A bank guarantee and a letter of credit are similar in many ways but they're two different things. The main difference between the two credit security instruments is the position of the bank relative to the buyer and seller of a good, service or basket of goods or services in the event of the buyer's default of payment. These financial instruments are often used in trade financing when suppliers, or vendors, are purchasing and selling goods to and from overseas customers with whom they don't have established business relationships.
A bank guarantee is a guarantee made by a bank on behalf of a customer (usually an established corporate customer) should it fail to deliver the payment, essentially making the bank a co-signer for one of its customer's purchases. Should the bank accept that its customer has sufficient funds or credit to authorize the guarantee, it will approve it. A guarantee is a written contract stating that in the event of the borrower being unable or unwilling to pay the debt with a merchant, the bank will act as a guarantor and pay its client's debt to the merchant.
The initial claim is still settled primarily against the bank's client, and not the bank itself. Should the client default, then the bank agrees in the bank guarantee to pay for its client's debts. This is a type of contingent guarantee. A bank guarantee is more risky for the merchant and less risky for the bank. But this is not the case with a letter of credit.
While a letter of credit is a similar, the principal difference is that it is a potential claim against the bank, rather than a bank's client. For example, a seller may request that a buyer be provided with a letter of credit, which must be obtained from a bank and which substitutes the bank's credit for that of its client. In the event that the borrower defaults, the seller would go the buyer's bank for the payment. The seller's risk is mitigated because it is unlikely that the bank will be unable to pay the debt. A letter of credit is less risky for the merchant, but more risky for a bank.
Banks accept full liability in both cases. With a bank guarantee, a client can default and the bank assumes the liability. With a line of credit, liability rests solely with the bank, which then collects the money from its client.
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Normally bank guarantees are compared to standby letters of credit. Banks according to the Glass Steagal Act were not allowed to issue guarantees, hence they used LCs where you do not have to present any shipping documents. Glass Steagal has been repealed, nevertheless the practice of issuing standbys instead of gurantees continued.
If you want to read about the European view on Standbys, LCs and bank guarantees, go to the Letter of Credit forum
and check out in the article section which you can find at the top the following article: "ISP 98: international bank guarantee, letter of credit and American standby"
(ISP stands for International standby practices which were published in 1998; like the rules governing LCs they are not laws but agreed on by committee and incorporated by reference as contractual language)
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