Difference Between Letter of Credit and Bank Guarantee

As the name indicates Letter of Credit (L/C) is a financial instrument, which is issued by banker basis Buyers creditworthiness. Usually, the terms “L/C” and “Bank Guarantees” are used interchangeably by finance person as they share certain similarities. However, there is a difference in how banks look at these products in terms of liability on their book. Definition of Bank GuaranteeAs the name indicates, a guarantee given by a bank on behalf of his customer (account holder) to the beneficiary, for assurance of payment in the event of default by its applicant is called bank guarantee. Bank guarantee is the usual practice in public tenders/govt related works in domestic markets. Bankers charge commission up to 1.5% per annum on the issuance of bank guarantees.  There are two types of bank guarantees:Financial GuaranteePerformance GuaranteeDefinition of Letter of CreditA letter of credit is a financial instrument, which is issued by a buyer to the seller, confirming a payment. A typical LC will have certain clause/terms which have to be met by both buyer and seller for the successful execution of the transaction. Basically, for Buyers/Importers, it will clearly mention terms of payment by the seller.For the seller, it will contain terms like type/quantity & condition of goods & documentary evidence along with relevant shipment bills etc. Once all the terms and condition are met, the bank will transfer funds . This Product is availed by Exporter/Importer.Types of Letter of Credit Sight L/CUsance L/CRevolving L/CIrrevocable L/CStandby L/CConfirmed L/CRed Clause L/CTypical cost of LC can run up to 2% of transaction cost which can be collected under various heads like-LC Opening Charges LC retirement Charges Forex MarginsKey Differences Between Letter of Credit and Bank GuaranteeGuarantee is an instrument given by the applicant’s bank to the beneficiary, confirming payment in the event of default, whereas the Letter of Credit is a payment assurance given by the applicant’s bank, subject to certain terms and condition.Under Bank Guarantee, a bank takes responsibility for payment when the client fails to honor commitment. In Letter of credit, Primary Liability lies with the bank to collect payment from the seller.The number of parties involved in Bank Guarantees is restricted to the applicant, beneficiary and banker, whereas in case of LC, it can be more than three, i.e applicant, Applicant/issuing bank, beneficiary, advising bank, negotiating bank and confirming bank.Bank Guarantee is used for domestic transactions, whereas the letter of credit is used for import/export transactions.Under LC, payment is honoured under successful acceptance of terms and conditions. Under bank guarantee, payment is made under default of certain terms and conditions.More about Bank Guarantee & Letter of credit can be read on-https://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=6523
Saurabh Jain
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Difference Between Letter of Credit and Bank Guarantee

Saurabh Jain
Blog
06th Oct, 2017
Difference Between Letter of Credit and Bank Guarantee
As the name indicates Letter of Credit (L/C) is a financial instrument, which is issued by banker basis Buyers creditworthiness. Usually, the terms “L/C” and “Bank Guarantees” are used interchangeably by finance person as they share certain similarities. However, there is a difference in how banks look at these products in terms of liability on their book.

Definition of Bank Guarantee

As the name indicates, a guarantee given by a bank on behalf of his customer (account holder) to the beneficiary, for assurance of payment in the event of default by its applicant is called bank guarantee.

Bank guarantee is the usual practice in public tenders/govt related works in domestic markets. Bankers charge commission up to 1.5% per annum on the issuance of bank guarantees.  

There are two types of bank guarantees:

  1. Financial Guarantee

  2. Performance Guarantee

Definition of Letter of Credit

A letter of credit is a financial instrument, which is issued by a buyer to the seller, confirming a payment. A typical LC will have certain clause/terms which have to be met by both buyer and seller for the successful execution of the transaction. Basically, for Buyers/Importers, it will clearly mention terms of payment by the seller.

For the seller, it will contain terms like type/quantity & condition of goods & documentary evidence along with relevant shipment bills etc. Once all the terms and condition are met, the bank will transfer funds . This Product is availed by Exporter/Importer.

Types of Letter of Credit

  1. Sight L/C

  2. Usance L/C

  3. Revolving L/C

  4. Irrevocable L/C

  5. Standby L/C

  6. Confirmed L/C

  7. Red Clause L/C

Typical cost of LC can run up to 2% of transaction cost which can be collected under various heads like-

  1. LC Opening Charges

  2. LC retirement Charges

  3. Forex Margins

Key Differences Between Letter of Credit and Bank Guarantee

  1. Guarantee is an instrument given by the applicant’s bank to the beneficiary, confirming payment in the event of default, whereas the Letter of Credit is a payment assurance given by the applicant’s bank, subject to certain terms and condition.
  2. Under Bank Guarantee, a bank takes responsibility for payment when the client fails to honor commitment. In Letter of credit, Primary Liability lies with the bank to collect payment from the seller.
  3. The number of parties involved in Bank Guarantees is restricted to the applicant, beneficiary and banker, whereas in case of LC, it can be more than three, i.e applicant, Applicant/issuing bank, beneficiary, advising bank, negotiating bank and confirming bank.
  4. Bank Guarantee is used for domestic transactions, whereas the letter of credit is used for import/export transactions.
  5. Under LC, payment is honoured under successful acceptance of terms and conditions. Under bank guarantee, payment is made under default of certain terms and conditions.

More about Bank Guarantee & Letter of credit can be read on-

https://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=6523

Saurabh
Blog Author

 

One of the Co-founders, Saurabh serves as an active advisor to several SaveDesk’s portfolio companies and also works closely with them to improve business performance, select key management personnel, ensuring statutory and financial oversight and compliance supported by various agreements.Prior to SaveDesk, Saurabh spent seven years with Standard Chartered Bank commercial banking team as an associate director, where he was responsible for client management,financial analysis, portfolio management and large ticket deal’s execution in South India. Saurabh holds an MBA in Marketing from the Institute of Technology Management, and graduated with Honors degree in Electrical and Electronics Engineering from RGPV, Madhya Pradesh

 

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