Bank Guarantees and LCs are financial instruments often used in inland or international trade when suppliers or vendors do not have established business relationships with their counterparts. The difference between the two instruments is the position of the bank relative to the buyer and seller of goods or services. The difference is as explained below.

A letter of credit is a bank’s DIRECT undertaking to the supplier (called the beneficiary) to pay. When a letter of credit is in use, the issuing bank does not wait for the buyer to default, and for the seller to invoke the undertaking.

In contrast, a guarantee is a written contract stating that IN THE EVENT the primary party (the buyer) is unable or unwilling to pay its dues to the supplier the bank, as guarantor to the transaction the BG issuer would pay (the client's debt) to the supplier.

In other words, a bank guarantee is an undertaking of a bank on behalf of its customer. But this comes into play ONLY WHEN the principal party (the buyer) has failed to pay its supplier. (Do note this key point.)

Essentially, the bank becomes a co-signer for its customer's purchases.

Hence, in a BG the initial claim is still settled primarily (i.e., first) against the bank's client, and not the bank itself. Should the client default, ONLY THEN would the bank (which has issued the BG) agree to pay for it's client's debts on behalf of its client. This is a type of contingent guarantee.

A bank guarantee, therefore, is more risky for the merchant and less risky for the bank. But this is not the case with a letter of credit (LC).

With a bank guarantee, if a client defaults the bank assumes liability. With a letter of credit, liability rests solely with the issuing bank (this being the key difference and the key advantage in an LC) which then must collect the money from its client.

Therefore, the principal character of an LC is that it is a potential claim against the bank, rather than a bank's client. An LC substitutes the bank's credit for its client's. The seller's risk is mitigated from the risk that the buyer will not pay to the risk that the BANK will be unable to pay, which is unlikely.

A letter of credit is less risky for the merchant, but more risky for a bank, though banks accept full liability in both cases.

so.. i have inquired about the company and on my gut feeling i am going for TT

fairtradegm wrote:

Dear Catalyst!

                            Thank you for your informative reply. I have another relevant question to ask. Every one knows opening the L/C means to open an L/C. But what does it mean by saying "closing the L/C"? We have a buyer who was supposed to open the L/C this week but now they say L/C is delayed and tthey wil open the same after few weeks. When I asked the reason I was informed by the buyer that they have opened L/Cs for many suppliers and expect some "L/Cs  to be closed by this weekend" . They will be able to open new L/C only after that. Please tell us what is "closing the L/C" means and how does it take place? I mean what is the procedure for the same? Thank you in advance.

Best Regards

Javed Ali

"Closing the LC" is not a standard or a formal term. It simply means that the applicant has too many LCs outstanding, his LC limits with the banks are fully drawn and hence fully used up (blocked). Once some LCs expire or are honoured, that will free up his limits with the banks. Then he can ask for the issue of more LCs.

Hi! I am thankful that you got this informative discussion going. I am more interested with BG. What does it take to get one?

vcara wrote:

Hi! I am thankful that you got this informative discussion going. I am more interested with BG. What does it take to get one?

Hi,

You would first have to get a line of credit from a bank towards BG facilities.On approval of the same, and completition of formalities, you may apply for issue of specific BGs fvg. specific parties on specific terms. Helpful if you can furnish a draft to the bank for their acceptance and approval.

Thanks for your kind reply Catalyst. I understand that BG is supposed to be backed by collateral. Should the collateral be equivalent to or more than the amount of BG? And would you know the shortest term?

vcara wrote:

Thanks for your kind reply Catalyst. I understand that BG is supposed to be backed by collateral. Should the collateral be equivalent to or more than the amount of BG? And would you know the shortest term?


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HI,

When a bank isues a BG it takes on a risk exposure on the applicant. The norms for its issue, therefore, depends on the bank concerned, and its risk perception about the client (applicant), its account reationship etc. You'd have  to enquire with the bank to find out the details. For an existing client with an approved (BG) facility, BGs are known to have been issued even for 5% or NIL margins.

The shortest term would generally be a calendar quarter i.e. three months.

 

What would be bank charges been paid by customer and supplier if they opt for Bank Gaurantee or for L/C?

learning thank you

parajiyagears wrote:

What would be bank charges been paid by customer and supplier if they opt for Bank Gaurantee or for L/C?

Hi,

I recall having answered this question earlier here itself. The charges vary from bank to bank, customer to customer, and with the size of each exposure. Generally speaking, it is about 1 to 1.5% per quarter or part thereof. You can do a Google search and find out the general levels, or search a bank by name and see their level of charges - if displayed.

Very good article! Thanx!