Difference between LC and BG

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.

DOCUMENTARY CREDIT/Letter of Credit is an undertaking by a bank to the Beneficiary (Exporter/ seller) that it would make payment to him against presentation of documents drawn in terms of the credit. The Documentary Credit (DC) would be issued at the request of the customer (Importer /buyer) of the bank.

DC is a widely prevalent mechanism for settlement of trade in international trade. It assures the exporter of payment. Also, he is assured that the importer is bonafide and that the formalities in the importer’s country regarding the import have been complied with. As far as the importer is concerned, he will pay for the import only on receipt of the documents conforming to the terms and conditions of the credit.

Bank Guarantee is an instrument issued by the Banks in which the Bank agrees to stand guarantee against the non-performance of some activity/event of a customer.  The guarantee is issued on receipt of a request from ‘applicant’ for some purpose/transaction in favour of a ‘Beneficiary’.  The guarantee amount will be paid by the ‘issuing bank’ to the ‘beneficiary’ of the guarantee on receipt of the ‘claim’ from the beneficiary i.e., when the guarantee is “Invoked”.

Similarities:

1. Both of these are contingent liabilities. That means a non fund based advance which can be changed to fund based respect to certain conditions mentioned therein.

2. Both eliminates the financial risk involved in the business

3. Both facilities require charges fee

Differences:

Letter of Credit: 

1. A bank guarantee is a promise for non-performance. In bank guarantee, a bank guarantees any work that has to be performed failing which the bank promises to pay the dues.

2. Mostly DC is used for day to day contracts on regular basis

3. Protects both the parties but usually in favour of exporter

4. Bank has Primary Liability

5. Less risk for merchant and more for Bank

6. Doesn't wait for applicant's default and beneficiary to invoke undertaking

7. Usually issued subject to UCP 600

Bank Guarantee:

1. A letter of credit on the other hand is a promise for performance. It promises the beneficiary that the payment will be made in time and in full, subject to conditions mentioned in the LC.

2. Mostly BG is used for new or big contracts like infra projects, Government projects

3. Protects both the parties but usually in favour of importer

4. Bank has Secondary Liability

5. More risk for merchant and less for Bank

6. Becomes active only when the applicant defaults in making payment

7. Usually issued subject to URDG 758

Hope this information will help you. Any other doubt, please ping me, I will try to respond asap.

- Sachin Gupta