Let’s discuss ‘Standby Letter of Credit vs Bank Guarantee’, which is a common confusion in the minds of many. A standby letter of credit and a bank guarantee are actually very similar products. As a matter of fact, if we go back and look at the origination of 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, they couldn’t issue a bank guarantee as well. As this was a lucrative business, they got around this act by forming their letters of credit as bank guarantees. They called this new product the standby letter of credit. From this, we can infer that the standby letter of credit is actually a hybrid version of a bank guarantee.
There are many similarities between the two products such as –
- Both serve similar purpose and intent to the prospective consumers of these products, i.e. minimizing financial risk.
- Banks performs similar credit checks for both the instrument i.e. issuing parties financial health, credit score and past record. Also, banks require a collateral for both the products.
- In both the products, the issuing bank replaces the applicant’s credibility with its own. Therefore, the risk for a bank in both the products is similar.
As time passed both standby letter of credit and bank guarantee developed as individual products. Though there are very subtle differences in both the products, let’s try to understand these differences in detail:
Difference Between Standby Letter of Credit (SBLC) and Bank Guarantee (BG)
The Difference in Nature
A standby letter of credit is a secondary payment method where bank promises the payment if the seller fulfills terms of the letter of credit. Which means if the buyer fails to pay, then as long as the seller meet’s the requirement of the standby letter of credit, the bank will pay.
Even though a bank guarantee is similar to 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 of bank guarantee in case of occurrence of a certain contingent event such as – a project never takes off, or construction project is halted in the middle stage.
Difference in Practice
From a practical perspective, the standby letter of credit is quite different from a bank guarantee. While bank guarantee is only concerned with financial performance (e.g. – sale of goods, construction, etc.), the standby letter of credit is extremely diverse and 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, but it may also cover non-financial risk factors such as a particular material requirement, defect margin, etc. Thus we can say that compared to a bank guarantee, the standby letter of credit is a more holistic instrument.
Scope of Usage
The standby letter of credit is majorly used in long-term contracts. It provides a guarantee to the beneficiary that he will get paid if he performs as per the clauses of the standby letter of credit.
Whereas the use of a bank guarantee is comparatively wide in scope. It is equally used in both long-term and short-term transactions and contracts. 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 location. Amongst the two, standby letter of credit is more commonly used in international trade transactions. In contrast, a bank guarantee is equally used in both domestic as well as international 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 5000 t-shirts from Indian exporter. On request, the American exporter opens a standby letter of credit in favor of the Indian exporter. Here the standby letter of credit covers only the financial risk of the Indian exporter i.e. the seller. Which means even though the buyer i.e. the American exporter may be vulnerable to financial risks, those risks are not covered in standby letter of credit.
In contrast, a bank guarantee may cover the financial risk of both the 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 its credibility. In case the construction company is unable to finish the project on time then 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 who will, in turn, cover the obligation as per contract of bank guarantee.
Another important point to note here is that in standby letter of credit the beneficiary has double coverage. Which means there is a primary coverage of letter of credit issuing bank plus there is a secondary coverage from a third party bank. Whereas in bank guarantee there is coverage from only a single bank.
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 the civil law whereas a standby letter of credit is subject to banking protocols – UCP 500 and ISP 98.