A bank guarantee is a type of guarantee from a lending institution. The bank guarantee means a lending institution ensures that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it. A bank guarantee enables the customer, or debtor, to acquire goods, buy equipment or draw down a loan.
A bank guarantee is when a lending institution promises to cover a loss if a borrower defaults on a loan. The guarantee lets a company buy what it otherwise could not, helping business growth and promoting entrepreneurial activity.
Features of a Valid Guarantee
- The period until which the guarantee holds is clearly specified
- The guarantee issuance is always for a specific amount
- The purpose of the guarantee is clearly stated
- The guarantee is valid for a specifically defined period
- The grace period allowed to enforce guarantee rights is also stated in the guarantee
- Guarantee clearly states the events under which it can be enforced
It is important that guarantee can be enforced based on terms of the contract (i.e. guarantee agreement) existing between the bank and the beneficiary. Generally, beneficiaries do state a clause to be included for charging penal interest in the case of delayed payment. Hence, it is essential for the bank to be cautious while finalizing the format and text of the contract (the guarantee agreement). While signing the same, the provision of penal interest and clauses attached to delays and default are to be carefully noted.
Examples of Bank Guarantees
Because of the general nature of a bank guarantee, there are many different kinds:
- 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.
For example, Company A is a new restaurant that wants to buy $3 million in kitchen equipment. The equipment vendor requires Company A to provide a bank guarantee to cover payments before they ship the equipment to Company A. Company A requests a guarantee from the lending institution keeping its cash accounts. The bank essentially cosigns the purchase contract with the vendor.
Types of Bank Guarantees
- Financial Guarantee
Here, the bank guarantees that the applicant will meet the financial obligation. And in case he fails, the bank as a guarantor has to pay.
- Performance Guarantee
Here the guarantee issued is for honoring a particular task and completion of the same in the prescribed/agreed upon manner as stated in the guarantee document.
- Advance Payment Guarantee
This guarantee assures that they would return the advance amount in case of no fulfillment of the terms.
- Payment Guarantee / Loan Guarantee
The guarantee is for assuring the payment/loan repayment. In case, the party fails to do so, a guarantor has to pay on behalf of the defaulting borrower.
- Bid Bond Guarantee
As a part of the bidding process, this guarantee assures that the bidder would undertake the contract he has bid for, on the terms the bidding is done.
- Foreign Bank Guarantee
Foreign BG is a guarantee which is issued for a foreign beneficiary.
- Deferred Payment Guarantee
When the bank guarantees some deferred payment, the guarantee is termed as Deferred Payment Guarantee. For example, A company purchases a machine on credit basis with terms of payment being 6 equal installments. In this case, since the payment is deferred to a later period, creditor seeks deferred payment guarantee for an assurance that the payment would reach him in the given time period.
- Shipping Guarantee
This guarantee protects the shipping company from all kinds of loss, in case the customer does not pay. This document helps the customer to take possession of goods.
Importance of Bank Guarantee
- Adds To Creditworthiness
BGs reflect the confidence of the bank in your business and indirectly certify the soundness of your business.
- Assessment of Business
In the case of foreign transactions or transactions with Government organizations, the foreign party or a Government Undertaking is constrained and cannot assess the soundness of each and every applicant to a project. In such cases, BGs act as a trusted instrument to assess stability and creditworthiness of companies applying for projects.
- The Confidence of Performance
When new parties associate in the business and are skeptic about the performance of the company undertaking the project, performance guarantees help in reducing the risk of the beneficiary.
- Risk Reduction
Advance payment guarantees act as a protection cover wherein the buyer can recover the advance amount paid to the seller if a seller fails to deliver the goods or services. This protects against any probable loss that a party can suffer from a new seller.
- A bank guarantee is when a lending institution promises to cover a loss if a borrower defaults on a loan.
- A bank guarantee is when a lending institution promises to cover a loss if a borrower defaults on a loan, of which there are many examples.
- Individuals often choose direct guarantees for international and cross-border transactions.
- A bank guarantee enables the customer, or debtor, to acquire goods, buy equipment or draw down a loan.