A BANK GUARANTEE VS A LETTER OF CREDIT: WHAT IS THE DIFFERENCE

                     A Bank Guarantee vs. a Letter of Credit: 

A bank guarantee and a letter of credit are both promises from a financial institution that a borrower will be able to repay a debt to another party, no matter what the debtor's financial circumstances. While different, both bank guarantees and letters of credit assure a third party that if the borrowing party can't repay what it owes, the financial institution will step in on behalf of the borrower. By providing financial backing for the borrowing party (often at the request of the other one), these promises serve to reduce risk factors, encouraging the transaction to proceed. But they work in slightly different ways and in different situations.

Letters of credit are especially important in international trade due to the distance involved, the potentially differing laws in the countries of the businesses involved, and the difficulty of the parties meeting in person. While letters of credit are used mostly in global transactions, bank guarantees are often used in real estate contracts and infrastructure projects.

KEY TAKEAWAYS
A bank guarantee is a promise from a lending institution that ensures that if a debtor can't cover a debt, the bank will step up.
Letters of credit are also financial promises on behalf of one party in a transaction and are especially significant in international trade.
Bank guarantees are often used in real estate contracts and infrastructure projects, while letters of credit are used mostly in global transactions.
A Bank Guarantee
Bank guarantees represent a more significant contractual obligation for banks than letters of credit do. A bank guarantee, like a letter of credit, guarantees a sum of money to a beneficiary; however, unlike a letter of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially ensure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.

Bank guarantees protect both parties in a contractual agreement from credit risk. For instance, a construction company and its cement supplier may enter into a new contract to build a mall. Both parties may have to issue bank guarantees to prove their financial bona fides and capability. In a case where the supplier fails to deliver cement within a specified time, the construction company would notify the bank, which then pays the company the amount specified in the bank guarantee.

A Letter of Credit
Sometimes referred to as a documentary credit, a letter of credit acts as a promissory note from a financial institution, usually a bank or credit union. It guarantees a buyer's payment to a seller or a borrower's payment to a lender will be received on time and for the full amount. It also states that if the buyer can't make payment on the purchase, the bank will cover the full or remaining amount owed.

A letter of credit represents an obligation taken on by a bank to make a payment once certain criteria are met. After these terms are completed and confirmed, the bank will transfer the funds. The letter of credit ensures the payment will be made as long as the services are performed.

For example, say a U.S. wholesaler receives an order from a new client, a Canadian company. Because the wholesaler has no way of knowing whether this new client can fulfill its payment obligations, it requests a letter of credit is provided in the purchasing contract.

The purchasing company applies for a letter of credit at a bank where it already has funds or a line of credit (LOC). The bank issuing the letter of credit holds payment on behalf of the buyer until it receives confirmation that the goods in the transaction have been shipped. After the goods have been shipped, the bank would pay the wholesaler its due as long as the terms of the sales contract are met, such as delivery before a certain time or confirmation from the buyer that the goods were received undamaged.

Basically, the letter of credit substitutes the bank's credit for that of its client, ensuring correct and timely payment.

Special Considerations
Both bank guarantees and letters of credit work to reduce the risk in a business agreement or deal. Parties are more likely to agree to the transaction because they have less liability when a letter of credit or bank guarantee is active. These agreements are particularly important and useful in what would otherwise be risky transactions, such as certain real estate and international trade contracts.

Banks thoroughly screen clients interested in one of these documents. After the bank has determined that the applicant is creditworthy and has a reasonable risk, a monetary limit is placed on the agreement. The bank agrees to be obligated up to, but not exceeding, the limit. This protects the bank by providing a specific threshold of risk. 

WHAT IS THE DIFFERENCE BETWEEN A BANK GUARANTEE VS A BOND

Bank Guarantees vs. Bonds: An Overview

A bank guarantee is often included as part of a bank loan as a provision promising that if a borrower defaults on the repayment of a loan, the bank will cover the loss. A bond is a debt instrument that allows an investor to lend money to a corporation or government institution in return for an amount of interest earned over the life of the bond. A bond is essentially a loan issued by an entity and invested in by outside investors.

Bank Guarantees

A bank guarantee is not a debt instrument or a loan in itself. It is a guarantee by a lending institution that the bank will assume the costs if a borrower defaults on its liabilities or obligations. A bank guarantee is often a provision placed in a bank loan prior to the bank agreeing to loan out the money. The bank will charge a fee for the guarantee. A bank guarantee encourages companies and private consumers to make purchases they otherwise would not make, which increases business activity and consumption and provides entrepreneurial opportunities.

KEY TAKEAWAYS

• A bank guarantee is often a component of a loan agreement whereby a bank promises to meet a borrower's obligations if they default on the loan.
• Banks will typically charge a fee to provide a guarantee.
• A bond is used by entities to raise money. The entity issues a bond for a set amount, and the buyer of the bond essentially lends the entity the amount of the bond for a set period with a set interest rate.
• Bonds are issued by an entity at a par value, usually in denominations of $100 with a stated coupon rate; 5%, for example.

