Letter of GuaranteeExplained & Defined

Lisa Borga

What Is a Letter of Guarantee?

A letter of guarantee is a written agreement issued by a bank on behalf of one of their customers stating that should the customer default on the payment of goods purchased from the supplier, the bank will pay for the goods.

This guarantee can help the supplier to feel more confident about receiving payment for the transaction and thus be more willing to supply the goods.

Customers do need to apply for a letter of guarantee.

Then, if the bank approves the application, they will supply the letter.

However, the bank will charge an annual fee.

Banks will also issue a letter of guarantee for a call writer.

In this case, the bank guarantees that the writer has ownership of the underlying asset.

The bank also guarantees that if the call is exercised, the bank will deliver the underlying securities.

Call writers commonly use a letter of guarantee if they are not holding the underlying asset of a call option in their brokerage account.

letter of guarantee

An Explanation of Letters of Guarantee

Letters of guarantee are frequently used in situations where one party in a transaction is not sure that the other party will meet its financial obligations.

This is especially common when a business is purchasing expensive property or equipment.

But, having a letter of guarantee does not always mean that the entire debt will be covered.

There are some cases in which only part of the debt will be covered, and the letter will state this.

A bank negotiates with its client to determine the amount it will cover.

Banks will charge a client for this service.

This will generally be an annual fee.

Typically, the fee will be a percentage of the amount the bank will be required to pay if the client should default on their debt.

Letters of guarantee can also be used by writers.

They are often used because a number of institutional investors keep their investment accounts at custodial banks instead of with a broker-dealer.

In these cases, the broker will frequently be willing to accept a letter of guarantee from the call writer with short options instead of holding the securities or the cash.

However, the exchange or Options Clearing Corporation will require the letter of guarantee to be in a form that they are willing to accept.

The bank issuing the letter agrees that if the call is exercised, the bank will give the underlying securities to the lender.

The Differences Between a Letter of Guarantee and a Letter of Credit

A letter of guarantee, which is sometimes called a bankers commercial credit or a documentary credit, is a guarantee from a bank that it will make a specified payment.

This letter will specify any obligations the buyer has to the seller.

It will state the amount of the payment as well as when the payment will be made.

The bank issuing the letter of credit will also ensure the buyer has the money to meet the financial obligation.

Then, once the terms of the agreement are met and verified, the bank will transfer the money to the executor of the terms.

In contrast, with a letter of guarantee, the guarantor might pay either the buyer or the seller if one of the parties defaults on the agreement.

Should the buyer default on their payment, the seller could ask the bank for payment if a letter of guarantee was provided.

However, if the buyer pays for goods before receiving them and the seller fails to provide the goods after having supplied a letter of guarantee, the buyer could ask the bank for compensation.

Letter of Guarantee Examples

Here are two examples of letters of guarantee.

Example 1

As an example of a letter of guarantee, suppose Company Y is buying a special production machine for their factory that costs $3 million.

It may take the supplier many months to build and then ship the machine.

The supplier would like to be paid before building the machine because they are worried they might spend a lot of money to build the machine, and then the buyer might not pay.

However, the buyer does not want to pay upfront.

But, in order to reassure the seller, the buyer could get a letter of guarantee from the bank.

This could help assure the seller that they will be paid since the bank would have to pay if the buyer defaults on the payment.

Example 2

Suppose Company Z has a contract to construct a new apartment complex, and they want to buy $50 million in lumber.

But, the supplier they want to purchase the lumber from is asking for a letter of guarantee.

Company Z then applies for the letter of guarantee from the bank.

The bank determines that the company qualifies for the letter of guarantee and charges an annual fee based on the amount that will be guaranteed.

After the supplier receives the letter of guarantee, they begin to supply the lumber for the construction project.

Advantages and Disadvantages of a Letter of Guarantee

Advantages

  • A letter of guarantee can make it easier for businesses to purchase necessary items from suppliers.
  • Letters of guarantee help protect suppliers in the event of a default.
  • A letter of guarantee is useful in overseas trade and helps to increase imports and exports.

Disadvantages

  • A letter of guarantee may not provide full protection if the amount of the claim is large, as the guarantor may be unable to pay the entire amount.
  • Letters of guarantee may increase default rates by allowing bond issuers to issue more bonds than necessary.

Key Takeaways

  • A letter of guarantee is a document that a bank issues stating that should the customer fail to pay for the goods they purchased from the supplier, the bank will pay for the goods.
  • Banks sometimes issue a letter of guarantee for a call writer. This letter states that the underlying asset is owned by the call writer and that the bank will turn over the underlying securities if a call is exercised.
  • Letters of guarantee are common in many types of business transactions, including declarations during export and import processes, when obtaining financing from a bank, or as a part of the construction process.

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  1. Cornell Law School "Guarantee" Page 1 . August 12, 2022

  2. University of Pennsylvania "BANK GUARANTEES AND LETTERS OF CREDIT: TIME FOR A RETURN TO THE FOLD" Publication. August 12, 2022