Bank Guarantee

12What is Bank Guarantee?

Bank Guarantee (BG) is an agreement between 3 parties viz. the bank, the beneficiary, and the applicant. The beneficiary is the one to who takes the guarantee. And the applicant is the party who seeks the bank guarantee from the bank. BGs are an important banking arrangement and play a vital role in promoting international and domestic trade.

The bank issues BG on the receipt of the request from the applicant. This receipt is of the “guarantee amount” towards some purpose / underlying transaction towards the “beneficiary”. If the bank i.e. “the guarantor” receives the “claim” from the beneficiary, it results in “BG invocation”. In the case of foreign BG, apart from these 3 parties, there is also a “correspondent bank”. If a bank does not have a branch in some foreign country, it issues BG in that country through its “correspondent bank”. The bank does all the required due diligence, financial and business analysis before issuing the guarantee.

Bank Guarantee

Example of Bank Guarantee

An exporter called “ABC LLC.” In Dubai seeks a bank guarantee from an importer called “XYZ Pvt. Ltd” in India. In this case, “XYZ Pvt. Ltd” approaches Corporation Bank to give a bank guarantee on its behalf to the exporter. Now, if corporation bank does not have a branch in Dubai, corporation bank would issue the guarantee through State Bank of India (SBI). Here, “XYZ Pvt. Ltd” is the applicant; “ABC LLC” is the beneficiary; “Corporation Bank” is the issuing bank and “SBI” is the correspondent bank.

This BG agreement acts as an undertaking. This agreement assures the beneficiary that the bank would pay the specified amount, in the case of its applicant’s default. The applicant might default in delivering the “financial” or “performance” obligation as mentioned in the guarantee. In effect, the BG acts as a promise that in case the liabilities of the applicant (bank’s customer) doesn’t meet, the bank shall meet the contractual liability. One must note that the obligation to pay is not of the applicant, but of the bank since the bank acts as the guarantor. BG contract is independent of the underlying transaction/contract that exists between the beneficiary and the applicant.

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.

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.

Guarantee for Warranty Obligation or Warranty Bond

This is an assurance that there will be a proper delivery of the ordered goods as per the agreement.

Bank Guarantee Limits

In case some company or firm has regular requirement of BGs in their course of business, banks also provide a facility of fixing “BG Limit” for that company/firm after BG assessment based on their track record, financial position, security offered by the company, margin and financial position of the business. For example: If a small company deals with Government Departments or Public Sector Units, the regular requirement of BG occurs. In such a case, getting a BG limit is beneficial; this means the bank from time to time can issue BGs to the applicant with the upper limit being the sanctioned “BG Limit Amount”.  BG limits are classified as “Non-Fund Based” limits.

Why is Bank Guarantee Important?

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.1,2

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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17 thoughts on “Bank Guarantee”

  1. If the beneficiary has lodged a claim with the bank before the expiry of the BG but bank does not honors it within the validity of BG due to may be whatever reason . Can bank still honor the claim request after the expiry of BG (Please note that there is no claim period defined in the BG). Can applicant challenge this action of bank?

    Reply
  2. For this case, we need to analyse the Bank Guarantee’s terms and conditions and Laws of the respective country.

    In general, if the beneficiary had lodged the complaint and ask for the bank guarantee devolvement before the expiry of the Bank guarantee then its bank’s liability to pay the beneficiary the respective amount.

    Reply
  3. Sir,
    Can a BG issued by a foreign bank is allowed to submit in indian govt department?I have to deposit a BG in a court.
    Please advice.
    Thanks
    Sunny

    Reply
  4. Is it mandatory for the bank to issue Bank Guarantee in its stationery ? Is it required to be printed out of computer or like system generated.
    Is the Bank Guarantee enforeceable if not printed in Bank Stateionery and not generated out of computer system.

    Reply
  5. Can a bank issue a guarantee in their own favor. I mean issued on behalf of their client A for securing the loan / exposure of their client B.

    Reply
    • Hi Sufyan,
      Delighted to see your question. It’s quite an interesting thought.
      Suppose Client A has got bank guarantee facility from X Bank.
      Now another Client B is looking out for a loan from the same bank i.e. X Bank and X bank needs some guarantee for lending that loan to Client B. This guarantee, if provided by the Client A, it will be called Corporate Guarantee in favor of B from A and not bank guarantee.
      If X Bank requires bank guarantee only, Client A can provide a bank guarantee to client B only when Client A is a customer of Client B where A will give an order to B along with bank guarantee for honoring payment. This bank guarantee, B can use to get the loan.
      Hope I have made it clear.
      Happy Reading. Keep coming back.

      Reply
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    Reply
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    Reply
  8. Sir , what is the format for assessment of Guarantee in Banking sector. Please guide with navigation. What are the requirements , we have to receive from the customer

    Reply
  9. I am in India I have concluded a contract with party based in Japan. Japan party is submitting a B.G in favor of SBI located in India and SBI in turn is issuing a counter bank guarantee in my favor. Whether I need to have any credit limits at SBI to avail their services? If so, will my credit limits will be reduced to the extent of issuance of counter bank guarantee from SBI.

    Reply
  10. What if Performance BG (during Tenure) is cancelled without prior concern of beneficiary in writing by giving original copy of beneficiary which is supposed to submit

    Reply

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