Bank Guarantees and Letters of Credit: Key Features for Indian Businesses
What Are Bank Guarantees (BGs)?
A Bank Guarantee is a promise made by a bank to cover a financial or performance obligation of its client (the applicant) if they fail to meet their commitment to a third party (the beneficiary).
Common Uses of BGs:
- Security in trade contracts.
- Performance guarantees in government tenders and large projects.
- Advance payment guarantees for pre-payment protection.
Key Features:
- Types of BGs:
- Financial Guarantees: Protect against payment defaults.
- Performance Guarantees: Ensure contract obligations are met.
- Bid Bond Guarantees: Secure commitments during tender processes.
- Advance Payment Guarantees: Protect funds advanced to the applicant.
- Parties Involved: Applicant, Beneficiary, and Issuing Bank.
- Validity Period: Fixed validity period; failure to renew nullifies the guarantee.
- Claim Process: Claims require proper documentation in case of non-performance.
What Are Letters of Credit (LCs)?
A Letter of Credit is a financial instrument issued by a bank guaranteeing payment to a seller upon fulfilling specific terms, such as delivering goods or services as per the agreed contract.
Common Uses of LCs:
- Ensuring secure payments in international trade.
- Bridging trust gaps in domestic trade.
Key Features:
- Types of LCs: Revocable vs. Irrevocable, Confirmed LC, Sight LC vs. Usance LC.
- Process Flow: Applicant requests LC issuance → Issuing Bank issues LC → Beneficiary fulfills conditions → Advising/Negotiating Bank facilitates payment.
- Risk Mitigation: Sellers receive payment even if the buyer defaults.
Key Differences Between BGs and LCs
| Feature | Bank Guarantee (BG) | Letter of Credit (LC) |
|---|---|---|
| Purpose | Guarantees performance or financial obligation | Guarantees payment upon conditions met |
| Payment Mechanism | Only triggered in case of default | Payment assured upon fulfilling terms |
| Use Cases | Contract performance, tenders | Trade transactions |
Advantages of BGs and LCs
- For Businesses: Mitigate risks, enhance credibility, and facilitate trade.
- For Banks: Generate fee-based income and strengthen customer relationships.
Challenges and Risks
- Bank Guarantees: High collateral requirements, risk of fraudulent claims.
- Letters of Credit: Discrepancies in documents and complexity for smaller exporters.
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