What Is A Bank Guarantee? Feature, Process, Types, Advantages, and Limitations

In the current day and age, organizations must ensure that they carry out safer and more secure transactions to get suitable and viable returns.

It is rudimentary for businesses working on credit to ensure that their credit risk is minimized and they can collect the amount their debtors owe them.

That is the main reason lending institutions have marginally increased in popularity over time, primarily because businesses excessively rely on them to meet their respective targets.

In this regard, a bank guarantee assures the lending party that their debts will be obligated if the buyer defaults on a particular loan.

Companies often sign bank guarantees to ensure that they are safe and secure, particularly when working for a customer for the first time or the customer is located in another country.

However, it must be noted that a guarantee provides an additional risk to the buyer, so loans built on a guarantee mostly come around with higher costs or interest rates.

This means that the lending institutions take on the risk on behalf of the seller of the goods, and therefore, they charge a premium for it.

Features of bank guarantee

As mentioned earlier, the main rationale behind a bank guarantee is assuring that the loss will be covered when the borrower defaults on a particular loan.

Therefore, the guarantee lets the business buy, what they otherwise could not, because of the lack of finances.

Hence, the main aspect that needs to be pointed out is how bank guarantees enable businesses to prosper and grow, keeping their financial hindrances aside.

Other than that, there are a few other features of bank guarantees that are given below:

  • Bank Guarantee comes at a cost higher than the prevailing market rate, mainly the interest cost.
  • Since a bank guarantee involves a financial institution taking responsibility on the part of the business, they charge a premium for it.
  • Bank Guarantee is a risk management tool, so the bank assumes liability when the buyer defaults on the obligation.

What is the process of bank guarantee?

Bank guarantees are not only limited to businesses. Individuals can also apply for bank guarantees.

However, it must be noted that the main preference or priority is given to businesses because they are registered, and the credit history is readily available for businesses compared to individuals.

They can be obtained after the relevant documentation, and businesses can go ahead and purchase what they need.

To apply for the bank guarantee, the business needs to get in touch with their bank and fill out the relevant information.

They are also supposed to specify the amount they require and what they need to purchase from it.

It is rudimentary for businesses to clarify what they require so that the companies answer all the relevant questions.

However, it must also be noted that banks take a certain time to process the information, after which they can get the loan.

In the same manner, some banks also require collaterals. Collaterals are mostly in the form of assets or other resources that are mostly liquid.

This ensures that if the buyer cannot pay the lending party and the lending party (the bank) pays on his behalf, the bank does not end up with a financial loss.

What are the types of bank guarantees?

There are numerous different types of bank guarantees, which differ depending on the reason behind the party applying for bank guarantees in the first place. The main types of bank guarantees are as follows:

  • Financial Bank Guarantee: This is the most commonly used type of bank guarantee. This mainly acts as an assurance that the buyer will repay all the debts owed to the seller. If the buyer cannot do so, the bank will pay back all the money owed to the supplier. In return for issuing this particular bank guarantee, the buyer is supposed to take permission from the bank for a fee that needs to be paid.
  • Performance-Based Bank Guarantee: performance Based Bank Guarantee is mostly used in the service sector. This is to act as a safeguard against the purchaser of the services against the amount that has already been given to the service provider. It states that in the case where the service provider is unable to properly execute the services that are laid down in the service agreement, the bank is going to settle the debts and make compensation.
  • Foreign Bank Guarantee: This is mostly in the case of international trade. Since both parties are located at different geographic locations, there is often high risk involved. To mitigate this particular risk, businesses often try to secure bank guarantees to ensure the seller of the goods that the payment will be obligated.
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What are the documents required for a bank guarantee?

Obtaining a bank guarantee is not an insurmountable task. However, it must be noted that the process for bank guarantees must be undertaken properly, with all the relevant documentation. Usually, the following documents are required for bank guarantees:

  • A letter of intent – this shows the reason why the business needs a bank guarantee in the first place.
  • The product they need to purchase. In other words, the supplier needs to provide a guarantee too.
  • Supplier and beneficiary details – the receiving party where the buyer defaults or cannot pay back the amount.
  • Previous bank history and credit details – this is to give an idea to the bank regarding the credit rating of the business (or the business owner).
  • The total amount and collaterals are required if the buyer fails to honor the obligation in due time.

