Bank Guarantee: Feature, Process, Types, Advantages, and Limitation

What is a bank guarantee?

In the current day and age, it is highly important for organizations to ensure that they carry out transactions that are safer and secure from the perspective of getting suitable and viable returns.

As a matter of fact, it is rudimentary for business working on credit to ensure that their credit risk is minimized, and they are duly able to collect the amount that their debtors owe them.

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

In this regard, a bank guarantee tends to give assurance to the lending party, which their debts are going to be obligated in the event where the buyer defaults on a particular loan.

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

However, it must be noted that guarantee provides an additional risk to the buyer, so loans that are built on premises of 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 bank guarantee is providing assurance that the loss is going to be covered, in the situation where 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 – the cost is mainly the interest cost, which is higher than the prevailing market rate.
  • Since 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 in the case where the buyer defaults on the given obligation.
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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, as compared to individuals.

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

In order to apply for the bank guarantee, 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 the need to purchase from that amount.

It is rudimentary for businesses to clarify what they require, so that all the relevant questions are answered by the companies.

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 in nature.

This is to ensure that in the case where the buyer is unable to 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 guarantee?

There are numerous different types of bank guarantees, which differ depending on the reason behind the party applying for bank guarantee 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 that are owed to the seller. In the case where the buyer is unable to do so, the bank will pay back all the money owed to the supplier. In return of issuing this particular bank guarantee, the buyer is supposed to take permission from the bank, in return of 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 a compensation.
  • Foreign Bank Guarantee: This is mostly in the case of international trade. Since both the parties are located at different geographic locations, there is often high risk involved. In order to mitigate this particular risk, businesses often try to secure bank guarantees to ensure the seller of the goods, that the payment is going to be obligated.
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What are the documents required for 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 in a proper manner, with all the relevant documentation. Usually, the following documents are required for bank guarantees:

  • A letter of intent – this basically shows the reason why the business needs bank guarantee in the first place.
  • The product they need to purchase. In other words, the supplier they need to provide the guarantee to.
  • Supplier and beneficiary details – the receiving party in the case where the buyer defaults, or is unable to pay back the amount.
  • Previous bank history and credit details – this is in order to give an idea to the bank regarding the credit rating of the business (or the business owner).
  • The total amount required, and the collaterals that would be required in the case where 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 responsibility of paying the seller in the case where the buyer defaults.

Bank Guarantee Letter is normally required by the seller of the goods, as proof that the bank of the buyer is on board with the transaction, and has undertaken the responsibility to ensure that the amount is going to be paid back to the seller, even if the seller defaults.

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

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This letter acts as proof, which can be presented later on to the bank, in the case where the selling party has failed to get payment of the goods they had sold.

Bank Guarantee Letter can only be issued by the bank 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 choose to directly send this letter to the selling party for greater authentication.

Advantages of bank guarantee

Bank guarantee has the following advantages:

  • Bank guarantee tends to be a very resourceful tool for companies, primarily on the grounds that it acts as a guarantee for the supplier of the goods, which they are going to be paid with the amount.
  • In the same manner, it is also important because it facilitates companies to carry out their operations, even if they are short on up front finance.
  • Particularly in the case of newly formed companies, bank guarantee helps them to start 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 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

Regardless of the fact that bank guarantees are often resourceful because they enable businesses to carry out their transactions, yet it can be seen that they come at a cost.

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

In the same manner, for newly formed organizations, getting a bank guarantee might be challenging, since they don’t have existing credit history and rating readily available.