Bank Guarantees (BG) and Letters of Credit (LC)

BG/LC funding refers to financial instruments known as Bank Guarantees (BG) and Letters of Credit (LC), which are commonly used to facilitate trade and business transactions. These instruments provide security and trust between parties, ensuring that obligations are met, and are often used in international trade, project financing, and business contracts.

A Bank Guarantee is a promise by a bank to cover a financial obligation if the borrower (or applicant) fails to meet their contractual commitments. BGs are typically used to mitigate risks in contracts, such as construction projects or business deals.

• Purpose: To provide assurance to the beneficiary that payment will be made if the applicant defaults on their obligation.
• Parties Involved:
  1. Applicant: The party requesting the guarantee (borrower or business).
  2. Beneficiary: The party in whose favor the guarantee is issued (seller or contractor).
  3. Bank: The institution issuing the guarantee.

1. Financial Guarantee: Covers a monetary obligation, such as loan repayments.
2. Performance Guarantee: Ensures the performance of contractual obligations, typically in construction or service contracts.
3. Advance Payment Guarantee: Assures the return of advance payments if the supplier fails to deliver on the contract.

A Letter of Credit is a document issued by a bank guaranteeing that a buyer’s payment to a seller will be made on time and for the correct amount. In case the buyer is unable to make the payment, the bank covers the full or remaining amount.

• Purpose: Used to reduce risk in international trade by ensuring that the seller receives payment as long as certain conditions (e.g., delivery of goods) are met.
• Parties Involved:
  1. Applicant: The buyer/importer.
  2. Beneficiary: The seller/exporter.
  3. Issuing Bank: The buyer's bank that guarantees the payment.
  4. Advising Bank: The seller's bank that may confirm the LC.

1. Revocable LC: Can be altered or canceled by the issuing bank without consent from the beneficiary.
2. Irrevocable LC: Cannot be changed without agreement from all parties involved.
3. Confirmed LC: A second bank (the advising bank) guarantees payment in addition to the issuing bank, offering extra security to the beneficiary.
4. Standby LC: Acts as a safety net and is only used if the buyer fails to pay as per the agreement.
5. Revolving LC: Allows for multiple transactions under one LC, commonly used in long-term contracts.

• Banks require the applicant to have a good credit score and a strong financial standing. A poor credit history may require additional collateral or a higher fee.

• A history of successful projects or contracts, steady revenue, and a proven ability to fulfill contractual obligations increase the chances of securing a BG or LC.

• Lenders will review financial documents such as balance sheets, income statements, and cash flow statements to assess the financial health of the business.

• The bank may require collateral or security, such as real estate, inventory, or other assets, to cover the risk associated with issuing a BG or LC.

• The contract or agreement related to the BG/LC must be clearly defined, including the roles of both parties, payment terms, and any milestones that need to be met.

• Banks charge a fee for issuing BG/LC, typically based on a percentage of the amount covered by the guarantee or credit. The applicant must be prepared to cover this cost, which is usually paid annually or per transaction.

• The bank conducts a risk assessment based on the industry, the nature of the contract, and the counterparties involved. Higher-risk industries or markets may face stricter terms or require additional security.

• The applicant must comply with all legal and regulatory requirements, including anti-money laundering (AML) and know-your-customer (KYC) norms. For international trade, this could also include customs documentation and export/import licenses.

• Established banking relationships can influence the terms of the BG/LC. A long-standing relationship with the bank may result in more favorable terms, such as lower fees or reduced collateral requirements.

• The bank evaluates the purpose for which the BG or LC is being requested. The more specific and clearly defined the use (e.g., securing payment for a major contract, financing a construction project), the more likely the bank is to approve the funding.

1. Application form from the bank for issuing the BG/LC.
2. Financial statements for the last 2-3 years.
3. Business profile and details of the project or transaction.
4. Collateral documentation (if applicable).
5. Copy of the contract/agreement related to the transaction.
6. KYC (Know Your Customer) documentation, including identity proof and business registration.
7. Board resolution (for companies) authorizing the application.
8. Import/Export licenses (for LC, if related to international trade).
9. Bank references and existing banking relationship details.

• Trust and Security: Provides assurance to all parties in a transaction that financial obligations will be met, reducing risk and fostering trust.
• Facilitates Trade: Particularly in international trade, LCs are critical for enabling transactions between parties in different countries.
• Improved Business Opportunities: Having a BG or LC in place can help businesses secure larger contracts or trade deals, as it reassures the counterparties that payments will be made.

• High Collateral Requirements: Depending on the bank and the business’s financial health, collateral requirements may be high, especially for large guarantees or credit lines.
• Cost: BG/LC funding comes with fees, which can be significant if the amounts involved are large or the risk profile is high.
• Strict Compliance: LCs, in particular, require strict compliance with terms and documentation, and even small errors can lead to payment delays or disputes.