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.
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.
Understand the Process of Bank Guarantee
- First, an applicant will ask for a loan from a beneficiary or creditor.
- While applying for the loan, these 2 parties will agree that a bank guarantee is necessary.
- Then, the applicant will request a bank to provide a bank guarantee for the loan taken from the creditor. The bank guarantee will be taken on behalf of the creditor.
- The bank will now offer the bank guarantee to the applicant and send a financial instruction to an advising 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, the 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 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.
Comparison between Bank Guarantee and Letter of Credit
Many times, people get confused between bank guarantee and a letter of credit. However, one should understand that both are pretty different.
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 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.