A credit letter is a kind of financial instrument that is issued by one institution and transferred to another one. The bank that is receiving the letter of credit is usually located in a different country. Its function is to ensure the payment is made to one individual and is governed by strict set rules and regulations.
Bank guarantees can be an instrument for financial purposes. It is given by a bank or other lender to a corporate organization. Its function is to guarantee that the loan amount will be paid back even if the debtor fails to pay the payment. In most cases, it is the issuing authority that is responsible for the obligation. A credit card is risky for banks, and a bank guarantee is dangerous for merchants.
Letter of Credit vs Bank Guarantee
The major difference between the two types of letters guarantee is that a bank of credit is a form that a buyer's lender provides to the seller, along with conditions for the seller to provide the product to the buyer. A bank guarantee refers to the fact that the bank guarantees the seller that if the buyer does not make the payment, the bank is responsible.
Difference Between Letter of Credit and Bank Guarantee in Tabular Form
|Parameters for Comparison||Letter of Credit||Bank Guarantee|
|Applications||A letter of credit can be used to provide a guarantee for importing businesses. It is also used to facilitate international trade..||A bank guarantee can be used to guarantee domestic trade and financial transactions. It facilitates large-scale infrastructural developments.|
|There are risks.||Although this instrument is risky for the bank, it is safer for the client..||This option, however, is less risky for the client than the one that is issued by the bank.|
|Issued By||is usually issued by the seller's bank to the recipient's bank, which is often located abroad.||issued by a buyer’s bank to a corporate body that is, in most cases, domiciled within the same country or territory.|
|Parties.||This instrument was drafted and executed by five parties. These include the negotiating bank and confirming bank, as well as the issuing bank, beneficiary, and advising banks.||This instrument is drafted and executed by three parties. The beneficiary, the banker, and the applicant are all involved in the drafting and execution of this instrument.|
|Conditions for Payments||Before payments can be released, you must meet all the conditions and terms..||Before the instrument can be invoked, it is necessary to comply with all conditions and terms.|
What Is a Letter of Credit?
A credit letter is a formal document that a bank issues in the name of the customer to the supplier. The document stipulates that the institution will honor the draughts drawn against the buyer for the items delivered to him as long as the conditions specified in it are met by the seller (seller).
The seller was required to comply with all conditions and terms set by the buyer as stated in the credit letter. Additionally, the seller must demonstrate that he complies with the conditions by presenting documentary proof together with the appropriate documents for the shipment. If the terms and conditions are fulfilled, the bank will then transfer cash to the vendor. The duties that are performed by the letters of credit include
- By eliminating credit risk, If the bank is in good standing,
- There is a reduction in uncertainty because it is clear to the vendor the terms that must be met for the payment.
- It provides security for the buyer who wishes to pay only when the terms stated in the L/C contract are fulfilled.
Here's the way it operates: You order goods from country A. However, you're unable to pay for the charges in full at the moment. Your bank is therefore instructed to send the "letter of credit" in the name of the international company's banking institution. The company will then give you the merchandise and hold it to make your payments in the future.
Types of Letters of Credit
A D.A. (Usance), also known as DP L, is a kind of credit note where the payment must be due at the time of maturity as per the terms of credit. The titles to the goods are given to the buyer only upon acceptance of the documents to pay. The buyer will then pay the amount on the due date of maturation of the LC. PLCs are a type of letter of credit in which they can pay for documents on the presentation.
Irrevocable and revocable LCL: an irrevocable letter of credit is a kind of LC that may be modified or canceled with the approval of the person who is the beneficiary, the applicant, and the bank that confirms. Revocable LC can be modified or canceled at any time without prior notification to the beneficiary. The LC is usually irrevocable.
LC: Without or without Recourse If the recipient holds itself accountable to the holder of the bill in case it is not honored, it is said that the LC is considered to have recourse. If the beneficiary does not hold itself accountable for the debt, it is said to be non-recourse.
Restricted LC: A restricted LC designates a single bank to accept, pay, and negotiate the LC.
Confirmed LCA A confirmed LCC is a letter of credit where the bank that advises, upon request from the issuing bank, confirms that the payment can be expected. The liability of the confirming bank is similar to that of the issuing bank. The confirming bank is required to pay the amount of the payment made by the person who is the beneficiary.
If an LC is transferable by the beneficiary in full or in part to another beneficiary (usually an intermediary or seller), the LC is considered to be a transferable LC. The second beneficiary, however, can't move this LC further.
In a back-to-back LC, the second LC is opened by the beneficiary who originally opened it to the second beneficiary in exchange for security from the first LC. It is widely assumed that reverse-to-rear LC is available to providers.
Standby LCA: a standing LC that functions similarly to performance bonds or guarantees, but is issued as an LC. The recipient of the standby LC may claim with documentary evidence the standby LC's stated purpose.
