Bank guarantees and letters of credit both ensure that parties in a transaction will receive the payments they were promised. However, there are some key differences in how they work and when they are likely to be used. While a bank guarantee only requires a financial institution to pay if the buyer fails to do so, a letter of credit is often the lending institution confirming that they will make a payment after certain services are performed.
Both bank guarantees and letters of credit are designed to provide peace of mind to the seller or services provider in a contract. In both cases, a lending institution promises the seller in a transaction will receive their payment, regardless of whether it comes from the buyer or directly from the bank itself.
While these financial instruments have the same core purpose, they also have some key differences that we’ll discuss in this article.
What is a bank guarantee?
A bank guarantee is a contractual agreement between a bank or other lending institution and another party in a transaction. With this type of arrangement, the confirming bank ensures payment to a beneficiary if the party who is supposed to make the payment fails to do so. The guarantee acts as a sort of insurance policy, where the company only has to take action if something goes wrong.
Bank guarantees are often used in trade transactions, such as between a contractor and a materials supplier. In many cases, both companies will provide a bank guarantee. The contractor acquires a guarantee with the financial obligation from a bank to pay the bill for the materials if the other party fails to do so. The materials supplier would also acquire a bank guarantee, under which the confirming bank promises to make a payment to the contractor if the supplier doesn’t come through with the materials it promised. The bank guarantees serve as a backstop to protect both parties in case one fails to follow through on its end of the bargain.
The two guarantees in this example are a financial bank guarantee and a performance bank guarantee. The financial bank guarantee is acquired by the company that has promised payment to another, while the performance-based bank guarantee is acquired by the company promising to provide a particular good or service.
Types of bank guarantees
Like other types of financial instruments, bank guarantees come in several different forms depending on the type of transaction they’re being used for.
- Shipping guarantees. Given to a carrier for a shipment that arrives before any documents are received.
- Loan guarantees. Promises the repayment of a loan by the bank if the original borrower fails to pay.
- Advance payment guarantees. Reimburses a party for an upfront payment when the other party fails to deliver the promised goods or services.
- Confirmed payment guarantees. Promises a specific amount will be paid by the bank to another party at a specific time.
What is a letter of credit?
Similar to a bank guarantee, a letter of credit is a promise from an issuing bank to make a payment on another party’s behalf in a transaction. These letters are generally used in transactions (often international ones) where one party is buying goods from another party. The letter of credit serves as a promise to the seller that the bank will provide timely payment as long as they deliver the promised goods.
This financial instrument represents less of an insurance policy and more of a promise of action. In most cases, it’s the issuing bank in this agreement that ultimately sends the payment to the seller on behalf of the buyer. The bank may send the payment directly to the seller or to the seller’s bank.
An example of when a letter of credit might be used is in an international trade where a buyer in the U.S. is purchasing a product from a seller in another country. In this case, the seller has no previous relationship with the buyer and no way of knowing for sure if they’ll get paid if they send the goods. Therefore, the buyer gets a letter of credit, where the buyer’s bank promises to make the payment. The letter provides peace of mind for the seller to go through with the transaction.
Types of letters of credit
Just like with bank guarantees, there are several different types of letters of credit, each of which works a bit differently.
- Irrevocable letter of credit. Promises to make a payment to the seller on behalf of the buyer once the seller has completed its end of the agreement — also known as a commercial letter of credit.
- A standby letter of credit. Guarantees a payment only if the buyer fails to make it first.
- Confirmed letter of credit. Provides an additional guarantee of payment from a second financial institution on top of the first one.
- Revolving letter of credit. Used for a series of transactions over a set period rather than a single transaction.
Differences between bank guarantees and letters of credit
As you can probably already tell, there are some key differences between bank guarantees and letters of credit. We’ll dive further into those in this section.
|Bank Guarantee||Letter of Credit|
|Liability||Bank holds secondary liability||Bank holds primary liability|
|Parties involved||3||3 or 4|
|Payment||Made when another party fails to do so||Made when the other party fulfills certain conditions|
|Who provides a guarantee||One or both parties||One party|
|Uses||Trade transactions||International transactions|
One of the most important differences between a bank guarantee and a credit letter is when the issuing bank is liable for the payment.
In the case of a bank guarantee, it’s not until another party has failed to fulfill its end of an agreement that a bank has to step in and make the payment. But in the case of a letter of credit, the issuing bank is responsible for making the payment on behalf of the buyer.
There are generally three parties for a bank guarantee: the party obligated to provide the payment or goods, the beneficiary of the payment or goods, and the issuing bank that promises to step in if the obligated party fails to follow through. Keep in mind that transactions often involve two different bank guarantees, each of which would have three parties.
In the case of a letter of credit, there are generally four parties. The first two parties are the buyer and the seller in a transaction. There’s also the financial institution that promises the payment on behalf of the buyer. Finally, there’s usually a financial institution representing the seller as well, often known as the advising bank, where the payment is likely to be sent.
Another key difference between bank guarantees and letters of credit is when the financial institution is obligated to make a payment. A bank guarantee primarily serves as an insurance policy, and the bank generally doesn’t have to make a payment unless the party that agreed to do so fails to.
But with a letter of credit, it is often the bank that’s obligated to make the payment. However, they aren’t required to do so until the other party — usually the seller — fulfills certain conditions, such as providing proof of shipment of goods.
Who provides the guarantee?
As we explained above, it’s not uncommon for both parties in a transaction to provide a bank guarantee. One party has a bank guarantee to provide its financial payment, while the other provides a guarantee to provide its goods or services. But in the case of a letter of credit, it’s usually only one party in a transaction — the buyer — that provides a credit letter.
Bank guarantees can be used in many different situations, but often appear in trade transactions where one business is buying goods and services from another. One party may provide a financial bank guarantee, while the other provides a performance bank guarantee. Letters of credit, on the other hand, are most commonly used in international trade contracts.
Bank guarantee and letter of credit: What they have in common
We’ve talked a lot about the differences between bank guarantees and letters of credit, but what’s even more important is their similarities.
At their very core, both of these financial instruments are designed to assure one or more parties in a transaction that they’ll be compensated as promised. They often help companies feel more comfortable working together — especially in global transactions — thanks to the peace of mind they provide.
What is the difference between a standby letter of credit and a bank guarantee?
A standby letter of credit and bank guarantee have basically the same function. In both cases, a financial institution promises to make a payment if another party fails to do so.
Which letter of credit is similar to a bank guarantee?
As we mentioned above, a standby letter of credit is most similar to a bank guarantee, because in both cases, the bank has secondary liability instead of primary.
What are ABG & PBG?
ABG generally stands for advance payment bank guarantee, which reimburses a party for an upfront payment when the other party fails to deliver the promised goods or services. PBG, on the other hand, usually refers to a performance bank guarantee.
- A bank guarantee is a financial instrument where a financial institution promises to make a payment to another party if the party who was originally supposed to fails to do it.
- Bank guarantees are often used in trade transactions and may involve each party providing a bank guarantee to the other party.
- A letter of credit is a document where a bank promises to make a payment to another party once that party fulfills its end of an agreement.
- Letters of credit are generally used to facilitate international trade to provide assurance to a seller that the buyer will pay for the goods as promised.
View Article Sources
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- Will Closing Credit Cards I Already Have Increase My Credit Score? – Consumer Financial Protection Bureau
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- What Are The Most Popular Types of Credit? – SuperMoney
- Home Equity Loan vs. Line of Credit: Which Should You Choose? – SuperMoney
- Personal Loan Vs. Line Of Credit: Which Is Better? – SuperMoney
- Personal Loans vs Credit Cards: Things You Should Know – SuperMoney