Everything you need to know about the bank guarantee

Welcome to this comprehensive article on the bank guarantee. Whether you are an entrepreneur, supplier or simply curious to learn more about this topic, you have come to 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 examine the pros and cons of 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 put together all the information you need.

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🥀 What is a bank guarantee?

Bank guarantees serve a key objective for small businesses. The bank, through its diligence towards the applicant, gives it credibility as a viable commercial 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 provides a bank guarantee to cover payments before shipping the raw material to the company Xyz.

The Xyz company requests and obtains a guarantee from the credit institution that maintains its cash accounts. The bank essentially co-signs the purchase contract with the seller. If Xyz Company defaults on payment, the supplier can recover it from the bank.

🥀 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 generally 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 can provide the seller with a financial bank guarantee which allows the seller to be compensated in the event of loss.

✔️ The performance guarantee

These guarantees are issued for the execution of a contract or a obligation. In the event of non-performance, non-performance or short performance of a contract, the beneficiary's loss will be compensated by the bank.

To 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 manufacturer of agricultural equipment. 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 metal workshop 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 large company will enter into a contract with the seller. At this point, the company can pay the $300 000 in advance, it being understood that the seller must deliver the agreed parts the following year.

If the seller is unable to do so, the farm equipment manufacturer may claim from the bank any 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, we consider that a financial GB assumes more risks than a performance GB.

Therefore, the commission for GB financial will be higher than the commission charged for GB performance. Depending on the type of GB, fees are generally billed 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 the obligation on the bank to make payment to the beneficiary upon completion of certain services as required by the applicant. The LC is issued by the bank when the buyer requests 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 together with the required fees. On the other hand, under the GB, the bank is only obliged to make payment to the third party if the applicant does not make the payment to the third party or does not fulfill the obligations provided for in the contract.

A GB is used to insure a seller against loss or damage due to non-performance by the other party in a contract. LC is commonly misunderstood as GB as they share some common characteristics. 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. The 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 the LC, the bank retains the primary responsibility for making the payment and later collects the same from the customer. With GB, the bank undertakes to make payment only in the event of default by the customer.

✔️ Payment

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

✔️ Work habits

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

✔️ Number of parties involved

There are several parties involved in the letter of credit. The bank issuing 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, his client and the beneficiary (third party).

✔️ Relevance

In general, the LC is more appropriate when importing and exporting goods and services. GB on the other hand 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 respect their contractual obligations. This reduces risks associated with business transactions and builds trust between parties.

✔️ Increased confidence

Bank guarantees build trust between the parties involved in a transaction. The beneficiary has the assurance that payment will be made by the issuing bank, which may 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 adapted to the specific needs of each transaction. There are different types of guarantees, such as payment, tender 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 facilitate access to credit for businesses. By providing a financial guarantee to the bank, a business can obtain loans or lines of credit on more favorable terms. This can help fund business growth 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 may result in financial costs for the issuer. Banks typically charge a fee to issue and maintain the guarantee, which can be an additional expense for the business.

Additionally, banks may require collateral or cash deposits to issue the guarantee, which may tie up funds.

✔️ Financial commitment

When a bank issues a guarantee, it makes a financial commitment to make payment in the event of non-compliance with contractual obligations by the debtor. This can represent a risk for the bank, as it must be prepared to honor the guarantee, even if the debtor cannot repay the guaranteed amount.

This may affect the bank's ability to make other 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 specific procedures of the issuing bank, which may require additional time and resources. Additionally, errors or omissions in documentation may result in warranty delay or invalidation.

✔️ 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

The 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.