Letters of credit and bank guarantees, explained

Letters of credit and bank guarantees are both promises made by a bank, and both are widely used in Indian trade and contracting, but they answer different questions. A letter of credit answers 'will I get paid if I do what the contract requires?' A bank guarantee answers 'will I be compensated if the other party fails to do what they promised?' Confusing the two — or assuming either one does more than it actually does — is a common and avoidable source of dispute.

How a letter of credit works

A letter of credit (LC) is an undertaking issued by the buyer's bank, at the buyer's request, to pay the seller a specified amount provided the seller presents documents that strictly comply with the terms set out in the LC — typically an invoice, transport document, and any certificates the contract requires. The bank's obligation to pay runs on the documents, not on whether the underlying goods actually meet the buyer's expectations; this is the central feature of an LC, often summarised as the independence principle.

Why sellers value an LC

An LC substitutes the buyer's bank's creditworthiness for the buyer's own, which matters considerably when trading with a new or overseas counterparty whose payment reliability is hard to judge. It also makes post-shipment finance — bill discounting or negotiation — more readily available and often better priced, since the financing bank's real exposure is to the issuing bank rather than the buyer directly.

Why documentary compliance matters so much

Because the bank pays against documents, not against physical inspection of goods, even small discrepancies — a misspelt name, a shipment date one day outside the stated window, a missing certificate — can lead to a bank refusing payment under the LC. Exporters who treat LC documentation as a formality rather than a strict compliance exercise are the most common source of payment delays under an otherwise sound LC.

How a bank guarantee works

A bank guarantee (BG) is a bank's undertaking to pay a specified sum to a beneficiary if the bank's own customer — the applicant — fails to perform an obligation, whether a contractual duty or a financial one. Unlike an LC, a BG is not the primary mechanism for routine payment; it is a fallback that is invoked only if something goes wrong.

Performance guarantees

A performance guarantee protects a buyer or project owner against the risk that a contractor or supplier fails to deliver as agreed, entitling the beneficiary to claim compensation up to the guaranteed amount if performance falls short.

Financial guarantees

A financial guarantee protects against non-payment of a financial obligation — for instance, guaranteeing that an advance payment made to a supplier will be refunded if the supplier fails to deliver against it.

The rules that sit behind most letters of credit

Most LCs used in international trade are issued subject to the Uniform Customs and Practice for Documentary Credits (UCP 600), a widely adopted set of rules published by the International Chamber of Commerce that standardises how banks examine documents, handle discrepancies, and process claims across borders. Knowing that an LC references UCP 600, and understanding a handful of its core principles — strict but reasonable document examination, defined discrepancy notice periods, and the independence of the bank's payment obligation from the underlying sale contract — is more useful to a business than trying to master the full rule set, which is best left to trade finance specialists and the bank's own documentary team when a genuine dispute arises.

Common variants worth knowing

• Irrevocable LC — cannot be amended or cancelled without the agreement of all parties, the standard form used in practice.
• Confirmed LC — a second bank, usually in the seller's country, adds its own undertaking to pay, giving the seller protection even if the issuing bank's country or bank itself becomes a credit concern.
• Revolving LC — automatically reinstates its value for repeated shipments under an ongoing supply relationship, avoiding the need to open a fresh LC for each shipment.
• Bid bond and advance payment guarantees — specific guarantee types used in tender and contracting processes, each covering a different stage of the relationship.

The costs involved, in general terms

Both instruments carry charges beyond any headline interest rate — issuance and amendment charges for an LC, commission for a bank guarantee calculated on the guaranteed amount and tenor, and, for cross-border LCs, additional charges from correspondent or confirming banks. These charges vary by bank, tenor, and the applicant's overall relationship and credit standing, so they are worth confirming upfront for a specific transaction rather than assumed from a previous, differently structured deal.

Amendments cost time as well as money

Changing an LC's terms after issuance — a revised quantity, a later shipment date, an additional document requirement — needs the agreement of all parties and typically an amendment fee, and it takes real time to process. Getting the original terms right, ideally by having the sale contract and the LC application drafted together rather than the LC applied for as an afterthought, avoids a good number of these amendments altogether.

What to check before relying on either instrument

1. Read the exact wording — an LC or BG is interpreted strictly on its own terms, and assumptions about what it 'should' cover are not a substitute for what it actually says.
2. Confirm the issuing bank's standing, particularly for cross-border LCs from banks the exporter has not dealt with before; a confirmed LC is worth the extra cost in higher-risk situations.
3. Check expiry dates and the exact document presentation window, since even a valid claim can fail if it is not made within the stated timeframe.
4. Understand the guaranteed sum as a ceiling, not an estimate — a bank guarantee pays up to the stated amount, not whatever the beneficiary's actual loss turns out to be.