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Bank guarantees are often used in real estate contracts and infrastructure projects, while letters of credit are primarily used in global transactions. But a bank guarantee and a letter of credit are similar in many ways.
With both instruments, the issuing bank accepts a customer’s liability if the customer defaults on the money they owe, and they are both, effectively, a show of good faith from the financial institution that it will step up if a debtor can’t cover a debt.
What Is a Bank Guarantee?
A bank guarantee is a lending institution’s agreement that it will assume liability for the completion of a contract between parties. This means that if one party defaults on their obligation or debt, the bank ensures the beneficiary receives their payment or compensation.
Essentially, the bank guarantee acts as a risk management tool in business. The bank, through its due diligence of the applicant, offers credibility that the applicant is a viable business partner in a particular business dealing. Bank guarantees apply to a certain monetary amount, and the contract typically dictates under which scenarios and at what point in time the guarantee is applicable.
In essence, the bank puts its seal of approval on the applicant’s creditworthiness, cosigning on behalf of the applicant as it relates to the specific contract that the two external parties are undertaking.
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Types of Bank Guarantees
There are a few different types of bank agreements Here’s a closer look at the main ones.
Financial Bank Guarantee
With a financial bank guarantee, the bank guarantees that the debtor (purchaser or borrower) repays all debts they owe to the beneficiary, and if they fail to pay those various types of debts, the bank has to assume responsibility for the money owed. The applicant has to pay a small initial fee when the guarantee is issued.
Performance-Based Bank Guarantee
When it comes to a performance-based guarantee, the beneficiary has the right to seek reparations from the bank if contractual obligations aren’t met due to nonperformance. If the counterparty doesn’t deliver on promised services, then the beneficiary has the choice to claim resulting losses caused by the lack of performance.
Foreign Bank Guarantee
Foreign bank guarantees can apply to unique scenarios such as international export situations. In this case, there may be a fourth party involved: a correspondent bank operating where the beneficiary resides.
What Is a Letter of Credit?
A letter of credit (sometimes referred to as a credit letter) is a document provided by a financial institution, such as a bank or credit union, that guarantees a payment will be made during a business transaction. The bank acts as an impartial third party throughout the transaction.
When the bank issues a letter of credit, it assures that the purchaser will, in fact, pay for any goods or services on time and in full. If the buyer doesn’t make its payment on time and in full, the bank that issued the letter of credit will guarantee that they will make the payment instead. The bank will cover any remaining overdue balance as long as it doesn’t surpass the full purchase amount.
Letters of credit are commonly used in international trade (but can be used domestically as well) where, understandably, companies require more certainty when making deals across borders. A letter of credit can provide security and confidence to importers and exporters since they know the issuing bank guarantees the payment.
Applicants for letters of credit need to work with a lender in order to secure this backing. The applicant has to provide a purchase contract and a copy of the purchase order or export contract (among other documents) during the application process. Applicants pay a fee to obtain the letter of credit, and this fee usually equates to a percentage of the amount that the letter of credit backs.
Types of Letters of Credit
There are multiple types of letters of credit, with some being more common than others and others applying to unique situations. Here’s a look at the main types.
Commercial Letter of Credit
This type of letter of credit applies to commercial transactions and is commonly used for international trade deals. In these cases, the bank makes a direct payment to the beneficiary.
Standby Letter of Credit
A standby letter of credit acts as a secondary payment method. The bank pays the beneficiary if the beneficiary can prove that it didn’t receive the promised product or service from the seller.
Revolving Letter of Credit
A revolving letter of credit can help secure multiple transactions when two parties anticipate doing multiple deals.
Traveler’s Letter of Credit
With a traveler’s letter of credit, the issuing bank guarantees to honor letters of credit signed at certain foreign banks.
Confirmed Letter of Credit
This type of letter of credit specifies that the seller’s bank will be the party to ensure that the seller receives payment if the buyer and its issuing bank default on the agreement.
Special Considerations
Bank guarantees and letters of credit differ slightly, but both serve the same purpose: to provide reassurance and protection during transactions.
Because the financial institutions that back these guarantees confirm that the buyer is creditworthy in the case of a bank guarantee or a letter of credit, the seller can be confident that the transaction goes through as planned if they have one of these agreements in place. If they do not, they know they’ll still receive payment from the institution that backed the agreement.
Key Differences Between a Bank Guarantee and Letter of Credit
These are the most important differences to know about a bank guarantee vs. a letter of credit.
Liability
With some letters of credit, the bank pays the seller directly, so it takes on the primary liability.
With a bank guarantee, the bank only pays if the buyer fails to do so, so the bank takes on a secondary liability.
Number of Parties Involved
At least three parties are involved in letters of credit and bank guarantee transactions. To start, there is the buyer, the seller, and a bank or another type of financial institution. With a letter of credit, a lender also gets involved. Sometimes two banks (more common in foreign transactions) are involved in a letter of credit or a bank guarantee.
Payment
With a bank guarantee, the bank only makes payment if the buyer fails to do so. With a letter of credit, this is also usually the case, but the bank may be more involved in the transaction, so disputes tend to be resolved faster.
Geography
Letters of credit are commonly used by U.S. companies in international trade. While bank guarantees may also be used for international transactions, they are often used for domestic contracts, such as large commercial or construction projects.
The Takeaway
When considering a letter of credit versus bank guarantee, both can help two parties involved in a transaction feel more confident that the seller will be paid and that the buyer will receive the goods or services promised — otherwise, they will be reimbursed by the bank that issued the agreement. Each type of agreement may be especially helpful when conducting business across borders.
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FAQ
How is a letter of credit different from a bank guarantee?
A letter of credit ensures payment is made when a transaction is completed, often serving as the primary payment method in international trade. In contrast, a bank guarantee acts as a financial safety net and only pays if a party fails to fulfill their contractual obligations. In addition, a letter of credit is frequently used for international transactions, while bank guarantees tend to be used for domestic transactions in the U.S.
What is a bank guarantee, and how does it work?
A bank guarantee is an assurance from a bank that a contract between parties will be executed or, if not, the bank will reimburse the wronged party accordingly. The bank essentially acts as a risk management tool.
What is the primary difference between a standby letter of credit and a bank guarantee?
A letter of credit and bank guarantee serve a similar purpose of offering assurance that payment or compensation will be provided if a party fails to fulfill its obligation. The main difference between the two is that a standby letter of credit is heavily standardized and often used for international contracts, while a bank guarantee is frequently used for domestic projects, and/or may be subject to different regional and national laws.
About the author
Jacqueline DeMarco
Jacqueline DeMarco is a freelance writer who specializes in financial topics. Her first job out of college was in the financial industry, and it was there she gained a passion for helping others understand tricky financial topics. Read full bio.
Photo credit: iStock/fizkes
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