Bank Guarantee vs Letter of Credit: Which one does your business need?

A letter of credit (LC) is a payment tool: the bank pays the seller when the seller performs and proves it with documents. A bank guarantee (BG) is a safety net: the bank pays the beneficiary only when its customer fails to do what it promised. If you are buying goods and the seller wants payment security, you need an LC. If you are bidding for or carrying out a contract and the other side wants protection against your non-performance, you need a BG.

Both are non-fund-based limits assessed by the same credit desk, which is why they get confused. The difference lies in who triggers payment, and why.

The one-line difference

• LC: "If the seller ships and presents the right documents, the bank will pay." Payment is the expected outcome.
• BG: "If our customer does not perform, the bank will pay you." Payment is the exception; in most cases the guarantee simply expires.

A useful way to remember it: an LC is meant to be used; a BG is meant not to be used.

How a letter of credit works, in brief

The buyer (applicant) asks its bank to open an LC in favour of the seller (beneficiary). The seller ships the goods and presents the documents the LC asks for: invoice, transport document, insurance, certificates and so on. If the documents comply with the LC, the bank pays at sight or on the due date of a usance LC, and recovers the money from the buyer.

Banks examine documents, not goods, and the LC is separate from the sale contract, so a buyer cannot stop payment under a compliant LC by complaining about quality. The full process is covered in how an LC works.

How a bank guarantee works, in brief

The bank's customer (applicant) asks the bank to issue a guarantee in favour of a third party (beneficiary), for a fixed amount and a fixed validity. The beneficiary holds the guarantee and can invoke it if the applicant defaults. Common types:

• Financial guarantee: covers a payment obligation, for example, a supplier giving goods on credit against a BG from the buyer's bank.
• Performance guarantee: covers the risk that a contractor does not complete the work as agreed.
• Bid bond / EMD guarantee: given with a tender in place of a cash deposit.
• Advance payment (mobilisation) guarantee: protects the advance a client pays to a contractor.
• Retention money guarantee: lets the contractor take back the part of each bill the client would otherwise hold back.

Most guarantees issued by banks are unconditional, on-demand guarantees. The beneficiary does not have to prove a default in court; it makes a written demand within the claim period and the bank pays. Where a guarantee is issued subject to the ICC's URDG 758 rules (common in international guarantees), the rules say plainly that a guarantee is independent of the underlying relationship, and that guarantors deal with documents and not with the performance behind them. The demand must state in what respect the applicant is in breach, and the guarantor has five business days after presentation to examine it. Domestic guarantees in India usually carry their own wording, so the bank and the borrower must read the text of each guarantee carefully.

Side-by-side comparison

• Purpose. LC: to make payment for goods or services. BG: to protect against default or non-performance.
• Who usually asks for it. LC: the seller, to be sure of payment. BG: the buyer, client or authority, to be sure of performance.
• When the bank pays. LC: when compliant documents are presented. BG: when the beneficiary invokes it on the applicant's default.
• Expected outcome. LC: payment happens in almost every case. BG: in most cases it expires without being invoked.
• What the bank examines. LC: shipping and commercial documents against the LC terms. BG: the demand, and any documents asked for, against the guarantee terms.
• Typical users. LC: importers, traders and manufacturers buying raw material. BG: contractors, EPC firms and suppliers to government and large companies.
• Typical tenor. LC: short, lead time plus usance, often within a year. BG: can run for years, matching the contract and defect liability period.
• International rules. LC: ICC UCP 600. BG: ICC URDG 758, when the guarantee says so.
• Becomes fund-based when. LC: the applicant does not fund the bill on the due date (devolvement). BG: the guarantee is invoked and paid.

How banks assess each limit

From a credit desk, both limits are contingent exposure, but the questions are different.

For an LC limit, the bank asks: what will the borrower buy on LC, and for how long will each LC stay open? The common working is:

LC limit = (Annual purchases on LC ÷ 12) × (Lead time + usance period, in months)

The bank also checks that the cash credit can absorb the stock once the LC bill is paid, because the imported goods then sit in inventory and are financed through the drawing power. You can work the numbers in the letter of credit limit calculator.

