Bank Guarantee vs Letter of Credit

Put the two documents side by side and they look like cousins: a bank's name at the top, a beneficiary, a face amount, an expiry, an undertaking to pay. Neither is a loan — no money moves when they are issued — and both sit on a customer's facilities as if it had. The difference is in what has to happen for the bank to pay. Under a letter of credit, the beneficiary presents documents proving it did what the trade required — shipped the goods, insured them, invoiced them — and the bank pays because those documents comply. Payment is the plan. Under a bank guarantee, the beneficiary presents a demand stating that the customer did not do what the contract required, and the bank pays because the demand complies. Payment is the failure.

That single difference decides who uses each, what each costs, and how a credit desk reads it. The guarantee file and the letter of credit file each take one instrument through a desk in full; this page is the comparison.

A letter of credit exists because the two sides of a cross-border sale do not trust each other enough to trade on open account. The exporter will not ship without knowing it will be paid; the importer will not pay without knowing the goods have shipped. So the importer's bank issues a credit: it will pay the exporter against the documents that prove shipment. The exporter now trusts a bank rather than a stranger, and the importer's money only moves when the paper says the goods did. That is why exporters live on letters of credit and why the site's Aoraki file is a business whose currency question comes before its credit question.

A guarantee exists because the other party to a contract wants something better than the customer's word. A landlord takes a rental bond instead of a cash deposit; a principal takes a performance bond from a contractor; a tender board takes a bid bond from every bidder; a supplier takes a payment guarantee from a customer it does not know. In each case the beneficiary hopes never to call it, and the customer hopes the same, and the bank has been paid a fee to stand behind a promise both sides expect to be kept. An exporter may hold both at once: a letter of credit for the shipment, and a performance guarantee for the supply contract it shipped under.

Both banks are examining paper, and that is the trap in both. Under a letter of credit the issuing bank may refuse documents for any discrepancy, and the tolerance is exact — a date, a quantity, a description that does not match — so an exporter can have shipped perfectly and still not be paid because the invoice said the wrong thing. Under an on-demand guarantee the bank must pay a compliant demand without asking whether the customer really failed, so a contractor can have performed perfectly and still see the bond called by a principal in a dispute, with the argument to be had afterwards between the two of them. The letter of credit protects the seller from the buyer's unwillingness; the guarantee exposes the customer to the beneficiary's.

The standby letter of credit sits between: a guarantee written in a letter of credit's form, payable on a document stating non-performance rather than on shipping documents, common in markets where banks were historically restricted from issuing guarantees. Read it as a guarantee.

Neither costs interest, because neither is funded until something happens. Both are charged as a fee on the face amount for each period the instrument is outstanding, plus charges for issuance and each amendment, and both consume a limit on the customer's facilities as if the bank had lent the money — because from the bank's side it may have to. A letter of credit that the exporter wants turned into cash before its usance date carries a further cost: the discount, priced on the issuing bank's standing rather than the exporter's, which is the subject of the LC discounting file. A guarantee the bank is uneasy about may be issued only against cash cover, which turns a contingent promise into a deposit the customer cannot touch — the dearest guarantee there is, measured in the working capital it locks up. Pricing and Fees puts both beside the rest of what a business pays its bank.

In opposite directions, which is the point of the comparison. Issuing a letter of credit for an importer, the desk expects to pay and asks the ordinary question: when we pay the exporter and debit our customer, does the customer have the means — a trade loan that the sale of the goods repays, a facility with room, cash — to pay us back? It is a loan that has not been drawn yet, read as a loan.

Issuing a guarantee, the desk expects not to pay and asks two questions instead. How likely is the call — which is a question about the customer's ability to perform the contract, the beneficiary's temperament, and the wording of the demand clause? And if it is called, can the customer repay us — which is the ordinary credit question again, asked about a business that has just failed to perform something, which is exactly when it is least able to. The guarantee file on this site is read with the Three Questions in that order, and the third question — the way out if the first answer is wrong — is the one a guarantee makes hardest, because a called bond and a distressed customer arrive together.

If you are being paid for goods by someone who does not know you, or paying for them, a letter of credit: it is the trade's payment mechanism, and the bank's promise replaces the trust neither side has yet. If you are being asked to back a promise — to perform, to pay rent, to honour a bid — a guarantee, and read its demand clause before you sign, because that clause decides whether your bank pays on a dispute or on a proven failure. If someone offers you a standby letter of credit in place of a guarantee, treat it as the guarantee it is. And in every case, remember what the bank remembers: the instrument is not a service it sells you; it is credit it has extended, and it will read your business the way it reads any borrower before it puts its name on the paper.