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 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, 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 purposes and intent to the prospective consumers of these products, i.e., minimizing financial risk.
- 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 in both products is similar.
As time passed, both standby letters of credit and bank guarantees 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 the bank promises the 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 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 from a bank guarantee in case of occurrence of a certain contingent event, such as – a project never takes off or a 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 a bank guarantee is only concerned with financial performance (e.g., sale of goods, construction, etc.), the standby letter of credit is extremely diverse. 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 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. 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 location. Among the two, standby letters of credit are more commonly used in international trade transactions. In contrast, a bank guarantee is equally used in both domestic and 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 an 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. This means even though the buyer, i.e., the American exporter, 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 a primary coverage of a letter of credit issuing bank plus a 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.