Everything you need to know about the bank guarantee
bank guarantee

Everything you need to know about the bank guarantee

Welcome to this comprehensive article on the bank guarantee. Whether you are an entrepreneur, a supplier or simply curious to know more about this topic, you are in the right place. Bank guarantees are essential financial tools that provide protection and security in business transactions.

In this article, we will explore in detail what a bank guarantee is, how it works and the different types of guarantees that exist. We will also look at the pros and cons on the use of bank guarantees, as well as the situations in which they are commonly used.

Whether you want to understand how to obtain a bank guarantee, how to use them in your business activities or simply expand your knowledge on the subject, we have gathered all the information you need. But before you start, here is a premium training that will help you allows you to know all the secrets to succeed in the Podcast.

🥀 What is a bank guarantee?

Bank guarantees serve a key objective for small businesses. The bank, through its due diligence on the applicant, gives it credibility as a viable business partner for the beneficiary of the guarantee. In essence, the bank puts its stamp of approval on the solvency of the applicant, as a co-signatory on behalf of the applicant with regard to the specific contract that the two external parties enter into.

For example, the Xyz company is a newly established textile factory which wants to purchase fabric raw materials of Rs.1 crore. The raw material supplier requires that the Xyz company provide a bank guarantee to cover payments before shipping the raw material to the company Xyz. Company Xyz requests and receives a guarantee from the lending institution that maintains its cash accounts. The bank essentially co-signs the purchase agreement with the seller. If Company Xyz defaults on payment, the supplier can recover it from the bank.

bank guarantee

🥀 Types of bank guarantees

A bank guarantee is for a specific amount and a predetermined period of time. It clearly indicates the circumstances in which the guarantee is applicable to the contract. A bank guarantee can be financial in nature or performance-based.

✔️ The financial guarantee

These guarantees are usually issued in lieu of security deposits. Some contracts may require a financial commitment from the buyer such as a security deposit. In such cases, instead of depositing the money, the buyer may provide the seller with a financial bank guarantee that allows the seller to be compensated in the event of a loss.

✔️ The performance guarantee

These guarantees are issued for the execution of a contract or a obligation. In the event of default, non-performance or short performance of a contract, the beneficiary's loss will be compensated by the bank. For foreign bank guarantees, as in international export situations, there may be a fourth party – a correspondent bank that operates in the recipient's country of domicile.

🥀 Real world example

For a concrete example, consider a large agricultural equipment manufacturer. Although the manufacturer may have suppliers in many locations, it is often preferable to have local suppliers for key parts, both for accessibility and transportation cost reasons.

As such, they may wish to enter into a contract with a small metalworking shop located in the same industrial area. Due to the fact that the small supplier is relatively unknown, the large company will require the supplier to obtain a bank guarantee before entering into a contract for $300 000 of machine parts.

If the small seller receives the bank guarantee, the big company will enter into a contract with the seller. At this point, the company can pay the $300 000 in advance, with the understanding that the seller must deliver the agreed parts the following year. If the seller is unable to do so, the agricultural equipment manufacturer can claim from the bank the losses resulting from the seller's breach of the terms of the contract. Thanks to the bank guarantee, the large agricultural equipment manufacturer can shorten and simplify its supply chain without compromising its financial situation.

🥀 How much does a bank guarantee cost?

Typically, GB fees are based on the risk assumed by the bank in each transaction. For example, A financial GB is considered to assume more risk than a performance GB. Therefore, the fee for financial GB will be higher than the fee charged for performance GB. Depending on the type of GB, fees are typically charged on a quarterly basis on the GB value of 0,75% or 0,50% during the validity period of the GB.

Apart from this, the bank may also charge application processing fee, documentation fee, and processing fee. In some cases, the bank requires a deposit from its applicant, which is usually 100% of the GB value.

🥀 The difference between a bank guarantee and a letter of credit

The Letter of Credit is a financial document that imposes an obligation on the bank to make a payment to the beneficiary upon completion of certain services as required by the applicant. The LC is issued by the bank when the buyer instructs his bank to make payment to the seller upon receipt of certain goods or services. The bank will later recover the amount paid from the buyer along with the required fees. On the other hand, under GB, the bank is only required to make payment to the third party if the requester fails to make payment to the third party or fails to fulfil the obligations under the contract.

A GB is used to insure a seller against loss or damage due to the other party's non-performance in a contract. LC is commonly misunderstood as GB because they share some common features. They both play an important role in trade finance when the parties to the transactions have not established business relationships.

