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A Bank Guarantee and a Letter of Credit (LC) are both financial instruments used in international trade and business transactions to provide security to the parties involved. However, they have distinct purposes, structures, and usage contexts. Below is a detailed comparison of the two:

1. Purpose and Function

• Bank Guarantee (BG):
  • A Bank Guarantee is a promise by a bank to pay a beneficiary in case a party (the applicant) fails to fulfill a contractual obligation. It serves as a safety net or assurance for the beneficiary that the bank will step in and compensate for any losses if the terms of the contract are not met.
  • It is often used in situations where there is a risk of default or non-performance, such as construction contracts, leasing agreements, or loans.
• Letter of Credit (LC):
  • A Letter of Credit is a written commitment from a bank (usually the buyer's bank) to pay the seller a specific amount, provided the seller meets the terms and conditions outlined in the LC (such as delivering goods or services). It is primarily used in international trade to ensure payment and reduce the risk for both parties.
  • It guarantees that the seller will be paid once they present the required documents proving that the agreed-upon goods or services have been shipped or delivered.

2. Risk Allocation

• Bank Guarantee:
  • The risk is typically on the applicant (the party who seeks the guarantee), as the bank steps in only if the applicant defaults. The beneficiary receives payment without having to prove any wrongdoing, only that the conditions of the guarantee were triggered.
• Letter of Credit:
  • The risk is shared more equally. The buyer is assured that the seller will only receive payment when they present the correct documents, reducing the risk of fraud. The seller is assured of payment as long as they meet the conditions set by the LC. The issuing bank’s role is to ensure that all terms are strictly followed.

3. Types of Guarantees or Credit

• Bank Guarantee:
  • There are different types of guarantees, such as:
    • Performance Guarantee: Ensures the applicant performs as per the contract terms.
    • Payment Guarantee: Ensures the applicant makes a payment as agreed.
    • Bid Bond Guarantee: Ensures that the bidder will accept the contract if awarded the tender.
• Letter of Credit:
  • Common types of LCs include:
    • Revocable LC: Can be amended or canceled by the buyer (with the seller's agreement).
    • Irrevocable LC: Cannot be changed or canceled without the consent of all parties.
    • Sight LC: Payment is made immediately upon presentation of documents.
    • Usance LC (or Time LC): Payment is made after a certain period, usually at a later date (e.g., 30, 60, or 90 days).
    • Standby LC: Functions similarly to a bank guarantee but is used mainly in the context of international transactions.

4. Parties Involved

• Bank Guarantee:
  • Applicant (the party requesting the guarantee): Typically the party seeking to reassure the beneficiary that they will fulfill their contractual obligations.
  • Beneficiary (the party receiving the guarantee): The party that is assured payment if the applicant defaults.
  • Issuing Bank: The bank that issues the guarantee on behalf of the applicant.
• Letter of Credit:
  • Applicant (the buyer): The party who requests the LC from their bank to ensure payment to the seller.
  • Beneficiary (the seller): The party who will receive payment once they comply with the terms of the LC.
  • Issuing Bank: The bank of the buyer that issues the LC and guarantees payment.
  • Advising Bank: The bank of the seller that notifies the seller of the LC.

5. When to Use Each

Bank Guarantee:

• Default Risk Management: When you want to provide assurance to a party (e.g., in construction contracts or lease agreements) that you will meet your obligations or compensate them if you do not.
• Non-performance or Payment Guarantees: For situations where you may need to guarantee performance or payment without requiring an actual transaction (e.g., bid bonds for tenders).
• Contractual Security: When you are entering into agreements or contracts that require a financial backstop in case of non-performance.

Letter of Credit:

• International Trade Transactions: When you need a secure payment method in global trade, ensuring the seller is paid only when they meet the delivery and documentation conditions.
• Reducing Payment Risk: When you are a seller, particularly in a foreign market, and want to avoid the risk of non-payment by ensuring the buyer's bank guarantees payment once terms are met.
• Assuring Delivery of Goods/Services: When the buyer is unsure of the seller's ability to meet the terms and needs proof that goods or services will be delivered according to the contract.

6. Payment Mechanism

• Bank Guarantee:
  • The payment under a bank guarantee is made when the conditions of the guarantee are triggered (e.g., failure to perform as agreed).
  • Payments are made even if the underlying contract is disputed, as long as the conditions are met.
• Letter of Credit:
  • Payment is made once the seller submits the correct documents as per the LC (such as shipping documents, invoices, etc.).
  • Payment is typically only made after documents are verified, and the terms are fulfilled.

7. Cost

• Bank Guarantee:
  • Generally, the cost of a BG depends on the amount guaranteed and the risk involved. Banks charge a fee based on the guarantee amount, which could be a flat fee or a percentage of the guaranteed amount.
• Letter of Credit:
  • The cost of an LC is typically higher than a BG due to the complexity of the documentation and the involvement of multiple banks (issuing and advising banks). The fees can include issuance fees, amendment fees, and negotiation fees.

About Chandra Credit Limited

We are specialized financial service providers based in Noida that provide various financial services letter of credit, bank Guarantee,SBLC and Project funding. Feel Free to Contact us on info.chandracredit.com or call us on +91 84482 78716