The world of finance and trade is built upon trust, and two of the most crucial instruments that help foster this trust between parties are Bank Guarantees and Letters of Credit (LCs). Both serve as financial promises made by banks to secure transactions, but they function differently in terms of intent, mechanism, and risk mitigation. This essay discusses the concept of a Bank Guarantee, its types, key characteristics, and elaborates on the difference between Bank Guarantee and Letter of Credit, with real-world applications.
What is a Bank Guarantee?
A Bank Guarantee is a promise made by a bank or financial institution that it will meet the obligations of a debtor in case the debtor fails to fulfill the terms of a contract or agreement. Essentially, the bank acts as a guarantor, assuring the creditor (beneficiary) that the bank will make the payment if the customer (applicant) defaults.
Key Features of Bank Guarantee:
- Contract-Based: Issued against a contract where performance or payment is assured.
- Risk Mitigation Tool: Protects the beneficiary from financial losses due to non-performance or breach of contract.
- Secondary Liability: The bank’s liability arises only when the applicant defaults.
- Common in Domestic Business: Frequently used in infrastructure, supply contracts, government tenders, etc.
- Non-Fund Based Facility: It does not involve the direct lending of money unless there’s a default.
Types of Bank Guarantees
- Financial Guarantee: Ensures the payment of money by the applicant to the beneficiary.
- Performance Guarantee: Ensures the fulfillment of contractual obligations.
- Bid Bond Guarantee: Issued during the bidding process to guarantee the seriousness of the bidder.
- Advance Payment Guarantee: Protects the buyer in case the supplier fails to deliver after receiving the advance.
- Foreign Bank Guarantee: Issued for international transactions and projects.
What is a Letter of Credit (LC)?
A Letter of Credit is a financial instrument issued by a bank on behalf of a buyer, guaranteeing that the seller will receive payment once the agreed conditions are met. It is mostly used in international trade to ensure that goods are shipped and received as per contract terms.
Key Features of a Letter of Credit:
- Primary Payment Method: Payment is assured upon compliance with terms and presentation of documents.
- Used in International Trade: Minimizes risk between parties in different countries.
- Bank is Primarily Liable: The bank undertakes the obligation to pay regardless of buyer’s ability.
- Document-Based Transaction: No actual goods are checked—only documents are verified.
- Fund-Based Facility: Payment is typically made by the issuing bank.
Difference Between Bank Guarantee and Letter of Credit
| Feature | Bank Guarantee | Letter of Credit |
|---|---|---|
| Nature of Commitment | Secondary liability | Primary liability |
| Use Case | Domestic contracts, performance assurance | International trade, assured payment |
| Trigger for Bank Involvement | Only upon default of applicant | Upon presentation of required documents |
| Risk Protection | Protects buyer or seller from loss due to default | Assures seller of payment |
| Payment Mechanism | Bank pays if applicant fails | Bank pays as per documentary compliance |
| Fund Based or Non-Fund Based | Non-fund based | Fund based |
| Verification Basis | Conditions of default | Presentation of documents |
| Usage Industries | Construction, services, government tenders | Import/export, manufacturing, shipping |
Real-Life Examples
- A contractor who wins a road construction tender must furnish a performance bank guarantee to assure the government that the work will be done on time. If not, the bank pays the damages.
- An importer in India wants to buy electronics from a supplier in Japan. The Indian buyer’s bank issues a Letter of Credit to the Japanese supplier’s bank, promising payment upon shipment of goods and submission of proper documents.
Legal Backing in India
- Bank Guarantees are governed by Indian Contract Act, 1872, and supported by Uniform Rules for Demand Guarantees (URDG 758) by ICC.
- Letters of Credit are governed by Uniform Customs and Practice for Documentary Credits (UCP 600) published by the International Chamber of Commerce (ICC).
Advantages of Bank Guarantee and Letter of Credit
Bank Guarantee:
- Builds trust in high-value domestic transactions.
- Protects buyer from financial losses.
- Helps businesses win large contracts.
Letter of Credit:
- Facilitates international trade.
- Reduces counterparty risk.
- Encourages sellers to work with new buyers.
Disadvantages
Bank Guarantee:
- May require high collateral or margin money.
- Increases cost of doing business due to bank charges.
Letter of Credit:
- Complex document compliance.
- High banking fees and administrative burden.
- Payment may be delayed if documents are incorrect.
Memory Aid Code – Comparison Table
| Code | Attribute | BG (Bank Guarantee) | LC (Letter of Credit) |
|---|---|---|---|
| A1 | Nature | Secondary Liability | Primary Liability |
| A2 | Usage | Domestic Projects | International Trade |
| A3 | Trigger Event | Default by Applicant | Document Presentation |
| A4 | Bank Role | Guarantor | Payer |
| A5 | Funding Type | Non-Fund Based | Fund Based |
| A6 | Legal Backing | Indian Contract Act | UCP 600 by ICC |
| A7 | Industry Use | Construction, Tenders | Export-Import, Shipping |