Revolving LC: In a revolving LC, an applicant can use the LC facility in the future following drawings drawn and payments made against LCs.
What Is A Bank Guarantee?
A bank guarantee is an agreement in which the bank guarantees the client's name to the beneficiary. The beneficiary agrees that the bank will be accountable for the payment in the event the client fails to pay off obligations. In this contract, the bank is a surety to make the debt payable within three days if it is defaulted upon by the person who applied for it.
They are employed to decrease the chance of losing money associated with commercial contracts. To do this, the bank is paid a commission on top of the amount that is guaranteed. Additionally, the bank isn't required to pay, i.e., it cannot make a payment if the claim is deemed in violation of the law.
Here's how it's used: The company that plans to purchase the product contacts its bank to request to borrow this tool.
The bank draughts it and then sends it to the corporate entity that is set to sell its products to the business concerned. The company then releases the merchandise and awaits payment.
Types of Bank Guarantees
There are several types of bank guarantees as follows, and each one is designed for a specific kind of transaction:
A performance guarantee can be utilized as collateral in transactions between a buyer and a seller. Performance guarantees are typically used when the buyer is liable for costs and the seller does not provide the products or services according to the terms of the agreement. To invoke a guarantee of performance, the buyer must affirm on paper that the seller failed to meet his or her contractual obligations correctly or on time.
Guaranteed Bid Bond
Bond guarantees for bidding are usually utilized in tenders to guarantee that the winning bidder can fulfill the contract following the conditions of the winning bid. If a bidder who is awarded the contract fails to meet the requirements of the tender as specified, the tenderer could use the bank guarantee to either completely or partially forfeit the amount. So, bid bonds are mostly used to guarantee that the winner adheres to the tender conditions following the award of the bid.
A financial guarantee is a promise by a bank to assume responsibility for a financial obligation if the business fails to meet its obligation. The bank offers financial guarantees, typically between two parties who are related, i.e., a partner company that provides an assurance of financial security to a subsidiary firm.
Guarantee of advance payment
An advance payment guarantee can be intended to safeguard the advance payment that is made by buyers to sellers. If the seller does not deliver the goods or services according to the conditions of the deal, then the buyer may invoke an advance guarantee to obtain an entire or partial advance payment that has been made by the vendor. Advance payment guarantees can be used for international trade transactions as well as domestic transactions where large amounts of advance payments are paid to the vendor.
Foreign bank guarantee
International trade requires the use of a foreign bank guarantee. The bank provides a foreign bank guarantee for the benefit of an international beneficiary.
Deferred payment guarantee
Deferred payments are made to ensure that one participant in a transaction agrees to pay a predetermined amount at the same time shortly. If the debtor cannot make the payment, then the deferred payment guarantee may be used to obtain the funds.
Main Difference Between Letter of Credit and Bank Guarantee in Points
- A Letter of Credit represents a promise from the buyer's banking institution to the seller's bank to accept invoices submitted by the seller and make payment with specific conditions. A guarantee is made from the lender to the recipient on behalf of the beneficiary to facilitate payment when the person who is the beneficiary fails to make the payment. This is referred to as a "guarantee by the bank." Guarantee.
- In a credit letter, the principal liability is sole with the bank that collects payments from the customer. In contrast, when a bank guarantees the payment, the bank is responsible if the client fails to pay.
- In terms of risk, when it comes to risk, the credit letter has a higher risk for the bank, but less so for the business. Contrarily, the bank guarantee is much riskier for the business but less so for the bank.
- At least five people are involved in an operation involving a letter of credit that includes the applicants, beneficiaries' issuing bank, the banking institution, negotiating banks, and confirming banks (maybe). However, in a bank guarantee, there are only three parties included, i.e., the applicant, the beneficiary, and the financial institution.
- In a credit letter, it is the case that the payment is made by the bank when it is due so that it does not have to wait for the default of the applicant and for the beneficiary to invoke the undertaking. In contrast, a bank guarantee is effective when the person who is the beneficiary defaults on paying the beneficiary.
- A credit letter guarantees that the sum will be paid if the service is performed in a specified way. In contrast, a bank guarantee protects against any loss if the party to the guarantee does not meet the conditions.
- A credit card is suitable for both import and export-related businesses. A bank guarantee can be used for government contracts.
A credit card is extensively used in the international market, but with the passing of time and the rise of domestic commerce, it has also begun. No matter if the market is a global or local one for a buyer, you must always make payments for purchases, and this is made easier by a letter of credit. However, bank guarantees are utilized to fulfill various obligations in business. In this case, the bank is an insurance company that provides a guarantee to the recipients and is necessary to satisfy the requirements of the business.