Table of Contents
- 1 What is Bank Guarantee?
- 2 Example of Bank Guarantee
- 3 Features of a Valid Guarantee
- 4 Types of Bank Guarantees
- 5 Bank Guarantee Limits
- 6 Why is Bank Guarantee Important?
What 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.
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
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.
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.
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 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.
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.1–3