A bank guarantee refers to a promise provided by a bank or any other financial institution that if a certain borrower fails to pay a loan, then the bank or the financial institution will take care of the losses. The bank will assure the original creditor through this bank guarantee that if the borrower does not meet his or her liabilities, then the bank will take care of them.
Bank Guarantee
Bank Guarantee a promise made by the bank to any third person to undertake the payment risk on behalf of its customers. Bank guarantee is given on a contractual obligation between the bank and its customers. Such guarantees are widely used in business and personal transactions to protect the third party from financial losses. This guarantee helps a company to purchase things that it ordinarily could not, thus helping business grow and promoting entrepreneurial activity.
For Example- Xyz company is a newly established textile factory that wants to purchase Rs.1 crore fabric raw materials. The raw material vendor requires Xyz company to provide a bank guarantee to cover payments before they ship the raw material to Xyz company. Xyz company requests and obtains a guarantee from the lending institution keeping its cash accounts. The bank essentially cosigns the purchase contract with the vendor. If Xyz company defaults in payment, the vendor can recover it from the bank.
A bank guarantee is a contract between 3 different parties and they include
- The applicant (the party that requests a bank guarantee from the bank and borrows from a creditor)
- The beneficiary (the party that receives a partial guarantee)
- The bank (the party that agrees to sign and assures payment in case the applicant fails to repay the loan)
Bank guarantees are very commonly utilised among business entities. With the help of a bank guarantee, the debtor or borrower or customer will be able to purchase equipment, machinery, raw materials, acquire additional funds, etc. for commercial purposes. Bank guarantees help businesses as creditors will get a proper reassurance that the loan amount will be repaid by the bank if the business is unable to repay the loan entirely on time.
When a bank signs a bank guarantee, it promises to pay any amount according to the request made by the borrower. Hence, signing a bank guarantee implies a high risk for banks.
Uses of Bank Guarantee
- When large companies purchases from small vendors, they generally require the vendors to provide guarantee certificate from banks before providing such business opportunities.
- Predominantly used in the purchase and sale of goods on credit basis, where the seller is assured of payment from the bank in case of default by the buyer.
- Helps in certifying the credibility of individuals, which in turn, enables them in obtaining loans and also assists in business activities.
Though there are lots of uses from a bank guarantee for the applicant, the bank should process the same only after ensuring the financial stability of the applicant/business. The risk involved in providing such a guarantee must be analysed thoroughly by the bank.
Kinds of Bank Guarantee
- Deferred payment guarantee: This refers to a bank guarantee or a payment guarantee that is offered to the exporter for a deferred period or for a certain time period. When a buyer purchases capital goods or machinery, the seller will give credit to the buyer when the buyer’s bank gives a guarantee that it will pay the unsettled dues of the buyer to the seller. Under this type of guarantee, payment will be made in installments by the bank for failure in supplying raw materials, machinery or equipment.
- Financial guarantee: A financial bank guarantee assures that money will be repaid if the party does not complete a particular project or operation entirely. According to the financial guarantee agreement, when there is a delay in the completion of the project, the bank will make the payment.
- Advance payment guarantee: Under this kind of guarantee, an advance payment will be made to the seller. There will also be a guarantee that if the seller fails to deliver the service or product accurately or promptly, the buyer will receive a refund of the payment.
- Foreign bank guarantee: A foreign bank guarantee is provided by a bank on behalf of a borrower. This will be offered on behalf of the foreign beneficiary or creditor.
- Performance guarantee: Under a performance guarantee, compensation of money will be made by the bank when there is any delay in delivering the performance or operation. Payment will have to be made even if the service is delivered inadequately.
- Bid bond guarantee: Under this type of guarantee, there will be a supply bidding procedure. This will be conducted by the contractor for the owner of an infrastructure or industrial project or any kind of operation. The contractor of the project will guarantee that the best bidder or the highest bidder will have the capability and authority to implement a project as per his or her preferences. The bid bond will be given to the owner of the project as a proof of guarantee and the bond will imply that the project will have to be devised according to the bid contract.
Advantages and Disadvantages of Bank Guarantees
Bank guarantee has its own advantages and disadvantages. The advantages are:
- Bank guarantee reduces the financial risk involved in the business transaction.
- Due to low risk, it encourages the seller/beneficiaries to expand their business on a credit basis.
- Banks generally charge low fees for guarantees, which is beneficial to even small-scale business.
- When banks analyse and certify the financial stability of the business, its credibility increases and this, in turn, increase business opportunities.
- Mostly, the guarantee requires fewer documents and is processed quickly by the banks (if all the documents are submitted).
On the flip side, there are some disadvantages such as:
- Sometimes, the banks are so rigid in assessing the financial position of the business. This makes the process complicated and time-consuming.
- With the strict assessment of banks, it is very difficult to obtain a bank guarantee by loss-making entities.
- For certain guarantees involving high-value or high-risk transactions, banks will require collateral security to process the guarantee.
Comparison between Bank Guarantee and Letter of Credit
A bank guarantee refers to a commercial or financial instrument that is provided by a bank, where the bank assures or guarantees a beneficiary that it will make the payment to the bank in case the actual customer fails to meet his or her obligations. The bank will pay on behalf of the customer who requests for a bank guarantee.
On the other hand, a letter of credit refers to a promise or commitment in writing made by a bank or any other financial institution or corporation to a particular seller that payment will be made to the seller if the seller completes performing whatever is mentioned in the letter of credit. For the bank to make the payment on behalf of the original buyer, there should be a documentary proof that the seller has completed the transaction accurately by delivering the right product or service on time. The seller will get a guarantee from the bank that the seller will definitely pay the amount on behalf of the original buyer once the obligations are fulfilled.
Under a bank guarantee, if the buyer is unable to make the payment to the seller or creditor, then the bank pays the fixed amount to the seller as the obligations of the contract are not met. On the other hand, under a letter of credit, the bank makes the payment to the seller once he or she delivers. This is because the seller has completed fulfilling the required obligations.
Bank guarantees are competitively priced in nature generally. They are usually valid for a long period. The tenure of a bank guarantee is usually high. Moreover, bank guarantees are commonly accepted in almost all countries. Bank guarantees are available in Indian Rupee as well as currencies of other nations. Hence, they are very helpful for global transactions with parties in different foreign countries.
Bank Guarantee (BG) Eligibility and Process
Any person who has a good financial record is eligible to apply for BG. BG can be applied by a business in his bank or any other bank offering such services. Before approving the BG, the bank will analyse the previous banking history, creditworthiness, liquidity, CRISIL, and CIBIL rating of the applicant.
The bank would also examine the BG period, value, beneficiary details, and currency as required for the approval. In certain cases, banks will require security to be provided by the applicant to cover the BG value. Once the banking officials are satisfied with all the criteria, they will provide the necessary approvals required for the BG processing.
Bank Guarantee Charges
BG charges are based on the risk assumed by the bank in each transaction. For example, a financial BG is considered to assume more risk than a performance BG. Hence, the fee for financial BG will be higher than the fee charged for performance BG. Based on the type of the BG, fees are generally charged on a quarterly basis on the BG value of 0.75% or 0.50% during the BG validity period.
Apart from this, the bank may also charge the application processing fee, documentation fee, and handling fee. In some cases, security is required by the bank from its applicant, which is generally 100% of the BG value. In certain cases, collateral security or cash margin may also be accepted by the issuing bank.
FAQs
How long does it take for the Bank Guarantee to be issued?
Depending on the bank, the time for the Bank Guarantee to be issued will vary.
Is it possible to apply for Bank Guarantee online?
Yes, you can apply for Bank Guarantee online.