However, there are many differences between LC and GB. The main differences between the letter of credit and the bank guarantee are as follows:

✔️ Nature

LC is an obligation accepted by a bank to make a payment to a beneficiary if certain services are performed. GB is an assurance given by the bank to the beneficiary to make the specified payment in the event of default by the applicant.

✔️ Main responsibility

In LC, the bank retains the primary responsibility to make the payment and later collects the same from the customer. With GB, the bank undertakes to make the payment only in case of default by the customer.

✔️ Payment

With LC, the Bank makes payment to the beneficiary as and when it falls due. There is no need to wait for a default to be made by the customer. With GB, it is only when the customer defaults on payment to the beneficiary that the bank makes payment.

✔️ Work habits

LC guarantees that the amount will be paid as long as the services are performed according to the agreed conditions. BG undertakes to compensate the loss if the applicant does not meet the specified conditions.

✔️ Number of parties involved

There are several parties involved in the Letter of Credit. The issuing bank of the LC, its client, the beneficiary (third party) and the advising bank. In the context of a GB, there are only three parties involved: the banker, its client and the beneficiary (third party).

✔️ Relevance

Generally, LC is more suitable when importing and exporting goods and services. GB is suitable for all commercial or personal transactions.

✔️ Risque

With the LC, the bank assumes more risk than the customer. On the other hand, with GB the customer assumes the main risk.

🥀 Advantages of bank guarantees

Bank guarantees offer several advantages for the parties involved in a commercial transaction. Here are some of the key benefits of bank guarantees:

✔️ Financial security

Bank guarantees provide financial security to the beneficiaries of the guarantee, usually suppliers or creditors. They have the assurance that their payments will be made, even if the debtor does not meet its contractual obligations. This reduces the risks associated with commercial transactions and strengthens trust between the parties.

✔️ Increased confidence

Bank guarantees build trust between parties involved in a transaction. The beneficiary has the assurance that payment will be made by the issuing bank, which can encourage suppliers to accept more favorable commercial terms or commit to longer-term contracts.

✔️ Facilitating international transactions

Bank guarantees are particularly useful in international transactions, where risks and uncertainties may be higher. They enable parties to overcome obstacles related to distance, regulatory differences and political risks, providing solid financial protection.

✔️ Flexibility of guarantees

Bank guarantees can be tailored to the specific needs of each transaction. There are different types of guarantees, such as payment guarantees, bid guarantees or performance guarantees. This allows the parties to choose the guarantee that best suits their situation and negotiate favorable terms.

Access to credit

Bank guarantees can make it easier for businesses to access credit. By providing a financial guarantee to the bank, a business can obtain loans or lines of credit on more favorable terms. This can help finance the growth of the business or meet other financial needs.

🥀 Disadvantages of bank guarantees

Although bank guarantees offer significant advantages, it is also important to consider some potential disadvantages. Here are some of the disadvantages of bank guarantees:

✔️ Financial costs

Bank guarantees can result in financial costs for the issuer. Banks typically charge fees to issue and maintain the guarantee, which can be an additional expense for the company. Additionally, banks may require collateral or cash deposits to issue the guarantee, which can tie up funds.

✔️ Financial commitment

When a bank issues a guarantee, it makes a financial commitment to make the payment in the event of the debtor's failure to meet its contractual obligations. This can pose a risk to the bank, as it must be prepared to honour the guarantee even if the debtor cannot repay the guaranteed amount.

This may affect the bank's ability to make further loans or provide other financial services.

✔️ Complexity and documentary requirements

Bank guarantees often involve complex processes and strict documentary requirements. The parties involved must comply with the issuing bank’s specific procedures, which can require additional time and resources. In addition, errors or omissions in the documents can result in a delay or invalidation of the guarantee.

✔️ Geographic limitations

Bank guarantees may be limited geographically. Some banks may not issue guarantees for certain regions or countries considered to be higher risk. This may limit the options available to businesses operating in these regions.

✔️ Dependence on the issuing bank

Beneficiaries of a bank guarantee are often dependent on the strength and reputation of the issuing bank. If the bank encounters financial difficulties or its reputation is compromised, this can affect confidence in the guarantee and the beneficiary's ability to obtain the promised payment.

It is important to carefully weigh the advantages and disadvantages of bank guarantees before deciding to use them in a specific business transaction.

I am a Doctor in Finance and an Expert in Islamic Finance. Business consultant, I am also a Teacher-Researcher at the High Institute of Commerce and Management, Bamenda of University. Group Founder Finance de Demain and author of several books and scientific articles.

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