Bank Guarantee

A type of financial protection provided by a lending institution

Author: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Reviewed By: Kevin Henderson
Kevin Henderson
Kevin Henderson
Private Equity | Corporate Finance

Kevin is currently the Head of Execution and a Vice President at Ion Pacific, a merchant bank and asset manager based Hong Kong that invests in the technology sector globally. Prior to joining Ion Pacific, Kevin was a Vice President at Accordion Partners, a consulting firm that works with management teams at portfolio companies of leading private equity firms.

Previously, he was an Associate in the Power, Energy, and Infrastructure Investment Banking group at Lazard in New York where he completed numerous M&A transactions and advised corporate clients on a range of financial and strategic issues. Kevin began his career in corporate finance roles at Enbridge Inc. in Canada. During his time at Enbridge Kevin worked across the finance function gaining experience in treasury, corporate planning, and investor relations.

Kevin holds an MBA from Harvard Business School, a Bachelor of Commerce Degree from Queen's University and is a CFA Charterholder.

Last Updated:November 21, 2023

What Is a Bank Guarantee?

A bank guarantee is a type of financial protection a lending institution provides. The lender will ensure that a debtor's liabilities are met.

In other words, if a debtor does not pay it, the bank will cover it. It allows the customer (or debtor) to purchase goods, purchase equipment, or obtain a loan.

It is a promise made by a lending institution to cover a loss if a borrower defaults on a loan. The guarantee allows a company to purchase items it could not afford otherwise, promoting business growth and entrepreneurship.

Bank assurance comes in various forms, including direct and indirect guarantees. In the foreign or domestic business, banks typically use direct guarantees issued directly to the beneficiary. 

Direct guarantees are used when the bank's security does not rely on the main obligation's existence, validity, and enforceability.

Individuals frequently choose direct guarantees for international and cross-border transactions because they are less formal and can be more easily adapted to foreign legal systems and practices.

Indirect guarantees are most common in the export business, particularly when government agencies or public entities are the beneficiaries.

Many countries refuse to accept foreign banks and guarantors due to legal concerns or other formalities. Therefore, with an indirect guarantee, a second bank, typically a foreign bank with a branch in the beneficiary's country of residence, is used.

1. What Are the Various Kinds?

A financial bank assurance and a performance guarantee are the two main types. Financial bank guarantees are for owed debts, whereas performance-based guarantees are for contractual obligations, such as specific tasks.

2. What Is a Bank Guarantee Financial Instrument?

A banker's acceptance is the financial instrument used in a bank assurance.

3. Do banks in the United States provide bank guarantees?

Banks rarely issue such guarantees in the United States. Instead, they issue promissory notes that serve the same purpose, such as standby letters of credit.

Types of Bank Guarantees

Some of the types are:

1. Guarantee of deferred payment

This is a bank or payment guarantee offered to the exporter for a deferred period or specific period.

The bank will pay for failure to supply raw materials, machinery, or equipment in installments under this guarantee.

A financial guarantee ensures that money will be repaid if a party fails to complete a specific project or operation. According to the financial guarantee agreement, the bank will make the payment if the project is not completed on time.

2. Advance payment guarantee

The seller will receive an advance payment under this type of guarantee. There will also be a guarantee that the buyer will be reimbursed if the seller fails to deliver the service or product accurately or on time.

A foreign bank guarantee is one that a bank provides on behalf of a borrower. This will be made on the foreign beneficiary's or creditor's behalf.

A performance guarantee requires the bank to compensate you financially if there is a delay in delivering the performance or operation. Payment must be made even if the service is inadequately delivered.

3. Bid bond guarantee

There will be a supply bidding procedure under this type of guarantee. This will be carried out by the contractor on behalf of the owner of the infrastructure, industrial project, or any other type of operation.

The project's contractor will ensure that the best or highest bidder has the capability and authority to carry out the project according to his or her preferences. 

The bid bond will be given to the project owner as proof of guarantee, implying that the project must be designed in accordance with the bid contract.

bank guarantees and letters of credit

People frequently mix up a bank assurance and a letter of credit. However, one must recognize that they are very different.

A bank assurance is a commercial or financial instrument provided by a bank in which the bank assures or guarantees a beneficiary that the payment will be made to the bank if the customer fails to meet his or her obligations. When a customer requests a bank assurance, the bank will pay on his or her behalf.

On the other hand, a letter of credit is a written promise or commitment made by a bank or any other financial institution or corporation to a specific seller that payment will be made to the seller if the seller completes whatever is mentioned in the letter of credit. 

For the bank to make the payment on behalf of the original buyer, documentary proof that the seller completed the transaction correctly by delivering the correct product or service on time is required. In addition, the seller will receive a guarantee from the bank that the amount will be paid on behalf of the original buyer once the obligations are met.

If the buyer cannot pay the seller or creditor, the bank pays the fixed amount to the seller as the contract's obligations are not met. On the other hand, a letter of credit is paid to the seller once he or she has delivered. Again, this is due to the seller having completed all of the required obligations.

