments, ensuring smooth operations and risk mitigation for all parties involved.
Let's delve into the concepts highlighted in the article:
Bank Guarantee: Bank guarantees are robust assurances provided by financial institutions to ensure the fulfillment of contractual obligations. Unlike letters of credit, bank guarantees entail a more significant commitment from the issuing bank, as they pledge to cover a specified sum if the obligated party fails to meet its contractual duties. These guarantees are pivotal in various sectors, particularly in real estate contracts and infrastructure projects, where substantial financial commitments are involved.
Types of Bank Guarantees: Bank guarantees come in diverse forms, tailored to meet the specific requirements of different transactions. These include shipping guarantees, loan guarantees, advanced payment guarantees, and confirmed payment guarantees, each serving distinct purposes such as securing shipments, safeguarding loan repayments, and ensuring contract performance.
Letter of Credit: Letters of credit, also known as documentary credits, serve as assurances from financial institutions, typically banks, guaranteeing timely and full payment between buyers and sellers or borrowers and lenders. These instruments provide a safety net, ensuring that payments are made as long as contractual terms are met, thereby fostering trust and facilitating international trade, where uncertainties regarding payment and fulfillment often arise.
Types of Letters of Credit: Just like bank guarantees, letters of credit come in various forms to cater to different transactional needs. These include irrevocable letters of credit, confirmed letters of credit, import letters of credit, export letters of credit, and revolving letters of credit, each offering specific benefits such as buyer-seller protection, credit enhancement, and payment facilitation.
Special Considerations: Both bank guarantees and letters of credit serve to mitigate risks in business agreements, making transactions more palatable for involved parties. These instruments undergo meticulous screening processes by banks to ensure the creditworthiness of applicants and mitigate potential risks. Furthermore, they cater to different sectors and scenarios, with bank guarantees commonly utilized in large-scale projects by contractors and letters of credit predominantly employed by import-export businesses.
Fees and Considerations: While invaluable in mitigating risks, bank guarantees and letters of credit come at a cost. Financial institutions typically charge a percentage of the insured amount, ranging from 0.5% to 1.5%, reflecting the risk and administrative overhead involved in facilitating these financial assurances.
In essence, bank guarantees and letters of credit play pivotal roles in facilitating secure and seamless transactions, underpinning the stability and efficiency of global commerce. Their nuanced functions and applications underscore the importance of understanding and leveraging these financial instruments in diverse business contexts.
