A Standby Letter of Credit and a Bank Guarantee are in reality very similar products.
As a matter of fact, if we go back and look at the origination of the Standby Letter of Credit, we may be able to understand the similarity better.
Under the Glass-Steagall Act, passed by the US Congress in 1933, banks were not allowed to participate in investment banking activities. Consequently, banks couldn’t issue a bank guarantee too. During the 1930’s investment banking was a profitable business and to overcome the barriers of the act, banks were able to form their own letters of credit as a form of a bank guarantee. Banks classified this new product as a Standby Letter of Credit.
Similarities between a Letter of Credit and a Bank Guarantee
The two products are very similar in terms of its purpose and use, such as:
- Both are intended to minimize financial risk for the prospective client making use of these products
- Banks perform similar credit checks for both instruments, i.e., issuing parties’ financial health, credit score, and past record. Also, banks require collateral for both products
- The issuing bank replaces the applicant’s credibility with its own in both the products. Therefore, the risk for a bank with both products is similar
As client needs and financial risks changed over time, both Standby Letter of Credit and Bank Guarantees were established as individual products. However, there are precise differences in both the products:
The Difference in Theory
- A Standby Letter of Credit is a secondary payment method where the bank promises payment if the seller fulfills the terms of the letter of credit. This means if the buyer fails to pay, then as long as the seller meets the requirement of the Standby Letter of Credit, the bank will pay
- Even though a Bank Guarantee is like a Standby Letter of Credit in a way that it is a promise of payment from the bank, it is based on a contingent obligation. This means one can take shelter from a bank guarantee in case of an occurrence of a certain contingent event, such as – a performance issue with a manufacturer or cancellation of a project once it has commenced
Difference in Practice
Realistically, the standby letter of credit is different from a bank guarantee. The main difference is that a bank guarantee is only concerned with financial performance (e.g., sale of goods, manufacturing, projects etc.), the standby letter of credit is exceptionally more diverse as it covers a host of financial and non-financial performance factors.
A Standby Letter of Credit most definitely covers regular financial risk factors such as timely payment of goods. Still, it may also cover non-financial risk factors such as a particular material requirement, defect margin, etc. Thus, we can say that the Standby Letter of Credit is a more holistic instrument compared to a bank guarantee.
Scope of Usage
The standby letter of credit is mainly used in long-term contracts. It provides a more perfected guarantee to the beneficiary that he will get paid as long as the beneficiary performs as per the contract terms and conditions as stated in the clauses of the Standby Letter of Credit.
However, the use of a Bank Guarantee is relatively more comprehensive in scope. It is similarly used in both long-term and short-term transactions and contracts. A Bank Guarantee can be used in a sale-purchase transaction, real estate, construction projects, government tendering, etc.
It is also important to note that the bank guarantee has a wider scope when it comes to geographical locations. Among the two, Standby Letters of Credit are more commonly used in international trade transactions. In contrast, a Bank Guarantee is used equally in both domestic and international trade transactions.
Scope of Risk Coverage
A Standby Letter of Credit covers the financial risk of the beneficiary only. For example, an American importer promises to buy a consignment of 10,000 golf balls from an exporter in Spain. On request, the American importer opens a standby letter of credit in favor of the Spain exporter. Here the standby letter of credit covers only the financial risk of the Spain exporter, i.e., the seller. This means even though the buyer, i.e., the American importer, may be vulnerable to financial risks, those risks are not covered in the Standby Letter of Credit.
In contrast, a Bank Guarantee may cover the financial risk of both parties if designed to do so. For example, a government department awards a tender project to build a bridge to a construction company. Both parties may have to issue bank guarantees to prove their credibility. If the construction company cannot finish the project on time, the government department will notify the issuing bank. The bank then pays the department as per the bank guarantee contract. On the other hand, if the government department fails to pay the correct amount on time, then the construction company will notify the bank, which will, in turn, cover the obligation as per the contract of the bank guarantee.
Another important point to note here is that the beneficiary has double coverage in a standby letter of credit. This means there is primary coverage of a letter of credit issuing bank plus secondary coverage from a third-party bank. At the same time, there is coverage from only a single bank in a bank guarantee.
There is a major legal difference between a bank guarantee and a standby letter of credit. A bank guarantee is a simple obligation subject to civil law, whereas a standby letter of credit is subject to banking protocols – UCP 500 and ISP 98.
|SCOPE||STANDBY LETTER OF CREDIT (SBLC)||BANK GUARANTEE (BG)|
|THEORY||A secondary payment method where the bank promises the payment if the seller fulfills terms of the SBLC.||A promise of payment from the bank, it is based on a contingent obligation.|
|PRACTICE||Covers host of financial and non-financial performances.||Only concerned with financial performance|
|USAGE||Used in long terms contracts and international trade transactions.||Used in long term and short-term contracts. Used in domestic and international transactions.|
|RISK COVERAGE||Covers the financial risks of the beneficiary only. Beneficiary has a double coverage from Issuing and third-party bank.||May cover the financial risk of both the parties if designed to do so. Coverage from only a single.|
|LEGAL||Subject to banking protocols: UCP 500&ISP 98.||A simple obligation subject to the civil law.|
There are many similarities between the two products, however, there is also many differences. It is important that a businesses understands the latter of the two. Our experienced team is always on hand, should you wish to know more. You can contact us by filling out our simple contact form or by emailing APTF at www.aptradefinance.com