A standby letter of credit and a bank guarantee are similar things, and they're most often used when making international transactions. However, they also can be used for U.S. sales, purchases and transactions when you need to prove you're able to access cash on short notice. A bank guarantee offers you more protection when making purchases.
Bank Risks Similar
Although banks face risks with both standby letters of credit and guarantees, the added protection offered by a bank guarantee increases their risk. Neither of these documents comes with automatic approval. In light of their risk, banks process your requests as if they were loans, approving or denying your application based on your credit standing.
Both of these items guarantee sellers they will be paid for your purchases. If you are the seller, you can "call in" the letter of credit or bank guarantee to ensure you receive payment for the things you sold. When you act as the buyer, the seller expects direct payment from you. Should you not make a timely payment, the seller can ask your bank to act on the letter of credit or guarantee. The uncertainties of international sales and currency exchanges make standby letters of credit and bank guarantees popular documents.
Although both these documents serve the primary purpose of ensuring that sellers get paid, there is a legal difference. A bank guarantee protects the seller, just like a standby letter of credit, but it also protects the buyer. When you function as seller, it is immaterial whether your buyer chooses to provide evidence of a letter of credit or bank guarantee. However, when you act as buyer, you'd prefer a bank guarantee, as it also protects you if the seller never sends your purchases or if the items arrive in damaged condition. A bank guarantee will reimburse the money you sent the non-performing seller.
For many international sales, a letter of credit is preferred by sellers. Since your bank advises the seller's financial institution that the credit letter exists, sellers often prefer that your bank perform by wiring these funds to the seller's bank. Sellers receive fast, guaranteed payment, including currency conversion, if needed, direct to their bank account. Bank guarantees work a bit differently. They are triggered not by a sale but only by the nonperformance of either buyer or seller.
Secured vs Unsecured
Since your bank is making a credit decision, should you or your business be credit challenged, you may be asked to "secure" a letter of credit. You typically do this by depositing an equal amount of cash, often in the form of a short-term certificate of deposit. Your bank may also allow you to pledge collateral that is equal in value to -- or greater than -- the amount of credit you've requested. Your bank may also allow you to receive a bank guarantee instead of a letter of credit by offering adequate security.
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