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What is a Bank Guarantee?- Understanding BG Bank Guarantee and its uses

A bank guarantee, like a letter of credit, is a promise from a bank or lending institution that it will assume liability for a particular debtor if its contractual obligations are not met. In other words, the bank offers to stand as the guarantor on behalf of a business customer in a transaction.

So the bank guarantee guarantees a sum of money to a beneficiary but the bank only pays that amount if the opposing party does not fulfill the obligations outlined by the contract.  Bank guarantees protect both parties in a contractual agreement from credit risk.

A bank guarantee can also be defined as an assurance that a bank provides to a contract between two external parties, a buyer and a seller, or in relation to the guarantee, an applicant and a beneficiary. The bank guarantee serves as a risk management tool for the beneficiary, as the bank assumes liability for completion of the contract should the buyer default on their debt or obligation.

A bank guarantee allows the customer, or debtor, to acquire goods, purchase equipment or draw down a loan. A bank guarantee is a promise from a bank or other lending institution that if a particular borrower defaults on a loan, the bank will cover the loss. Note that a bank guarantee is not the same as a letter of credit.

 

As already explained above, a bank guarantee acts similarly to a line of credit, except that a line of credit can be drawn upon at will by the bank’s client.

A bank guarantee is used only if the client does not pay its vendor an agreed-upon amount. U.S. credit institutions are forbidden from assuming guarantee obligations, and therefore most international transactions require a standby letter of credit.

Bank guarantees serve a key purpose for small businesses; the bank, through their due diligence of the applicant, provides credibility to them as a viable business partner for the beneficiary of the guarantee. In essence, the bank puts its seal of approval to the applicant’s creditworthiness, co-signing on behalf of the applicant as it relates to the specific contract the two external parties are undertaking.

 

A bank guarantee is a contract between 3 different parties and they include:

• The applicant (the party that requests a bank guarantee from the bank and borrows from a creditor)
• The beneficiary (the party that receives a partial guarantee)
• The bank (the party that agrees to sign and assures payment in case the applicant fails to repay the loan)

Bank guarantees are very commonly utilised among business entities. With the help of a bank guarantee, the debtor or borrower or customer will be able to purchase equipment, machinery, raw materials, acquire additional funds, etc. for commercial purposes. Bank guarantees help businesses as creditors will get a proper reassurance that the loan amount will be repaid by the bank if the business is unable to repay the loan entirely on time.

When a bank signs a bank guarantee, it promises to pay any amount according to the request made by the borrower. Hence, signing a bank guarantee implies a high risk for banks.

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The Different Types and Kinds of Bank Guarantees

 

• Deferred payment guarantee: This refers to a bank guarantee or a payment guarantee that is offered to the exporter for a deferred period or for a certain time period. When a buyer purchases capital goods or machinery, the seller will give credit to the buyer when the buyer’s bank gives a guarantee that it will pay the unsettled dues of the buyer to the seller. Under this type of guarantee, payment will be made in installments by the bank for failure in supplying raw materials, machinery or equipment.
• Financial guarantee: A financial bank guarantee assures that money will be repaid if the party does not complete a particular project or operation entirely. According to the financial guarantee agreement, when there is a delay in the completion of the project, the bank will make the payment.
• Advance payment guarantee: Under this kind of guarantee, an advance payment will be made to the seller. There will also be a guarantee that if the seller fails to deliver the service or product accurately or promptly, the buyer will receive a refund of the payment.
• Foreign bank guarantee: A foreign bank guarantee is provided by a bank on behalf of a borrower. This will be offered on behalf of the foreign beneficiary or creditor.
• Performance guarantee: Under a performance guarantee, compensation of money will be made by the bank when there is any delay in delivering the performance or operation. Payment will have to be made even if the service is delivered inadequately.
• Bid bond guarantee: Under this type of guarantee, there will be a supply bidding procedure. This will be conducted by the contractor for the owner of an infrastructure or industrial project or any kind of operation. The contractor of the project will guarantee that the best bidder or the highest bidder will have the capability and authority to implement a project as per his or her preferences. The bid bond will be given to the owner of the project as a proof of guarantee and the bond will imply that the project will have to be devised according to the bid contract.

