Letters of credit vs bank guarantees: Tools for credit risk in uncertain times

Even after checking every box—financials, references, payment history—there’s always that lingering question for every credit manager: What if? What if the customer fails to pay? What if circumstances suddenly change? For moments like these, letters of credit and bank guarantees aren’t just optional—they’re essential tools to protect a company in an unpredictable world. 

Why it matters: Letters of credit and bank guarantees serve as financial safety nets for credit professionals navigating risk—something that’s all too common nowadays. But what exactly sets them apart, and how do you know which one to use, and when? Knowing the difference is vital in securing payment from customers. 

LC or bank guarantee? Decide wisely 

A letter of credit (LC) is a form of documentary credit in which the creditworthiness of the issuing bank stands in place of the creditworthiness of the buyer. This means that the bank is obligated to pay the seller if all the documentary requirements have been met, even if there is an issue with the goods involved.  

Letters of credit come in various forms, including commercial or standby, confirmed or unconfirmed, irrevocable or revocable, revolving and transferable. The most commonly used LCs are: 

• Commercial: for direct payment 
• Standby: functions as a payment guarantee 
• Revolving: covers multiple shipments 
• Confirmed: includes a second bank’s guarantee 

LCs are used mostly in international transactions and can cover single or multiple transactions. Here’s a real-life example:  

A manufacturer is exporting goods to a new customer. However, the country the customer is based in is facing increased geopolitical risk that may impact their ability to pay you on time. To reduce the risk of non-payment, a credit manager may require a commercial LC. While letters of credit offer a strong sense of financial security, it’s important to note they are not an absolute guarantee of payment. 

In contrast, a bank guarantee sets up the buyer as the primary obligor, and the bank only steps in if the customer fails to pay. Unlike LCs, bank guarantees are not typically used in international trade. Instead, they’re tied to specific contracts and long-term commitments, such as real estate developments or large construction projects. For instance, a developer bidding on a large government project may request a bank guarantee to secure their performance obligations. 

Under lock and key: Conditions to secure payment 

For a letter of credit, the bank fulfills its payment obligation upon presentation of specified documents, such as a statement from the beneficiary that the account party has defaulted. This obligation is entirely independent of the underlying commercial contract between the buyer and seller. The bank is not required to assess questions of fact or law or to verify whether a default has actually occurred. 

Comparatively, a bank guarantee is only triggered if the buyer fails to meet their contractual obligations. It may be structured to become payable upon the occurrence, or nonoccurrence, of a specific event, such as the customer’s default. Unlike an LC, bank guarantees may or may not be independent of the underlying contract. Before issuing a guarantee, the bank typically requires the customer to sign a counter-indemnity agreement, committing to reimburse any amount the bank pays under the guarantee. 

Issuing banks: Laying down the law 

Regardless of which instrument you use, clear and accurate documentation is critical to prevent the bank from denying payment. The terms and prepared documents are to be completed in the specific timeframe that the bank requires. The LC should be prepared with terms that are favorable to the seller so that the supporting documentation is in the buyer’s control.  

Moreover, under an LC, there must be a definite expiration date and the credit must be a maximum specified amount. Alternatively, a bank guarantee tenure could be indefinite but, by law, the amount cannot be unlimited.  

When considering these two tools, think of it this way: a letter of credit is like a prepaid lock that opens when you follow the exact combination (the required documents). A bank guarantee is more like a backup key held by someone else, where you can only use it if something goes wrong, and you can prove that you need it. 

The bottom line: Letters of credit and bank guarantees are both powerful tools in managing credit risk, especially when trust alone isn’t enough. Understanding how each works, and when to use them, can mean the difference between getting paid and writing off a bad debt.