Bank guarantee Vs Letter Of Credit

A bank guarantee and a letter of credit are similar in many ways but they're two different things. The main difference between these two credit security instruments is the position of the bank relative to the buyer and seller of a good, service or basket of goods or services in the event that the buyer defaults. These financial instruments are often used in trade financing when suppliers, or vendors, are purchasing and selling goods to and from overseas customers with whom they don't have established business relationships.

A bank guarantee is a guarantee made by a bank on behalf of a customer (usually an established corporate customer) in case it fails to deliver the payment, essentially making the bank a co-signer for one of its customer's purchases. A guarantee is a written contract stating that in the event that the borrower is unable or unwilling to pay its debt to a merchant, the bank will act as a guarantor and step in to pay that debt.

The initial claim is still settled primarily against the bank's client, and not the bank itself. This is a type of contingent guarantee. A bank guarantee is more risky for the merchant and less risky for the bank. But this is not the case with a letter of credit.

While a letter of credit is similar, the principal difference is that it is a potential claim against the bank, rather than a bank's client. For example, a seller may request that a buyer be provided with a letter of credit, which must be obtained from a bank and which substitutes the bank's credit for that of its client. In the event that the borrower defaults, the seller would go the buyer's bank for the payment. The seller's risk is mitigated because it is unlikely that the bank will be unable to pay the debt. A letter of credit is less risky for the merchant, but more risky for a bank.

With a bank guarantee, a client can default and the bank assumes the liability. With a letter of credit, liability rests solely with the bank, which then collects the money from its client.