Because of the general nature of a bank guarantee, there are many different kinds of bank guarantees:

• A payment guarantee assures a seller the purchase price is paid on a set date.
• An advance payment guarantee acts as collateral for reimbursing advance payment from the buyer if the seller does not supply the specified goods per the contract.
• A credit security bond serves as collateral for repaying a loan.
• A rental guarantee serves as collateral for rental agreement payments.
• A confirmed payment order is an irrevocable obligation where the bank pays the beneficiary a set amount on a given date on the client’s behalf.
• A performance bond serves as collateral for the buyer’s costs incurred if services or goods are not provided as agreed in the contract.
• A warranty bond serves as collateral ensuring ordered goods are delivered as agreed.

Real-World Example

For a real-world example, consider a large agricultural equipment manufacturer. While the manufacturer may have vendors in many places, it is often best practice to have local vendors for key parts, both for accessibility and transportation cost reasons.

As such, they may wish to enter into a contract with a small metalworks shop that is located in the same industrial area. Due to the small vendor being relatively unknown, the large company will require the vendor to secure a bank guarantee before entering into a contract for $300,000 worth of machine parts. In such a case, the large company will be the beneficiary, and the small vendor will be the applicant.

Should the small vendor receive the bank guarantee, the large company will enter into a contract with the vendor. At this point, the company may pay the $300,000 in advance, with the understanding that the vendor is to deliver the agreed-upon parts in the following year. If the vendor is unable to do so, the agricultural equipment maker can claim the losses resulting from the vendor breaking the terms of the contract from the bank.

Through the bank guarantee, the large agricultural equipment manufacturer can shorten and simplify its supply chain without compromising its financial situation.

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Comparison between Bank Guarantees and Letters of Credit

Many times, people get confused between bank guarantee and a letter of credit. However, one should understand that both are pretty different.

 

A bank guarantee refers to a commercial or financial instrument that is provided by a bank, where the bank assures or guarantees a beneficiary that it will make the payment to the bank in case the actual customer fails to meet his or her obligations. The bank will pay on behalf of the customer who requests for a bank guarantee.

 

On the other hand, a letter of credit refers to a promise or commitment in writing made by a bank or any other financial institution or corporation to a particular seller that payment will be made to the seller if the seller completes performing whatever is mentioned in the letter of credit. For the bank to make the payment on behalf of the original buyer, there should be a documentary proof that the seller has completed the transaction accurately by delivering the right product or service on time. The seller will get a guarantee from the bank that the seller will definitely pay the amount on behalf of the original buyer once the obligations are fulfilled.

 

Under a bank guarantee, if the buyer is unable to make the payment to the seller or creditor, then the bank pays the fixed amount to the seller as the obligations of the contract are not met. On the other hand, under a letter of credit, the bank makes the payment to the seller once he or she delivers. This is because the seller has completed fulfilling the required obligations.

Bank guarantees are competitively priced in nature generally. They are usually valid for a long period. The tenure of a bank guarantee is usually high. Moreover, bank guarantees are commonly accepted in almost all countries. Bank guarantees are available in Indian Rupee as well as currencies of other nations. Hence, they are very helpful for global transactions with parties in different foreign countries.

 

Advantages of Bank Guarantees

To the applicant:

• Small companies can secure loans or conduct business that would otherwise not be possible due to the potential riskiness of the contract for their counterparty. It encourages business growth and entrepreneurial activity.
• The banks charge low fees for bank guarantees, normally a fraction of 1% of the overall transaction, for the assurance provided.

To the beneficiary:

• The beneficiary can enter the contract knowing due diligence’s been done on their counterparty.
• The bank guarantee adds creditworthiness to both the applicant and the contract.
• There is a risk reduction due to the bank’s assurance that they will cover the liabilities should the applicant default.
• There is an increase in confidence in the transaction as a whole.

Disadvantages of Bank Guarantees

• The involvement of a bank in the transaction can bog down the process and add an unnecessary layer of complexity and bureaucracy.
• When it comes to particularly risky or high-value transactions, the bank itself may require assurance on the part of the applicant in the form of collateral.

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