In this blog, we’ll discuss about the difference between Bank Guarantee and Letter of Credit, Both are the non-fund based credit facilities, that are given by a bank in trading finance, Many people get confused and understand the bank guarantee and letter of credit, as the same type of instruments, But these are 2 different financial instruments, And are used in different situations, I made detailed blogs on bank guarantee and letter of credit earlier.
In those, I explained the concept of bank guarantee and letter of credit, I also made a separate blog on types of letter of credit. So do read those blogs as well.
You’ll understand the concepts in detail, in this quick blog, we’ll talk about the main differences between bank guarantee and letter of credit, and in which situations you should use bank guarantee and in which situations you should use letter of credit, So read this blog right from the beginning to the end.
I already made detailed blogs on bank guarantee and letter of credit, So, if you haven’t read those blogs yet, then do read those first, so that you understand the concept clearly. Now let’s do a quick recap about the working of the bank guarantee.
Meaning of Bank Guarantee (BG)
So, a buyer and a seller come to an agreement. It may be a trading agreement, Maybe the seller is selling something, or it may be an agreement of a contractor or tendering agency. Maybe a government agency signs a contract. Let’s it’s a contract of construction, real estate, or infrastructure. Let’s take an example, let’s it’s there is a road construction project worth Rs 100 Cr, so in this case, this is a tendering agency, and this is a government department, so they’ll ask how you’ll complete a Rs 100 Cr project immediately, and we want a performance guarantee, so that if we find any defect in your work. Then the performance guarantee will be forfeited, and we’ll do some recovery. So, in this case, a bank comes in between, and the guarantee is given through that bank. So, the buyer/contractor request this bank guarantee from the bank. And the bank issue this bank guarantee to the seller or the tendering agency, So when the seller/government agency get the bank guarantee, the contract gets executed, So if there was an agreement for goods, then the seller sends the goods as they get the bank guarantee, So these goods can be some equipment worth Rs.1 crore, Let’s say some computer equipment, So in this case, it may be goods or contract, So if they get the bank guarantee, the contract will be signed. This bank guarantee will be a performance bank guarantee, In the case of goods, the computer equipment’s will be transferred and will reach the buyer, so when the goods will be transferred, or the contract will be signed. After that delivery is to be done to the buyer, so either they will do the payment or they will do the construction of the road.
What is the use of bank guarantee here?
Where the buyer and seller don’t know each other, So it is generally used in the relationship of importer and exporter, So the seller says that he will ship the goods, only when they will give a letter of credit.
How does letter of credit work?
The buyer will request for a letter of credit from the bank, that bank is called issuing or opening bank, Then the bank of the seller is the advising bank, The letter of credit reaches the advising bank, then advising bank sends the letter of credit to the seller, All the details are there in that letter of credit, like seller’s name, product name, amount of that letter of credit, When the seller gets the letter of credit, it becomes cash equivalent. So, the seller gets to know that the buyer is very serious, After that, he ships the goods, As the goods are shipped, he gets the bill of lading which is the main document of the shipment, And this bill of lading goes to the advising bank, And then the advising bank do the payment. So, the letter of credit is acting as a payment.
Comparison Between BG and LC
This is basically a cash equivalent and there’s no default here, so transaction takes place with letter of credit, and this becomes a surety of 100% payment to the seller, but bank guarantee works only in case of default, and it is a type of insurance. It is basically not a transaction, but if any default takes place, then the bank guarantee is encased. But in the case of a letter of credit, it is considered equivalent to cash, and the seller has surety that he’ll get his money 100%. So, because issuing and advising banks to come in between, and the advising bank do the payment on its credit risk. And later on, it recovers its payment from the issuing bank, and issuing bank recovers from the buyer, so this whole process is detailed, and I explained it in detail. So, if you want to know in detail, then do read my letter of credit blog. So, if we want to summarize the differences and similarities between bank guarantee and letter of credit.
Summary
Bank guarantee is a promise from the bank, that if the buyer/seller doesn’t meet their liabilities and default the agreement. In that case, the bank will pay the bank guarantee. the bank will pay the payment to the seller according to the bank guarantee amount, but this is an obligation in the letter of credit, that the bank has to pay the amount mentioned in it. So, transaction becomes easier with this, so bank guarantee works as an insurance, and it reduces to loss, Loss of the seller is reduced here. If the buyer/contractor goes out of the business, then only the bank guarantee amount will be recovered, and there’s no 100% recovery. But there’s 100% payment through letter of credit. so the transaction takes place easily, And there’s a surety.
Where is the bank guarantee & letter of credit used generally?
It is used in trading and infrastructure contracts, Like real estate, road projects, telecom towers, power projects. So, it is used in big projects, and it is used in domestic, and it is used in both domestic and international contracts. And the letter of credit is mainly used in international trades, where buyer and seller don’t know each other. because of lack of trust, the transaction takes place through the letter of credit. these are the main differences between a bank guarantee and a letter of credit.
Now let’s see the similarities.
Both reduce the financial risks of buyer and seller, and banks check the credit worthiness of the buyer. before issuing any BG or LG, credit worthiness is seen,
How are their relationships with the banks, do they repay their loans on time, fulfil the liabilities. Whatever credit they take, right! And how is the financial standing, how strong is their balance sheet, Bank keep collateral be it FD or bank deposits. A bank guarantee or letter of credit is issued only against a collateral. And bank charges a fee for bank guarantee or letter of credit. Both are non-fund-based credit facilities, but the work is totally different. Bank guarantee is encased in case of default, but the letter of credit makes transactions easier, and it is a type of cash equivalent. so the risk of the seller reduces and ships the goods on the basis of letter of credit.
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