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The primary difference between a letter of credit and bank guarantee is the level of responsibility assumed by the bank. The two also differ in their purpose, the frequency of their use, and the parties involved. A letter of credit is generally used in international trade to assure that transactions proceed as planned. A bank guarantee helps assure that financing will be available for a project should one of the parties involved become insolvent. This arrangement is often seen in construction projects and infrastructure development.
In international trade, the seller wants to make certain that payment is forthcoming, and the buyer wants to make sure that the order has been shipped. A letter of credit (LC) facilitates this process. The buyer would contract with a bank to issue a LC. This contract stipulates the terms to be fulfilled for payment to the seller and the obligation of the buyer to repay the bank.
The issuing bank sends the letter of credit to the seller stating the terms. Typically, this involves presenting a standard shipping document, such as a bill of lading. The seller is paid by the bank upon presentation of this document. The bank then forwards the bill of lading to the buyer, who would present it to the carrier and receive shipment of the order. The buyer then repays the bank.
The only responsibility of the issuing bank is to make payment when presented with the agreed upon documents. A letter of credit depends on the contractual arrangement between the issuing bank and the buyer. It is not the bank's responsibility to oversee the contract between the buyer and seller. Any violation of the terms of that contract would have nothing to do with the handing of a LC. For example, if the seller presented the proper documentation and was paid, but had shipped a defective product, the buyer would still have to repay the issuing bank.
The issuing bank assumes a greater liability with a bank guarantee. In this situation, the bank accepts liability for the payment of the debt or performance of some duty for a party to an agreement. If the party becomes insolvent, or fails to complete contractually obligated requirements, then the bank assumes responsibility and must make good on the terms of the contract. Such a guarantee is often necessary when public bonds are to be issued.
The usage disparity between a letter of credit and bank guarantee can be seen in the underlying roles they play. A LC facilitates trade without becoming directly involved in the contractual obligation between the parties. In a bank guarantee, the issuer is intimately involved in the contractual terms and the performance of the parties involved. Both work to lessen risk, but the depth of involvement and liability accepted by the issuing bank distinguishes the two.
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