Question

Using your language, write about the difference between the letter of credit and letter of guarantee

Word Limit for the assignment:
Upper word limit: 1200 words
Lower word limit: 600 words

Answer 1

Difference Between Letter of Credit and Bank Guarantee

Letter of Credit (L/C) is a financial instrument, used as an evidence of creditworthiness, issued by the bank of the buyer, concerning his credit history. L/C is often confused with a bank guarantee, as they share some common characteristics like both play a significant role in trade financing when the parties to the transactions don’t have established the business relationship.

Nevertheless, the two differs, in the bank’s position vis-à-vis buyer and seller of goods and services. A bank guarantee is a guarantee given by the bank to the seller, that if the buyer defaults in making payment, the bank will pay to the seller. Hence, to understand the terms better, all you need to know is the difference between letter of credit and bank guarantee, so take a read.

Comparison Chart

BASIS FOR COMPARISON	LETTER OF CREDIT	BANK GUARANTEE
Meaning	Letter of credit is an financial document for assured payments, i.e. an undertaking of the buyer's bank to make payment to seller, against the documents stated.	A bank guarantee is a guarantee given by the bank to the beneficiary on behalf of the applicant, to effect payment, if the applicant defaults in payment.
Liability	Primary	Secondary
Risk	Less for merchant and more for bank.	More for merchant and less for bank.
Parties Involved	5 or more	3
Default	Doesn't wait for applicant's default and beneficiary to invoke undertaking.	Becomes active only when the applicant defaults in making payment.
Payment	Payment is made only when the condition specified is fulfilled.	Payment is made on the non-fulfillment of obligation.
Suitable for	Import and Export business	Government contracts

The points given below are noteworthy, so far as the difference between letter of credit and bank guarantee is concerned:

1. Letter of Credit is a commitment of buyer’s bank to the seller’s bank that it will accept the invoices presented by the seller and make payment, subject to certain conditions. A guarantee given by the bank to the beneficiary on behalf of the applicant, to effect payment, if the applicant defaults in payment, is called Bank Guarantee.
2. In a letter of credit, the primary liability lies with the bank only, which collects payment from the client afterwards. On the other hand, in a bank guarantee, the bank assumes liability, when the client fails to make payment.
3. When it comes to risk, the letter of credit is more risky for the bank but less for the merchant. As opposed, the bank guarantee is more risky for the merchant but less for the bank.
4. There are five or more parties involved in a letter of credit transaction, as in applicant, beneficiary, issuing bank, advising bank, negotiating bank and confirming bank (may or may not be). As opposed, only three parties are involved in a bank guarantee, i.e. applicant, beneficiary and the banker.
5. In a letter of credit, the payment is made by the bank, as it becomes due, such that it does not wait for applicant’s default and beneficiary to invoke undertaking. Conversely, a bank guarantee becomes effective, when the applicant defaults in making payment to the beneficiary.
6. A letter of credit ensures that the amount will be paid as long as the services are performed in a defined manner. Unlike, bank guarantee mitigates loss, if the parties to the guarantee, does not satisfy the stipulated conditions.
7. A letter of credit is appropriate for import and export business. In contrast, a bank guarantee suits government contracts.