Bank Guarantee (BG): A bank guarantee is a promise made by a bank to cover a loss if a borrower defaults on a loan or contractual obligations. It is a type of financial backstop offered by the bank that assures the beneficiary that the financial commitments of the applicant will be fulfilled. If the applicant fails to meet the obligations, the bank steps in and covers the payment.
Letter of Credit (LC): A letter of credit is a financial instrument issued by a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. It is predominantly used in international trade to ensure that transactions proceed smoothly. The issuing bank pays the seller once the terms of the LC are met, and necessary documents are presented.
Parties Involved and Their Roles
Bank Guarantee:
- Applicant: The party that requests the bank guarantee, usually the borrower or the party required to provide the guarantee.
- Beneficiary: The party in whose favor the guarantee is issued, often the seller or creditor.
- Issuing Bank: The bank that issues the guarantee and commits to paying the beneficiary if the applicant defaults.
Letter of Credit:
- Applicant (Buyer): The party that requests the issuance of the LC.
- Beneficiary (Seller): The party in whose favor the LC is issued and who receives the payment upon fulfilling the terms.
- Issuing Bank: The bank that issues the LC on behalf of the applicant.
- Advising/Confirming Bank: The bank, usually in the seller’s country, that advises the LC to the seller and may confirm the LC, adding its own guarantee to pay.
Governing Rules
Bank Guarantee:
- Bank guarantees are governed by local banking laws and regulations of the issuing bank’s country.
- They can also be subject to international standards like the Uniform Rules for Demand Guarantees (URDG) 758.
Letter of Credit:
- LCs are primarily governed by the International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits (UCP 600).
- They ensure standardized procedures and practices in international trade, reducing the risk of discrepancies and disputes.
Examples and Application in International Trade
Bank Guarantee Example: A construction company (applicant) needs to provide a performance guarantee to a project owner (beneficiary) to ensure that the project will be completed as per the contract. The bank issues a guarantee, promising to pay the project owner if the construction company fails to deliver the project.
Letter of Credit Example: An exporter in India is selling goods to an importer in the United States. To ensure payment, the importer requests an LC from their bank. The LC stipulates that the payment will be made upon the presentation of specific documents, such as the bill of lading, invoice, and certificate of origin. Once the exporter ships the goods and presents the required documents to their bank, they receive the payment.
Differences and Comparison
Bank Guarantee vs Letter of Credit:
- Purpose: A bank guarantee ensures the fulfillment of obligations by the applicant, while a letter of credit ensures the payment for goods and services provided.
- Usage: Bank guarantees are commonly used in domestic and international contracts to mitigate performance and financial risks. Letters of credit are predominantly used in international trade to secure payments.
- Payment: Under a bank guarantee, the bank pays only if the applicant defaults. Under a letter of credit, the bank pays upon presentation of the required documents.
- Risk: A bank guarantee mitigates the beneficiary’s risk of non-performance by the applicant. A letter of credit mitigates the seller’s risk of non-payment by the buyer.
Which is Better: The choice between a bank guarantee and a letter of credit depends on the specific needs of the parties involved. For securing payment in international trade, a letter of credit is more suitable. For ensuring performance or fulfilling contractual obligations, a bank guarantee is better.
For Export: In the context of exports, letters of credit provide more security to the exporter, ensuring that payment will be received if the terms of the LC are met. Bank guarantees, on the other hand, may be used to ensure that the exporter fulfills their obligations, such as delivering goods on time.
Conclusion
Understanding the concepts of bank guarantees and letters of credit is crucial for businesses engaged in international trade. While both financial instruments provide security, they serve different purposes and involve different parties and risks. By choosing the appropriate instrument based on the nature of the transaction and the specific requirements of the parties, businesses can mitigate risks and ensure smooth operations in both domestic and international markets.