What is a bank guarantee letter?

Bank Guarantee Letter is the letter that is issued to the selling party as an indication that the bank has taken the responsibility of paying the seller in the case where the buyer defaults.

The seller normally requires a Bank Guarantee Letter of the goods as proof that the buyer’s bank is on board with the transaction and has undertaken the responsibility to ensure that the amount will be paid back to the seller, even if the seller defaults.

Normally when conducting trade for the first time or when a significant amount of trade is made, a bank guarantee letter is required so that the selling party has a reasonable assurance and clarity that they will be paid back.

This letter acts as proof, which can be presented later on to the bank if the selling party has failed to get paid for the goods they had sold.

The bank can only issue Bank Guarantee Letter once the application has been reviewed, processed, and approved.

It is issued by the bank only, and the buyer of the goods is then supposed to share this letter with the seller that the bank is not assuring them of the payment being made.

However, the bank can also directly send this letter to the selling party for greater authentication.

Advantages of bank guarantee

Bank guarantee has the following advantages:

  • A Bank guarantee tends to be a very resourceful tool for companies, primarily because it is a guarantee for the supplier of the goods, which they will be paid with the amount.
  • Similarly, it is also important because it facilitates companies to carry out their operations, even if they are short on upfront finance.
  • Particularly in the case of newly formed companies, a bank guarantee helps them to start a business. Established businesses are often reluctant to work with new businesses, and bank guarantee helps them establish their businesses.
  • Safe and secure trade practice acts as an incentive to the seller of goods and services, and in the case where a bank guarantee is presented, it can be seen that the seller might end up giving an additional discount to the buyer of the goods.

Limitations of bank guarantee

Even though bank guarantees are often resourceful because they enable businesses to carry out their transactions, it can be seen that they come at a cost.

The interest charge and the processing fees are quite substantial, and this might put an unnecessary strain on the financials of the company.

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Similarly, getting a bank guarantee might be challenging for newly formed organizations since they don’t have existing credit history and ratings readily available.

What Is the Difference Between a Letter of Credit and a Bank Guarantee?

Letter of Credit and Bank Guarantee are financial instruments that ensure payment between two parties.

A Letter of Credit is a legal document about international trade where a bank promises the seller it will be paid when certain documents are presented.

The buyer has to reimburse the bank for any payments made under the credit. On the other hand, a Bank Guarantee is issued by a bank and guarantees they will cover the amount due if the buyer fails to make payment on time.

However, this instrument requires that all parties involved keep up with their contractual obligations since it is not reversible or negotiable. The main difference between these two lies in their primary purpose.

A Letter of Credit is an assurance against non-payment by guaranteeing payment from an issuing bank. In contrast, a Bank Guarantee guarantees performance by guaranteeing payment from an obligor (seller).

Letters of Credit are primarily used in international trade transactions, while Bank Guarantees are commonly used in domestic and commercial transactions such as leases, contracts, or tenders.

Banks also charge fees for both Letters of Credit and Bank Guarantees; however, They attract higher fees due to their complexity and nature.

Furthermore, several different types/structures are available for each instrument to fit individual needs better than just one monolithic type.

In summary, Letters of Credit protect against non-payment from buyers, and Bank Guarantees protect sellers from buyers who fail to keep their contractual obligations after purchase.

Both instruments come with fees, but those associated with Letters of Credit tend to be higher due to their intricate nature.

What Is the Different Between Bank Guarantee and Performance Bond?

Bank guarantees and performance bonds have similarities but also distinct differences. A bank guarantee is a commitment by a bank to pay money if certain obligations are not met.

This type of guarantee could protect buyers in cases where there is a contractual breach between the parties.

On the other hand, a performance bond is an insurance policy assures that a contractor will fulfill their contractual obligations to receive payment.

In this situation, the surety company will often pay out on behalf of the contractor if they fail to meet their obligations.

What is the Different Between a Bank Guarantee and a Standby Letter of Credit?

Bank guarantees and standby letters of credit are both forms of financial security, but they are used for different purposes.

A bank guarantee is a commitment from a bank to pay money if certain obligations are not met, and it can be used as financial security or to secure the performance of an agreement.

On the other hand, a standby letter of credit is an assurance from the issuing bank to make payment upon presentation of specific documents and adherence to conditions outlined in the agreement.

