Bank Guarantee vs Letter of Credit

Quick Answer

A bank guarantee (BG) is a promise by a bank to pay if a party fails to fulfill a contractual obligation (default-based). A letter of credit (LC) is a bank commitment to pay the seller upon presentation of compliant shipping documents (document-based). BGs protect against non-performance; LCs ensure payment for delivered goods.

Both are standard trade finance instruments in EPC piping procurement, but they serve fundamentally different purposes. Getting them confused — or using the wrong one — can leave either the buyer or seller exposed on a six-figure material order.

Bank Guarantee vs Letter of Credit: Comparison

Feature	Bank Guarantee (BG)	Letter of Credit (LC)
Purpose	Protects against non-performance or default	Ensures payment for goods/services delivered
Trigger for payment	Beneficiary claims default occurred	Seller presents compliant documents
Who is protected	The party receiving the guarantee (buyer or seller)	Primarily the seller (payment assured by bank)
Payment basis	Default/breach of contract	Documentary compliance
Bank role	Guarantor (pays if principal defaults)	Primary obligor (pays against documents)
Governed by	URDG 758 (ICC) or local law	UCP 600 (ICC)
Typical cost	0.5-2% per annum	1-3% of LC value
Common types	Advance payment guarantee, performance bond, bid bond	Sight LC, deferred payment LC, standby LC
Utilization	Only if default occurs (ideally never called)	Used for every compliant shipment

How Each Instrument Works

Bank Guarantee flow:

1. The applicant (e.g., supplier) requests their bank to issue a guarantee
2. The bank issues the BG in favor of the beneficiary (e.g., buyer)
3. If the applicant defaults, the beneficiary presents a claim to the bank
4. The bank pays after verifying the claim meets the guarantee terms
5. The bank recovers the amount from the applicant

Letter of Credit flow:

1. The buyer instructs their bank (issuing bank) to open an LC
2. The seller ships goods and presents shipping documents to the bank
3. The bank checks document compliance against the LC terms
4. If compliant, the bank pays the seller
5. The buyer reimburses the bank

Types of Bank Guarantees in EPC

Guarantee Type	Protects	Typical Value	Duration
Bid bond	Buyer (against bid withdrawal)	2-5% of bid value	Until contract award
Advance payment guarantee	Buyer (against advance not recovered)	Equal to advance amount	Until advance is offset
Performance bond	Buyer (against non-performance)	10-15% of contract value	Until final acceptance
Warranty bond	Buyer (against defects)	5-10% of contract value	12-24 months after delivery
Retention guarantee	Seller (replaces cash retention)	5-10% of contract value	Until warranty expiry

Pro Tip

In large EPC piping orders, it is common to use both instruments together: an LC for the payment mechanism and a performance bank guarantee to protect against non-delivery or defective goods. The LC handles the money flow; the BG handles the risk of contract non-compliance.

When to Use Each

Use a bank guarantee when: the buyer needs assurance that the supplier will perform (deliver on time, meet specifications, honor the warranty) or the seller needs assurance that the advance payment will be refunded if the buyer cancels.

Use a letter of credit when: the seller needs certainty of payment backed by the buyer’s bank, especially for international transactions with new counterparties or in countries with transfer restrictions.

For a full overview of Incoterms 2020 and how they interact with payment instruments, see the detailed reference.

Read the full guide to Incoterms