By Lal Singh In trade and business, trust is important—but trust alone is not enough. When large sums of money, distant buyers, or unknown sellers are involved, financial risk increases. To reduce this risk, banks provide two powerful instruments: Bank Guarantee (BG) and Letter of Credit (LC).
At first glance, both look similar because a bank stands in between the buyer and seller. But in reality, they serve different purposes, work in different situations, and protect different parties.
Many students, business owners, and even professionals confuse these two. So let’s break it down step by step and understand everything — meaning, working, benefits and limitations.
What Is a Bank Guarantee?
A Bank Guarantee is a promise by a bank that if its customer fails to meet a contractual obligation, the bank will compensate the affected party.
In simple words: “If my customer defaults, I will pay you.”
Here, the bank acts as a backup payer, not the primary payer.
How a Bank Guarantee Works
- Two parties enter into a contract (for supply, service, project, etc.)
- One party requests a bank guarantee from its bank
- The bank guarantees payment to the beneficiary only if default occurs
- If the customer performs properly, the bank pays nothing
What Is a Letter of Credit?
A Letter of Credit is a written commitment by a bank to pay the seller on behalf of the buyer, provided the seller submits documents as per agreed terms.
In simple words: “If you submit correct documents, I will pay you.”
Here, the bank becomes the primary payer.
How a Letter of Credit Works
- Buyer and seller agree on trade terms
- Buyer asks their bank to issue an LC
- Seller ships goods and submits required documents
- Bank checks documents
- If documents match, payment is made—even if buyer later fails
Purpose: Why They Exist
Purpose of Bank Guarantee
- To protect against non-performance or default
- Common in contracts, tenders, construction, services
Purpose of Letter of Credit
- To ensure payment in trade
- Common in domestic and international trade of goods
Types at a Glance
Common Types of Bank Guarantee
- Performance Guarantee
- Financial Guarantee
- Bid/Tender Guarantee
- Advance Payment Guarantee
Common Types of Letter of Credit
- Revocable LC
- Irrevocable LC
- Confirmed LC
- Sight LC
- Usance (Time) LC
Key Differences: Bank Guarantee vs Letter of Credit
| Basis | Bank Guarantee (BG) | Letter of Credit (LC) |
| Nature | Secondary obligation | Primary obligation |
| When bank pays | Only if customer defaults | On submission of correct documents |
| Main purpose | Risk protection | Payment assurance |
| Used in | Contracts, projects, tenders | Trade (domestic & international) |
| Trigger for payment | Failure or non-performance | Document compliance |
| Risk covered | Performance risk | Payment risk |
| Bank’s role | Backup payer | Main payer |
| Common users | Contractors, service providers | Importers & exporters |
Advantages of Bank Guarantee
1. Reduces Risk for Beneficiary
The beneficiary is protected if the customer fails to perform.
2. Improves Business Credibility
A bank-backed guarantee increases trust.
3. No Immediate Cash Outflow
Customer’s money is not blocked unless default occurs.
4. Useful in Non-Trade Contracts
Widely used in construction, infrastructure, and service contracts.
5. Flexible Use
Can be structured based on contract terms.
Disadvantages of Bank Guarantee
1. Payment Only on Default
If no default occurs, beneficiary cannot claim money.
2. Legal Disputes Possible
Disagreements over “default” can delay payment.
3. Bank Charges and Collateral
Banks often require margin money or security.
4. Limited Use in Trade Payments
Not ideal where payment certainty is required.
Advantages of Letter of Credit
1. Strong Payment Assurance
Seller is assured payment once documents are correct.
2. Ideal for International Trade
Reduces country and buyer risk.
3. Improves Seller Confidence
Encourages trade with new or distant buyers.
4. Bank Creditworthiness Involved
Seller relies on bank, not buyer’s financial position.
5. Clearly Defined Process
Rules and documentation reduce ambiguity.
Disadvantages of Letter of Credit
1. Document-Based, Not Goods-Based
Bank checks documents, not actual goods quality.
2. Complex Documentation
Minor errors can lead to payment delays or rejection.
3. Higher Cost
LCs are generally more expensive than guarantees.
4. Rigid Terms
Less flexibility once LC is issued.
Which One Should You Use?
Choose Bank Guarantee when:
- Performance matters more than immediate payment
- You are entering a service or project contract
- Risk is about default, not trade payment
Choose Letter of Credit when:
- You are buying or selling goods
- Parties are in different countries
- Payment certainty is critical
Role of Regulation in India
In India, both instruments are governed by banking norms laid down by the Reserve Bank of India, while international LCs follow global trade rules like UCP guidelines. Banks strictly evaluate creditworthiness before issuing either instrument.
Final Thoughts
Bank Guarantee and Letter of Credit may look similar, but they solve different problems.
- A Bank Guarantee is a safety net—it activates only if something goes wrong.
- A Letter of Credit is a payment engine—it ensures money flows when conditions are met.
Understanding this difference is crucial for exams, business decisions, and real-world contracts. Using the wrong instrument can increase risk, cost, or disputes.