In general, bank assurances are competitively priced. They are typically valid for an extended period. A bank guarantee typically has a long term. Furthermore, bank assurance is widely accepted in nearly all countries. 

Bank guarantees are available in Indian Rupees as well as other currencies. As a result, they are extremely useful for global transactions involving parties from various foreign countries.

Bank Guarantee Usage

Bank guarantees are applied or used:

  • When large companies buy from small vendors, they usually require the vendors to provide a bank assurance certificate before offering such business opportunities.
  • Primarily used in purchasing and selling goods on credit, the seller is guaranteed payment from the bank if the buyer defaults.
  • Aids in the certification of individuals' credibility, which allows them to obtain loans and participate in business activities
  • Though a bank assurance has many applications for the applicant, the bank should only process it after ensuring the applicant's/financial business's stability. In addition, the bank must thoroughly assess the risk of providing such a guarantee.

Advantages of Bank Guarantees

Bank assurance has its own set of benefits and drawbacks. The benefits are as follows:

  • A bank assurance lowers the financial risk of a business transaction
  • Because of the low risk, it encourages the seller/beneficiaries to expand their business on credit
  • Banks typically charge low fees for guarantees, which benefits even small businesses.
  • When banks examine and certify a company's financial stability, its credibility grows, which increases business opportunities.
  • Most guarantees require fewer documents and are processed quickly by banks (if all the documents are submitted)

Disadvantages of Bank Guarantees

On the other hand, there are some drawbacks, such as:

  • When evaluating a company's financial position, banks can be very strict. As a result, the procedure becomes more difficult and time-consuming.
  • With the strict assessment of banks, it is extremely difficult for loss-making entities to obtain bank assurance.
  • Banks will require collateral security to process guarantees involving high-value or high-risk transactions.

Eligibility and Procedure for a Bank Guarantee (BG)

Anyone with a good financial history is eligible to apply for BG. A business can use BG in its bank or any other bank that provides such services. Before approving the BG, the bank will review the applicant's previous banking history, creditworthiness, liquidity, CRISIL, and CIBIL rating.

The bank would also look into the BG period, value, beneficiary information, and currency as part of the approval process. Sometimes, banks require the applicant to provide security to cover the BG value. Once all criteria have been met, the banking officials will provide the necessary approvals for the BG processing.

Let's see the bank guarantee fees.

BG charges are generally based on the risk assumed by the bank in each transaction. A financial BG, for example, is thought to be riskier than a performance BG. As a result, the fee for financial BG will be higher than for performance BG.

Fees are generally charged quarterly on the BG value of 0.75 percent or 0.50 percent during the BG validity period, depending on the type of BG.

In addition, the bank may assess an application processing fee, documentation fee, and handling fee. In some cases, the bank may require security from its applicant, typically 100 percent of the BG value. Sometimes, the issuing bank may accept collateral security or cash margin.

Bank Guarantee vs. Line of Credit

LOC is a financial document that requires the bank to pay the beneficiary upon completion of certain services as specified by the applicant. For example, LOCs are issued by banks when a buyer requests that his bank pay the seller upon receipt of certain goods or services.

Suppose the buyer encounters cash flow issues or other similar situations and cannot immediately pay the seller. In that case, he will approach his bank and request that payment is made to the seller upon submission of certain documents.

The bank will later recover the amount paid by the buyer and the applicable charges. In contrast, under BG, the bank is only required to pay the third party if the applicant fails to pay the third party or fails to fulfill the contract's obligations.

A BG is essentially used to protect a seller from loss or damage caused by the other party's failure to perform under a contract. LOC is frequently confused with BG because they share some characteristics.

When the parties to the transactions do not have established business relationships, they play an important role in trade financing. However, there are numerous distinctions between LOC and BG.

The following are the primary distinctions between a Letter of Credit (LOC) and a Bank assurance:

Comparable Company Analysis (comps)
Particulars LOC BG
Nature A LOC is a bank-accepted obligation to pay a beneficiary if certain services are performed. BG is a bank's assurance to the beneficiary that it will make the specified payment if the applicant fails to do so.
Primary liability The bank retains primary liability for making the payment and later collecting it from the customer. Only when the customer fails to make a payment does the bank assume responsibility for making the payment.
Payment When the payment is due, the bank sends it to the beneficiary. It does not have to wait for the customer to make default. Only when the customer fails to pay the beneficiary does the bank make the payment.
Way of working The LOC guarantees that the amount will be paid as long as the services are performed in accordance with the agreed-upon terms. If the applicant does not meet the specified conditions, BG guarantees to compensate for the loss.
Number of parties involved There are several parties involved in this transaction: the LOC issuing bank, its customer, the beneficiary (third party), and the advising bank. There are only three parties involved in this transaction: the bank, its customer, and the beneficiary (third party).
Suitability In general, this is more appropriate when importing and exporting goods and services. It is appropriate for any business or personal transaction.
Risk The bank bears more risk than the customer. The primary risk is assumed by the customer.

Researched and authored by Javed Saifi | Linkedin

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