Bank Guarantees & Letter of Credit

In commerce, buyers and sellers often live in different cities or continents, speak different languages, and have never met in person. A seller in Germany is reluctant to ship expensive industrial machinery to India without getting paid first, while an Indian buyer fears losing money if goods arrive damaged or late. To bridge this trust gap, commercial banks step in with Non-Fund-Based Facilities: specifically, Bank Guarantees and Letters of Credit.

1. What are Non-Fund-Based Facilities?

In a Non-Fund-Based Facility, the bank does not immediately disburse cash to the customer. Instead, the bank lends its financial reputation, credibility, and creditworthiness by issuing a contingent legal commitment. Cash is paid out only if a specified default or contractual breach occurs in the future.

2. Bank Guarantee (BG)

A Bank Guarantee is a tripartite legal contract where a commercial bank (the Guarantor) promises a third party (the Beneficiary) that in the event the bank’s customer (the Applicant / Principal Debtor) fails to perform an obligation or pay a debt, the bank will pay the specified sum of money to the beneficiary upon demand.

Three Parties to a Bank Guarantee

1. The Applicant (Principal Debtor): The customer (contractor, supplier) who requests the bank to issue the guarantee.
2. The Beneficiary (Creditor): The party in whose favor the guarantee is issued (e.g., National Highways Authority of India, Indian Railways).
3. The Guarantor Bank: The bank issuing the guarantee.

                  ┌───────────────────────────────────────────────┐
                  │                 GUARANTOR BANK                │
                  └───────────────┬──────────────┬────────────────┘
         1. Customer requests     │              │ 3. Bank pays claim
            guarantee & provides  │              │    if customer fails
            collateral/margin     │              │    to perform
                                  ▼              ▼
           [ APPLICANT / DEBTOR ] ────────► [ BENEFICIARY / CREDITOR ]
                   2. Undertakes commercial work/contract

Major Types of Bank Guarantees

1. Financial Guarantee: The bank guarantees that the applicant will fulfill a monetary payment obligation (e.g., payment of advance taxes, custom duties, or loan repayments).
2. Performance Guarantee: The bank guarantees that the applicant will complete a physical commercial project or supply goods according to agreed technical specifications and timelines (e.g., constructing a bridge on schedule).
3. Bid Bond (Earnest Money) Guarantee: Submitted by bidders in high-value public tenders to guarantee that if awarded the contract, the bidder will not back out.
4. Deferred Payment Guarantee (DPG): Guarantees the payment of installments on imported heavy capital equipment over several years.

3. Letter of Credit (LC / Documentary Credit)

A Letter of Credit (LC) is a formal financial undertaking issued by a buyer’s bank (the Issuing Bank), at the request of the buyer (the Applicant), guaranteeing to pay the seller (the Beneficiary) a specified amount of money, provided the seller presents exact compliant shipping and commercial documents within the stipulated time.

Four Key Parties to an LC

1. Applicant (Importer / Buyer): The party purchasing goods who requests the LC.
2. Issuing Bank (Buyer’s Bank): The bank opening the LC and assuming primary payment liability.
3. Beneficiary (Exporter / Seller): The supplier receiving the payment guarantee.
4. Advising / Confirming Bank (Seller’s Local Bank): Notifies the seller that an LC has been opened, and may add its own independent payment guarantee (in a Confirmed LC).

The Golden Rule of Letters of Credit

Under UCP 600 Rules (International Chamber of Commerce):
“Banks deal in documents, not in goods.”
If the seller presents the exact Bill of Lading, Commercial Invoice, Certificate of Origin, and Inspection Certificate matching the LC terms to the letter, the issuing bank must pay, regardless of any underlying dispute about the physical quality of the goods.

4. Step-by-Step Lifecycle of a Letter of Credit

1. Contract: Buyer & Seller sign sales agreement agreeing to LC payment
                           │
                           ▼
2. LC Application: Buyer requests their bank (Issuing Bank) to open LC
                           │
                           ▼
3. LC Transmission: Issuing Bank transmits LC via SWIFT to Seller's Bank
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                           ▼
4. Shipment: Seller manufactures & ships goods on cargo vessel, obtaining Bill of Lading
                           │
                           ▼
5. Document Presentation: Seller submits complete shipping documents to Advising Bank
                           │
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6. Document Scrutiny & Payment: Issuing Bank verifies documents and remits payment
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                           ▼
7. Delivery: Buyer pays bank, receives original Bill of Lading, and clears cargo at port

5. Bank Guarantee vs Letter of Credit: Key Differences

This is a premier comparative exam topic:

6. Summary for BBA Exams

• Both BG and LC are non-fund-based credit facilities leveraging bank reputation.
• Bank Guarantee: Bank pays only upon default of the applicant (secondary liability); includes Financial and Performance guarantees.
• Letter of Credit: Bank pays as the primary payment channel when seller submits compliant shipping documents (primary liability).
• Cardinal rule of LC: Banks deal in documents, not goods (governed globally by UCP 600).