Compare a letter of credit, a bank guarantee, and a surety bond — when would you use each in trade?
A core Corporate Treasury interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
All three are third-party credit-support instruments but differ in trigger and use. A letter of credit (especially a documentary/commercial LC) is a bank's undertaking to pay the seller against compliant shipping documents — it's a payment mechanism in trade, giving the exporter payment certainty independent of the buyer once documents conform. A bank guarantee (e.g., a demand/standby guarantee or standby LC) is a promise to pay if the principal defaults on an underlying obligation — used to backstop performance or payment, paid on demand against a simple claim (independent of proving the default in a demand guarantee). A surety bond is issued by an insurer/surety guaranteeing performance, but typically the surety can investigate and may perform or indemnify rather than pay on first demand — more conditional, common in construction. So: LC to effect and secure payment on shipment; bank guarantee/standby for on-demand default protection; surety bond for performance assurance with the surety's involvement.
WHAT INTERVIEWERS LISTEN FOR
- ✓LC: bank pays seller against compliant documents (payment mechanism)
- ✓Bank/demand guarantee: pay on demand if principal defaults
- ✓Surety bond: insurer guarantees performance, more conditional
- ✓Choose by whether you need payment, on-demand backstop, or performance assurance
COMMON MISTAKES
- ✗Treating all three as identical
- ✗Not knowing LC pays against documents
- ✗Confusing on-demand guarantee with conditional surety
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