A standby letter of credit and a bank guarantee are documents used with international sales. They are both letters that buyers obtain from a financial institution at the request of a seller.
Standby Letter of Credit
The purpose of a standby letter of credit is to protect a seller against nonpayment by a buyer. In the event a buyer fails to pay for goods received, a seller turns in the standby letter of credit the buyer gives them. The financial institution then backs the buyer up and pays the total bill to the seller. The bank charges the buyer an annual fee of approximately 1 per cent to 8 per cent of the face amount, according to Investopedia.
A bank guarantee is similar to a standby letter of credit, but differs in a few key ways. A bank guarantee not only protects a seller, but it also protects the buyer. If the seller fails to ship the goods agreed upon or if the goods are damaged, the bank will pay the buyer the amount it agreed to pay the seller.
Both types of letters contain risk for the financial institution. Banks go through an underwriting process in order to approve customers for these letters. A bank guarantee protects both parties and therefore contains more risk for the bank than a standby letter of credit.
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