Bank Guarantee : What It Is, Types, Features And Pros & Cons
What Is A Bank Guarantee?
A bank guarantee is a type of financial assurance or promise provided by a bank or other financial institution where it ensures the beneficiary that the liabilities of the buyer will be met in case if he fails to settle a debt. In other words, a bank guarantee is an agreement between the bank, the beneficiary, and the applicant (buyer) where the bank serves as the guarantor for the buyer and enables him to acquire goods, or buy equipment.
Such bank guarantees are commonly used in business and personal transactions to protect the third party from payment risks. With the help of the bank guarantee, the customers can buy equipment, machinery, or raw materials, etc for commercial use while the beneficiary gets a proper assurance that the full amount will be paid to them on-time in exchange for their goods & services. In short, a bank guarantee is an assurance from a bank to a beneficiary to cover the loss if the buyer defaults on a loan.
Example Of A Bank Guarantee
Let’s assume a company XYZ Ltd is a small cafe that wants to purchase a bundle of kitchen equipment. The vendor company however demands a bank guarantee to the XYZ ltd to ensure on-time payment of the said amount. For this reason, Company XYZ applies to one of its lenders to obtain a bank guarantee. The bank provides a guarantee in writing and passes it on to both the parties.
Why Is A Bank Guarantee Necessary? Uses of Bank Guarantee
Types Of A Bank Guarantee
A Bank guarantee is similar to any type of financial instrument with a specific amount to be paid and a predetermined period. They are available in different forms. Here are some of the major types of bank guarantee. Let’s have a look:
- Financial Guarantee — In this type of guarantee, the bank guarantees the beneficiary that the buyer will fulfill the financial obligations, and in case if he fails or there is any delay, the bank will repay the debts.
- Performance-based Guarantee — Under a performance-based guarantee, the bank acts as a guarantor to compensate the money to the beneficiary if there is any delay in delivering the performance, non-performance, or short-performance of the contract. The payment will be made even for the inadequately delivered services.
- Advanced Payment Guarantees — In this type of guarantee, advance payment is made by the bank to the seller but with a guarantee that if the seller fails to deliver the goods or services properly, the buyer will receive the refund.
- Foreign Bank Guarantee -As the name suggests, a foreign bank guarantee is issued by a bank for a foreign beneficiary.
- Bid Bond Guarantee -This guarantee assures that the bidder would undertake the contract he has bid for with the terms of the bidding.
- Deferred Payment Guarantee -When a bank provides a guarantee to an exporter for a deferred period or a certain period, it is known as a deferred payment guarantee.
- Shipping Guarantees — Under this type of a bank guarantee, the bank protects the shipping company from all types of risks in case the buyer fails to repay the debt.
- Payment/ Loan guarantees -When a guarantee is issued for an assurance of the payment or loan payment.
Advantages And Disadvantages Of A Bank Guarantee
Bank guarantee has several advantages and disadvantages. Let’s have a look:
Advantages:
- Reduces The Financial Risks — The bank guarantee reduces the financial risks involved in a business transaction. This i.e. increased defaults by the buyer is the main reason behind the popularity of bank guarantees.
- Low Fees — The fees charged by the bank is very nominal and due to this, it does not have a significant impact on the profits of the business.
- Several Opportunities — With a bank guarantee, you can expand the business in the market which was not available earlier.
- To The Beneficiary — The beneficiary can enter into the contract because of the due diligence.
- To the Applicant — The buyers can initiate the transactions for growing their business in the expanded market.
Disadvantages:
- Rigid Procedure By Banks -The banks can be so rigid in evaluating the financial position of the business. This makes the entire process complex and time-consuming.
- Difficulties For Loss-making Entities -Due to the rigid assessment done by the banks, the loss-making entities find it difficult to obtain a bank guarantee.
- Security Requirements — The guarantees involving high-value or high-risk transactions, the bank can demand collateral security to process the guarantee.
How To Obtain A Bank Guarantee?
Any person or individual who has a sound financial track record can obtain a bank guarantee by applying to his bank or any other bank offering such types of services. Before approving the guarantee, the bank analyses the previous bank history, creditworthiness, liquidity, and CIBIL rating of the candidate. It also includes period, value, details of beneficiary, and currency as required for the approval. In some cases, the banks can also demand security from the applicant to cover the bank guarantee value. Once the bank is satisfied with all the criteria, they provide the necessary approvals to the candidate required for the processing.
Difference Between Bank Guarantee And Letter Of Credit
Letter of credits and bank guarantees are sometimes misunderstood as they share common characteristics. They both play an essential role in trade financing where both provide a guarantee to the third-party to repay the debt if the buyer fails to do so. But they both work with a slight difference. Know what it is:
The letter of credits is widely used in international trade due to the foreign transaction risks involved such as distance or respective laws or difficulty of the parties meeting in-person. Letter of credits is commonly used in global transactions while bank guarantees are often used in domestic markets especially in real estate contracts and infrastructure projects.
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