Bank Guarantee – Types, Working and Advantages Explained
Bank guarantee means that the bank would have your back in case you fail to settle a debt. To be more precise, it’s when a bank or lending institution promises to cover your loss in case you default on your loan.
Wonder how that works? In this piece of content we have simplified the little-known banking jargon – bank guarantee, its types, advantages and how it works. Scroll to read more!
What is a Bank Guarantee?
A bank guarantee indicates that the lender will ensure that the debtor’s obligations are met. In other words, the bank will pay the loan if the borrower doesn’t. Furthermore, a bank guarantee gives the customer (or debtor) the ability to buy products and equipment or obtain credit.
There are different types of bank guarantees that you need to know of. The next section explains the same in detail.
Types of Bank Guarantees
Listed below are the most common types of bank guarantees:
1. Deferred Payment Guarantee
A bank or payment guarantee provided to the exporter for a predetermined time is referred to as a “deferred payment guarantee”. Suppose the buyer’s bank guarantees that it will pay the buyer’s outstanding debts to the seller.
In that case, the seller will extend credit to the buyer when they purchase capital goods or machinery. For failing to supply raw materials, machinery, or equipment, the bank will pay in instalments under this kind of guarantee.
2. Financial Guarantee
Suppose a party does not fully execute a particular project or activity. In that case, money will be refunded according to a financial bank guarantee. Per the financial guarantee agreement, the bank will pay any late fees associated with project completion.
3. Advance Payment Guarantee
The seller will get an advance payment under this type of guarantee. There will also be a guarantee that the buyer will get their money back if the seller doesn’t provide the service or product on time.
4. Foreign Bank Guarantee
A bank offers a foreign bank guarantee on behalf of a borrower. It will be made on behalf of the foreign beneficiary or creditor.
5. Performance Guarantee
In the case of a performance guarantee, the bank will compensate you financially for any delays in the performance or operation.
6. Bid Bond Guarantee
The bank will use a supply bidding process for this kind of guarantee. This will be done on behalf of the business owner, whether it is an industrial enterprise, a construction project, or something else.
Furthermore, the project’s contractor will ensure that the highest or best bidder has the power and ability to carry out a project according to their preferences. The bank will give the project’s owner a bid bond as security, meaning the project must follow the bid contract.
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How does a Bank Guarantee Work?
A solid financial history is required to apply for a bank guarantee. A company can apply for a bank guarantee from its bank or from any other bank that provides these services.
Before approving the bank guarantee, the bank will examine the applicant’s past banking behaviour, creditworthiness, liquidity, and CRISIL and CIBIL ratings.
The bank guarantee process is relatively straightforward. As needed for the approval, the bank would look at the bank guarantee period, value, beneficiary information, and currency. In some circumstances, banks will demand that the applicant provide security to cover the bank guarantee value.
The necessary approvals for the bank guarantee processing will be given when the banking personnel are satisfied with the requirements.
Importance of a Bank Guarantee
For the following reasons, a bank guarantee is essential:
- Given that the beneficiary’s funds are guaranteed to flow from the application, it serves as security for them.
- Small vendors must provide a bank guarantee when doing business with larger companies. Thus, it becomes vital for them to ensure their business.
- Receiving a security concern indicates a bank’s confidence in the applicant. Consequently, their credibility increases.
Bank Guarantee Fees and Charges
The bank guarantee fees are often calculated based on the bank’s risk for each transaction. A financial bank guarantee, for instance, is thought to take on more risk than a performance bank guarantee.
Consequently, the cost of a financial bank guarantee will be more than that of a performance bank guarantee. Fees are assessed quarterly on either a bank guarantee value of 0.75% or 0.50% during the bank guarantee validity period, depending on the type of bank guarantee.
The bank may further charge a processing cost for the application, a price for the documentation, and a handling fee. It may occasionally request security from an applicant, typically 100% of the bank guarantee value. Sometimes, the issuing bank may accept a cash margin or collateral security.
Advantages of Bank Guarantee
Listed below are the primary benefits of a bank guarantee:
- A bank guarantee helps bring down the risk associated with the transaction.
- It pushes sellers to grow their business on a credit basis because of the low risk.
- Guarantee fees are often cheap, which is advantageous for even small businesses.
- The legitimacy of a company rises when banks examine and verify its financial stability, which expands business opportunities.
- Usually, the banks process the guarantee with fewer papers and quickly (if all the documents are submitted).
Disadvantages of Bank Guarantees
Here are the primary drawbacks of a bank guarantee:
- The banks may be slightly more stringent when evaluating the company’s financial situation. As a result, the bank guarantee process becomes challenging and time-consuming.
- Due to the strict scrutiny of banks, it is hugely challenging for loss-making enterprises to secure a bank guarantee.
- Banks will need collateral security to process some assurances involving high-value or high-risk transactions.
Comparison Between Bank Guarantee and Letter of Credit
The below table highlights the differences between a letter of credit and bank guarantee:
| Parameters | Letter of credit | Bank guarantee |
| Nature | It is a financial obligation accepted by banks to pay a beneficiary if some services are performed. | It is an assurance given by the bank to the beneficiary to make the specified payment in case of default by the applicant. |
| Primary liability | Bank retains the primary liability to make payments and later collects the same from the customer. | The bank assumes to make the payment only if the customer defaults in making the payment. |
| Payment | Banks need not wait for a default to make the payment to the beneficiary and can do it as and when the payments are due. | The bank makes the payment only if the customer defaults clearing the payment. |
| Way of working | It ensures that the payment will be made as long as the services are performed based on the agreed terms. | It ensures compensation for the loss if the applicant does not satisfy the specified conditions. |
| The number of parties involved | Multiple parties are involved, including the bank that issued the LOC, its customer, the beneficiary (third party), and the advising bank. | Only three parties are involved: the banker, its customer, and the beneficiary (third party). |
| Suitability | It’s more suited for the import and export of goods and services. | It suits all personal transactions and any business. |
| The risk involved | The bank assumes more trouble than the customer. | The customer assumes the primary risk. |
Final Word
A bank guarantee assures the payment of a specific amount to the beneficiary if the applicant does not meet all conditions listed in the contract. Furthermore, bank guarantees are mostly used to protect a buyer or seller from loss or damage due to the non-performance of the other party in a contract.
FAQs
Ans. Yes, you can apply for a bank guarantee online.
Ans. Even if you have a savings account with a bank, you can easily opt for a bank guarantee.
Ans. The time for issuing a bank guarantee will vary from one bank to another.
Ans. A guarantee lowers the financial risk associated with the business deal. It promotes the seller/beneficiaries to grow their business on a credit basis because of the low risk. Furthermore, banks usually don’t charge much for guarantees, which is advantageous for even small businesses.
Ans. After a bank guarantee expires, the issuing bank or NBFC is not liable to pay anything to the beneficiary, even if the borrower defaults on their loan.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
