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Difference between letters of credit and bank guarantee

enero 28, 2020

The letter of credit (L / C) a financial instrument, used as proof of creditworthiness, issued by the buyer's bank, concerning his credit history. L / C often confused with a bank guarantee, as they share some common characteristics as both play a significant role in commercial financing when the parties to the transactions have not established the commercial relationship.

However, the two differ, in the bank's position towards the buyer and seller of goods and services. A Bank guarantee a guarantee provided by the bank to the seller, that if the buyer defaults in the payment, the bank will pay to the seller. So to better understand the terms, all you need to know is the difference between the letter of credit and the bank guarantee, so take a reading.

Comparative chart

Basis for comparison Credit letter Bank guarantee
SenseThe letter of credit is a financial document for secured payments, i.e. a commitment by the buyer's bank to make the payment to the seller, against the declared documents.A bank guarantee A guarantee given by the bank to the beneficiary on behalf of the applicant, to make the payment, if the applicant defaulting on the payment.
responsibilityPrimarySecondary
RiskLess for the merchant and more for the bank.More per merchant and less per bank.
The parties involved5 or more3
defaultIt does not wait for the default of the applicant and the beneficiary to invoke the company.It becomes active only when the applicant defaulting on the payment.
PaymentPayment is made only when the specified condition is met.Payment is made in case of non-fulfillment of the obligation.
Useful toBusiness import and exportPublic 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 declares that the bank will honor the drafts drawn on the buyer, for the goods supplied to him, provided that the conditions written on the document are met by the supplier (seller).

The seller had to comply with all the terms and conditions established by the buyer and indicated in the letter of credit. Furthermore, it must demonstrate compliance with the conditions, producing documentary evidence together with the relevant shipping 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:

  • Credit risk removal if the bank has a good reputation.
  • Reduction of uncertainty, as the merchant is aware of the conditions that must be met to receive payment.
  • It offers security to the buyer, who wishes to make the payment only if the conditions mentioned in the L / C are met.

Various types of letters of credit include vision L / C, usage L / C, swiveling 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, in which the bank provides the guarantee on behalf of the customer to the payee, that the bank will be responsible for the payment, in the event that the customer does not fulfill the discharge obligations. In this agreement, the bank acts as a guarantee, to make the debt good within three working days, if not paid by the applicant.

These are used to reduce the risk of loss that associated with commercial contracts. To do this, the bank receives a certain amount of commissions based on the guaranteed sum. In addition, the bank is not required to make the payment, that is, it can refuse to make the payment if the complaint is deemed illegal. There are two types of bank guarantee:

  • Financial guarantee
  • Performance guaranteed

Key differences between letter of credit and bank guarantee

The points indicated below are noteworthy, as regards the difference between the letter of credit and the bank guarantee:

  1. The letter of credit is a commitment from the buyer's bank to the seller's bank that will accept the invoices presented by the seller and make the payment, under certain conditions. A guarantee provided by the bank to the payee on behalf of the applicant, to make the payment, if the applicant defaulting on the payment, called a bank guarantee.
  2. In a letter of credit, the primary responsibility lies solely with the bank, which subsequently collects the payment from the customer. On the other hand, in a bank guarantee, the bank takes responsibility when the customer fails to make the payment.
  3. When it comes to risk, the letter of credit is riskier for the bank but less risky for the trader. On the contrary, the bank guarantee is riskier for the trader but less risky for the bank.
  4. There are five or more parties involved in a credit transaction letter, such as in the applicant, payee, issuing bank, advisory bank, trading bank and confirmation bank (may or may not be). By contrast, only three parties are involved in a bank guarantee, i.e. applicant, beneficiary and banker.
  5. In a letter of credit, the payment is made by the bank, as it becomes due, so as not to wait for the default of the applicant and the beneficiary. Conversely, a bank guarantee becomes effective when the defaulting applicant makes the payment to the payee.
  6. A letter of credit guarantees that the amount will be paid as long as the services are performed in a defined way. Otherwise, the bank guarantee mitigates the loss if the parts of the guarantee do not meet the established conditions.
  7. An appropriate letter of credit for import and export activities. By contrast, a bank guarantee fits government contracts.

Conclusion

A letter of credit widely used in international trade, but over time, its use in domestic trade has also begun. Whether it's a global or local market, as a buyer you always have to pay for your purchases, which is facilitated by a letter of credit. On the other hand, the bank guarantee is used to fulfill various commercial obligations, for which the bank acts as a guarantee and guarantor, necessary to meet company requirements.

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