It is often used for trade finance, protecting against non-payment. With both forms of financial protection, the banks may charge fees for providing this service.

Can Bank Guarantee be Discounted?

Bank guarantees can be discounted, which means a third party agrees to pay the guarantee beneficiary in advance at a discounted rate.

This transaction is known as discounting a bank guarantee and is often used when companies need access to capital quickly, such as during periods of cash flow shortages or when making large investments.

Discounting a bank guarantee is beneficial because it eliminates the waiting period for payment from the bank and makes funds available for immediate use.

However, it does come with fees that must be paid to the third party for providing this service.

Can a bank guarantee be used as collateral?

Yes, a bank guarantee can be used as collateral. Collateral is any asset pledged by a borrower to secure a loan or other financial obligation.

Using a bank guarantee as collateral assures that the borrower will be able to meet their obligations in the event of default.

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In most cases, the lender will require that the bank guarantee amount be equal to or greater than the loan’s value.

The bank guarantee serves as security and an incentive for repayment; if the borrower defaults, the lender can draw on the funds held in the guarantee.

List of Top 10 Banks that Normally Offer Bank Guarantee

  1. HSBC Bank: HSBC offers corporate clients access to bank guarantees and standby letters of credit.
  2. Citi Bank: Citi provides a range of business products, including bank guarantee facilities.
  3. Standard Chartered Bank: This UK-based bank specializes in business banking and offers numerous customer guarantees.
  4. DBS Bank: DBS is a global banking powerhouse with a strong presence in Asia and the Middle East that provides an array of financial services from which bank guarantees are included.
  5. Bank of America (BofA): BofA is a significant player in the US with operations in over 30 countries; they offer tailored bank guarantee services to suit any customer’s needs.
  6. JP Morgan Chase & Co.: The most significant US bank also has an expansive international portfolio, providing diverse financial solutions such as third-party guarantees and standby letters of credit (SLOCs).
  7. UBS Group AG: This Switzerland-based investment banking giant can provide everything from trade finance to standby letters of credit, including guaranteed payment instruments such as banker’s acceptances and promissory notes at competitive rates, among other bank offers within this list.
  8. Barclays PLC: With over 300 years of experience in banking, Barclays provides financial solutions such as performance bonds, bid bonds, advance payment bonds, all types of commercial guarantees, and more across its various international markets.
  9. Deutsche Bank AG: Deutsche offers a wide range of financial services ranging from debt origination to foreign exchange derivatives and even various forms of securities such as trade finance backed by securities and irrevocable documentary credits that can be used as collaterals for making payments against invoices or letter of credits etc.,—all backed by Deutsche’s formidable presence in the world market.
  10. Royal Bank Of Canada (RBC): One of the world’s top five most powerful banks, RBC serves millions of people around the globe with its comprehensive products, such as lines credit facility backed by irrevocable letter credits or banker’s acceptances supported RBC’s network 11 countries worldwide.

What is the difference between a bank guarantee and a security deposit?

A bank guarantee is a written promise by a bank on behalf of its customer to pay the beneficiary upon default or failure to fulfill a contractual obligation.

It typically involves an upfront fee and protects the beneficiary in case of non-payment from the customer.

On the other hand, a security deposit is a money paid by the tenant or buyer to secure a loan or rental agreement.

Generally, it is equal to one month’s rent but can vary depending on the terms of the agreement.

The security deposit serves as collateral and will be returned if all requirements of the lease or loan are met.

If not, it may be forfeited as payment towards any outstanding debt.

Can the bank guarantee expire?

Yes, a bank guarantee can expire. A bank guarantee is a binding document assures the beneficiary (the person or company receiving the guarantee) that a debt owed by the guarantor (the person or company providing the guarantee) will be honored.

In other words, if the guarantor fails to honor the debt due to insolvency or any other reason, the beneficiary can receive funds from the bank to cover their losses.

The expiry date of a bank guarantee is usually specified in its terms and conditions, and this date marks the end of its validity.

At this point, all liabilities of both parties cease, and no claims against either will be valid after this date – thus eliminating possible disputes over debt repayment.

The length of time for which a bank guarantee is valid depends on several factors, such as: how much money is being guaranteed, what type of transaction it relates to, and whether any legal considerations need to be taken into account.