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Both a letter of credit and a bank guarantee are assurances from a commercial bank that a client will be able to pay back a loan to a third party regardless of the borrower’s financial position. Although they differ, bank guarantees and letters of credit are both assurances to the third party that the financial institution will step in on the borrower’s behalf if the borrower is unable to pay back loans.
These guarantees help to lower risk factors, thus encouraging the transaction to proceed by providing financial backing for the borrowing party (often at the other party’s request). However, they work somewhat differently and under various conditions.
Due to the distance involved, the possibility of different regulations in the countries of the companies involved, and the difficulties of the parties meeting in person, letters of credit are particularly crucial in global trade.
Bank guarantees are frequently utilized in real estate contracts and infrastructure projects, whereas letters of credit are mostly required in international transactions.
The Bank Guarantee
A more important contractual responsibility for banks than letters of credit is represented by bank guarantees. A bank guarantee is similar to a letter of credit; it ensures payment to the client. The bank only makes such a payment in the event that the other party doesn’t carry out the terms of the contract. A buyer or seller can effectively be insured by the guarantee against loss or damage resulting from the other party’s breach of the contract.
Both parties to a contract are protected from credit risk by bank guarantees. For instance, a mall building project may involve a contract between a construction company and its cement supplier. To demonstrate their financial credibility and capacity, both parties could be required to provide bank guarantees. The construction business would inform the bank in the event that the supplier did not deliver the cement within the allotted period, and the bank would then pay the company the amount specified in the bank guarantee.
Different Bank Guarantees
Like any other type of financial instrument, bank guarantees come in a wide range of shapes and sizes. For instance, in both local and international trade, banks give direct guarantees.
The most typical types of warranties include:
Shipping guarantees: A consignment that arrives before any documents are obtained is covered by this type of guarantee, which is granted to the carrier.
Shipping guarantees: A consignment that arrives before any documents are obtained is covered by this type of guarantee, which is granted to the carrier. And assurances When a loan is guaranteed, the institution promises to undertake the loan in case the borrower can’t pay it back.
Advance payment guarantees: These guarantees support a contract’s execution. This guarantee essentially serves as security to cover the advance payment in the event that the seller fails to deliver the agreed-upon items.
Confirmed payment guarantees: Under this binding commitment, the bank will make a specified payment to a beneficiary on the client’s behalf by a specific date.
A letter of credit, also known as a documentary credit or a debt instrument from a financial institution, often a bank or credit institution, functions as a promissory note. It ensures that a borrower’s or a buyer’s payment to a lender will be made on time and in full. Additionally, it indicates that the bank will pay the entire balance due if the buyer is unable to make a payment on the purchase.
A letter of credit is a commitment made by a bank to make a payment if certain conditions are satisfied. The bank will only send the money if these conditions are satisfied and verified. As long as the services are performed, the letter of credit guarantees payment. In effect, the letter of credit replaces the client’s credit with that of the bank, assuring accurate and timely payment.
Consider the scenario when an X-country exporter receives an order from a new client from a Y-country company. The exporter asks that a letter of credit be used in the purchase agreement since it has no means of knowing if this new client would be able to pay.
The purchasing company contacts a bank where it already has money or a line of credit to get a letter of credit (LOC). Payment is withheld by the bank issuing the letter of credit until it receives confirmation that the goods involved in the transaction have been shipped. As long as the terms of the sales contract are followed, such as delivery within a specific deadline or proof from the buyer that the items were received undamaged, the bank would pay the exporter its due after the goods have been shipped.
Types of Credit Letters
Letters of credit differ according to the requirement for them, just as bank guarantees. These are a few of the letters of credit that are most frequently used:
The buyer is bound to the seller by an irrevocable letter of credit.
In the event that the first bank’s credit is in doubt, a second bank will issue a verified letter of credit and guarantee it. If the business or issuing bank fails to fulfill its commitments, the confirming bank confirms payment.
An import letter of credit gives importers a short-term cash advance, enabling them to make payments immediately.
An export letter of credit, in the event that all of the terms of the contract are fulfilled, advises the buyer’s bank that it must pay the seller.
A revolving letter of credit Customers may make withdrawals under certain restrictions throughout a specific time frame.
Bank guarantees and letters of credit both help to lower the risk of a trade agreement or contract. When a letter of credit or bank guarantee is in place, the parties are more liable to agree to the transaction since they are less responsible. These agreements are especially significant and practical in situations where dangerous transactions, like some real estate and international trade contracts, might otherwise take place.
Clients who are interested in one of these papers are thoroughly verified by banks. A financial limitation is put on the agreement once the bank decides the applicant is creditworthy and poses a reasonable risk. The bank consents to obligations up to the limit but not above. Setting a certain risk threshold protects the bank.
The parties who accept them represent yet another substantial difference between bank guarantees and letters of credit. Typically, contractors that bid on huge projects utilize bank guarantees. By offering a bank guarantee, the contractor confirms its sound financial standing. In essence, the guarantee provides reassurance to the organization supporting the project that it is financially sound enough to undertake it from start to finish.
On the other hand, businesses that often import and export commodities need letters of credit.
Writer: Shakir Ali Rajput: Global Trade Professional
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