Commercial banks often provide bank guarantees to an individual or business owner who wants to borrow money to purchase new equipment, for example. Through the guarantee, the bank assumes liability for the debtor if they fail to meet their contractual obligations. In other words, the bank offers to stand as the guarantor on behalf of the business customer in a transaction. Most bank guarantees charge a fee equal to a small percentage amount of the entire contract, normally, 0.5 to 1.5% of the guaranteed amount.

There are different types of guarantees including performance guarantees, bid bond guarantees, financial guarantees, and advance or deferred payment guarantees. Guarantees are used for different reasons. Often, they are included in arrangements between a small firm and a large organization. The larger organization may seek protection against counterparty risk and will require the smaller party to receive a bank guarantee in advance of work.

 

Sometimes a bank will require collateral to provide a guarantee. This could be in the form of a pledge agreement for assetssuch as stocks, bonds, or cash accounts. Illiquid assets are generally not acceptable as collateral.

Bonds

Bonds are used by governments and corporations to raise money and finance needed projects. A bond resembles an I.O.U. between a lender (the bondholder) and the borrower (the entity that issues the bond). Tne entity issues a bond at a par value, usually in denominations of $100 with a stated coupon rate of around 5%. An investor effectively lends the bond issuer $100 and receives coupon payments from the entity that issued the bond until the $100 par value is repaid by the entity that borrowed the money.

A bond is issued with an end date, or maturity date. The maturity date is when the principal of the loan is due to be paid to the bond owner and includes the terms and amounts for the variable or fixed interest payments that will be made by the borrower. The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.

Bonds are fixed income securities and are one of three asset classes. The other two asset classes more familiar to investors are stocks (equities) and cash equivalents. Many corporate and government bonds are publicly traded; others are only traded over-the-counter (OTC) or privately between the borrower and lender.

Special Considerations

While governments issue many bonds, corporate bonds can be purchased from brokerages.  

ALL YOU NEED TO KNOW ABOUT BANK GUARANTEE

       Bank Guarantee

What Is a Bank Guarantee?

A bank guarantee is a type of guarantee from a lending institution. The bank guarantee means a lending institution ensures that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it. A bank guarantee enables the customer, or debtor, to acquire goods, buy equipment or draw down a loan.

How Bank Guarantees Work

A bank guarantee is when a lending institution promises to cover a loss if a borrower defaults on a loan. The guarantee lets a company buy what it otherwise could not, helping business growth and promoting entrepreneurial activity.

There are different kinds of bank guarantees, including direct and indirect guarantees. Banks typically use direct guarantees in foreign or domestic business, issued directly to the beneficiary. Direct guarantees apply when the bank’s security does not rely on the existence, validity, and enforceability of the main obligation.

[Important: A bank guarantee is when a lending institution promises to cover a loss if a borrower defaults on a loan.]

Individuals often choose direct guarantees for international and cross-border transactions, which can be more easily adapted to foreign legal systems and practices since they don't have form requirements.

Indirect guarantees occur most often in the export business, especially when government agencies or public entities are the beneficiaries of the guarantee. Many countries do not accept foreign banks and guarantors because of legal issues or other form requirements. With an indirect guarantee, one uses a second bank, typically a foreign bank with a head office in the beneficiary’s country of domicile.

Examples of Bank Guarantees

Because of the general nature of a bank guarantee, there are many different kinds:

• A payment guarantee assures a seller the purchase price is paid on a set date.
• An advance payment guarantee acts as collateral for reimbursing advance payment from the buyer if the seller does not supply the specified goods per the contract.
• A credit security bond serves as collateral for repaying a loan.
• A rental guarantee serves as collateral for rental agreement payments.
• A confirmed payment order is an irrevocable obligation where the bank pays the beneficiary a set amount on a given date on the client’s behalf.
• A performance bond serves as collateral for the buyer’s costs incurred if services or goods are not provided as agreed in the contract.
• A warranty bond serves as collateral ensuring ordered goods are delivered as agreed.

For example, Company A is a new restaurant that wants to buy $3 million in kitchen equipment. The equipment vendor requires Company A to provide a bank guarantee to cover payments before they ship the equipment to Company A. Company A requests a guarantee from the lending institution keeping its cash accounts. The bank essentially cosigns the purchase contract with the vendor.

Key Takeaways

• A bank guarantee is when a lending institution promises to cover a loss if a borrower defaults on a loan, of which there are many examples.
• Individuals often choose direct guarantees for international and cross-border transactions.
• A bank guarantee enables the customer, or debtor, to acquire goods, buy equipment or draw down a loan.