For a BG limit, the bank asks: what contracts will the borrower bid for and win, what percentage of each must be guaranteed, and for how long? For each type of guarantee:

BG required = Contract value × BG % × Validity in months ÷ 12

Bid bonds are worked on the value of bids; performance, advance and retention guarantees on the orders expected to be won. The bank guarantee limit calculator does this type by type and adds the guarantees already outstanding.

The bigger difference is in how the risk is read. An LC devolves mainly when the borrower is short of cash on the due date, so the bank looks at liquidity and the working capital cycle. A BG is invoked mainly when the borrower fails on the contract itself, so the bank looks at execution capability: past completion record, order book, disputes with clients, and whether the borrower has taken more work than it can finish.

Margin, security and charges

In practice, banks take a cash margin on both, usually as a fixed deposit marked as a lien, at the percentage set in the sanction letter. The margin can be lower for borrowers with strong financials and collateral, and higher for new or weaker borrowers. Both limits are generally secured along with the fund-based limits, under the same charge on current assets and collateral.

Charges are a commission on the amount and the period, so a long-dated performance guarantee costs more than a short bid bond of the same amount. Rates are set by each bank and negotiated in the sanction; compare the full cost, including amendment charges and the interest lost on margin money.

A worked example

A typical case: an engineering MSME in Nashik has two needs in the same year.

Need 1: importing components. It buys components worth Rs 80 lakh from an overseas supplier, on a 90-day usance LC. The supplier insists on an LC because it does not know the buyer.

If the MSME performs, the guarantee expires and the bank pays nothing. If the client invokes it, the bank pays Rs 50 lakh to the client and debits the MSME's account.

Sizing the limits for the coming year. Suppose the MSME plans LC purchases of Rs 9.6 crore a year, with a lead time of 1 month and usance of 3 months. The LC limit works out to (9.6 ÷ 12) × (1 + 3) = Rs 3.2 crore. On the BG side, if it expects to win orders of Rs 20 crore needing 10% performance guarantees for 24 months, that alone needs 20 × 10% × 24 ÷ 12 = Rs 4 crore; bid bonds of 2% on Rs 60 crore of bids, valid 3 months, add 60 × 2% × 3 ÷ 12 = Rs 0.3 crore.

So the same business needs both instruments, and the bank assesses each limit on its own logic. Remember that an invoked guarantee or a devolved LC becomes a fund-based liability overnight, and the bank reads it as a stress signal, just like an overdrawn cash credit account.

Which one does your business need?

• You are buying goods and the seller wants payment security: LC.
• You are selling goods and want to be sure of payment: ask the buyer for an LC (or, for regular domestic supplies on open credit, a financial guarantee from the buyer's bank).
• You are bidding for a tender: bid bond / EMD guarantee.
• You have won a contract and the client wants protection against poor or incomplete work: performance guarantee.
• Your client is paying you an advance: advance payment guarantee.
• The client is holding back retention money: retention money guarantee, to release the cash.

A standby LC (SBLC) sits between the two: it is written as a letter of credit, but it works like a guarantee, because the beneficiary draws on it only when the applicant defaults. It is mostly seen in international transactions.

Frequently asked questions

Is a bank guarantee safer for the beneficiary than a letter of credit?

They protect against different risks. An LC secures payment for goods the beneficiary supplies. A BG secures the beneficiary against the applicant's failure to perform or pay. Choose by the risk you want covered.

Can a bank refuse to pay an invoked guarantee because the customer disputes the claim?

Under an unconditional, on-demand guarantee, the bank's obligation is independent of the dispute between its customer and the beneficiary. If the demand complies with the guarantee terms, the bank pays, and the dispute is settled between the parties.

What happens to my limit when a guarantee expires?

Once the guarantee expires and the claim period is over, or the beneficiary returns the original or releases the bank in writing, the bank reduces the outstanding and the limit is free to use again.

Sources

• ICC Uniform Rules for Demand Guarantees, URDG 758 (Articles 1, 5, 6, 15 and 20)
• ICC, "New rules for demand guarantees effective 1 July" (URDG 758 in force from 1 July 2010)