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

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.