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What is the Difference Between a Letter of Credit and a Bank Guarantee?

What is the Difference Between a Letter of Credit and a Bank Guarantee?

There are different ways of obtaining finance to do business. The easiest way is to take a Personal Loan or a Business Loan. Banks offer a range of financial products to business enterprises. They include the standard working capital finance products, loans for purchasing machinery and equipment, letters of credit, bank guarantees, and so on. We will look into the Letter of Credit (LC) and Bank Guarantees (BG) and see the difference between the two.

The Concept of the Letter of Credit

In any business transaction, there has to be a minimum of two parties, the buyer and the seller. It is not necessary for the seller and buyer to know each other to do business. You can imagine the following scenarios in any trade transaction:

  • The buyer and seller know each other and do business in the same town
  • They know each other and do business in different cities or countries
  • They do not know each other in spite of doing business in the same city
  • They do not know each other and do business in different towns or states

In case they know each other:

  • The buyer can pay in advance and order for the goods or equipment, OR
  • The buyer can place an order for the products and pay after the delivery of the goods or equipment

In case they do not know each other, both the above options can be risky. The Letter of Credit is the best solution in such situation.

The buyer approaches the bank and requests them to open a letter of credit in favour of the seller. At the instance of the buyer, the bank opens the letter of credit in favour of the seller and transmits the document to the seller’s bank for onward delivery to the seller. The document states that the buyer’s bank will arrange to make the payment of the goods/equipment to the seller provided the seller complies with the terms and conditions listed in the LC.

The seller now has the comfort of receiving the guaranteed payment. The seller despatches the goods/equipment and complies with the terms listed out in the LC. The buyer’s bank recovers the money from the buyer and makes the payment. In fact, the buyer’s bank is under an obligation to pay the seller even if the buyer does not make the payment. The principal criterion is that the seller should comply with the terms listed out in the LC.

In short, we can define the LC as follows:

The Letter of Credit is a document, issued by the buyer’s bank at the instance of the buyer and undertaking to pay the amount listed in the LC provided the seller complies with the terms and conditions listed out in the LC. The bank places a lot of emphasis on the terms and conditions of the LC. There should be an underlying trade transaction for the bank to issue an LC.

There are various types of LCs in the banking sector. We need not go into the details now. We shall look at another similar financial product, the Bank Guarantee.

The Concept of the Bank Guarantee

Various Governmental organisations issue tenders for carrying out different projects. Eligible business entities bid for such tenders. These organisations insist on the business entities producing a BG that guarantees their performance. The business entities approach their bank for issuance of the BG. The bank issues the BG at the instance of the business entity and ensures the performance of the contract. It lists the conditions of the BG and undertakes to pay the amount in case the business entity fails to comply with the conditions laid down in the BG.

Thus, we define the BG as follows. The business entity’s bank issues a Bank Guarantee at the instance of the entity undertaking to pay the amount mentioned in the BG provided the business entity fails to comply with the terms enumerated in the BG. There should be an underlying contract for the bank to issue a BG.

The Difference Between an LC and a BG

  • Both LC and BG are documents issued by the bank at the instance of its customer
  • Both the LC and the BG list out terms and conditions on the document.
  • The difference is that, in an LC, the bank pays the amount if the seller satisfies the conditions whereas, in a BG, the bank pays if the business entity fails to meet the requirements laid down in the document.

Therefore, the terms and conditions mentioned in the documents are crucial. Understand that in both the cases, the customer at whose instance the banks issues the documents has to pay the bank. The bank has the right to recourse. Hence, banks issue LC and BG as part of regular financial limits by insisting on payment of margin and furnishing of adequate collateral.

Now, when you have such financial products, there is no need for businesses to scout for the Best Personal Loan Rates. They can avail these products by providing their business estimates and adequate collateral.

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About Subodh Tandon

Subodh is a full time marketing consultant and a skilled blogger. His area of interest belongs to marketing and finance related news and love to share all of those topics over the internet. You can catch him directly through this blog.