A bank guarantee is an assurance that a bank provides to a contract between two external parties, a buyer and a seller, or in relation to the guarantee, an applicant and a beneficiary. The bank guarantee serves as a risk management tool for the beneficiary, as the bank assumes liability for completion of the contract should the buyer default on their debt or obligation.
Bank guarantees serve a key purpose for small businesses; the bank, through their due diligence of the applicant, provides credibility to them as a viable business partner for the beneficiary of the guarantee. In essence, the bank puts its seal of approval to the applicant’s creditworthiness, co-signing on behalf of the applicant as it relates to the specific contract the two external parties are undertaking.
A bank guarantee is an assurance to a beneficiary that the bank will uphold a contract if the applicant and counterparty to the contract are unable to do so.
Bank guarantees serve the purpose of facilitating business in situations that would otherwise be too risky for the beneficiary to engage.
The underlying contracts to a bank guarantee can be both financial, such as loan repayment, or performance-based, such as a service provided by one party to another.
Types of Bank Guarantees
A bank guarantee is for a specific amount and a predetermined period of time. It clearly states the circumstances under which the guarantee is applicable to the contract. A bank guarantee can be either financial or performance-based in nature.
In a financial bank guarantee, the bank will guarantee that the buyer will repay the debts owed to the seller. Should the buyer fail to do so, the bank will assume the financial burden itself, for a small initial fee, which is charged from the buyer upon issuance of the guarantee.
For a performance-based guarantee, the beneficiary can seek reparations form the bank for non-performance of the obligation as laid out in the contract. Should the counterparty fail to deliver on the services as promised, the beneficiary will claim their resulting losses from non-performance to the guarantor – the bank.
For foreign bank guarantees, such as in international export situations, there may be a fourth party – a correspondent bank that operates in the country of domicile of the beneficiary.
For a real-world example, consider a large agricultural equipment manufacturer. While the manufacturer may have vendors in many places, it is often best practice to have local vendors for key parts, both for accessibility and transportation cost reasons.
As such, they may wish to enter into a contract with a small metalworks shop that is located in the same industrial area. Due to the small vendor being relatively unknown, the large company will require the vendor to secure a bank guarantee before entering into a contract for $300,000 worth of machine parts. In such a case, the large company will be the beneficiary, and the small vendor will be the applicant.
Should the small vendor receive the bank guarantee, the large company will enter into a contract with the vendor. At this point, the company may pay the $300,000 in advance, with the understanding that the vendor is to deliver the agreed-upon parts in the following year. If the vendor is unable to do so, the agricultural equipment maker can claim the losses resulting from the vendor breaking the terms of the contract from the bank.
Through the bank guarantee, the large agricultural equipment manufacturer can shorten and simplify its supply chain without compromising its financial situation.
Advantages of Bank Guarantees
To the applicant:
Small companies can secure loans or conduct business that would otherwise not be possible due to the potential riskiness of the contract for their counterparty. It encourages business growth and entrepreneurial activity.
The banks charge low fees for bank guarantees, normally a fraction of 1% of the overall transaction, for the assurance provided.
To the beneficiary:
The beneficiary can enter the contract knowing due diligence’s been done on their counterparty.
The bank guarantee adds creditworthiness to both the applicant and the contract.
There is a risk reduction due to the bank’s assurance that they will cover the liabilities should the applicant default.
There is an increase in confidence in the transaction as a whole.
Disadvantages of Bank Guarantees
The involvement of a bank in the transaction can bog down the process and add an unnecessary layer of complexity and bureaucracy.
When it comes to particularly risky or high-value transactions, the bank itself may require assurance on the part of the applicant in the form of collateral.
Bank Guarantees vs. Letters of Credit
For a bank guarantee, the primary debtor is the buyer or applicant. Only when the applicant defaults on its obligation, will the bank guarantee step into the transaction. Often, a delayed payment is not a trigger for a bank guarantee. Contrastingly, in the financial instrument termed as a letter of credit, the seller’s claim first goes to the bank.
Thus, a letter of credit offers more confidence that there will be prompt repayment, as the bank is involved in the transaction throughout the process. With a bank guarantee, there must be an inability to uphold the contract on the part of the applicant before the bank becomes involved.