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Bank Guarantee Definition
A bank guarantee is a document from a lending institution that acts as a guarantee. What a bank guarantee from a lending institution does is that it ensures that the debtor’s liabilities are settled. So, in case the debtor fails to meet the loan obligation, the bank will come in to cover it. Generally, a bank guarantee ensures the protection of customers from credit risk as a result of one party not fulfilling part of their contractual obligation.
A Little More on What is a Bank Guarantee
A bank guarantee is basically an assurance from a lending institution that it will cover the amount involved in a transaction should a borrower fails to honor the payment. It is an important document that provides confidence in the world of trade. It enables firms to buy things that would be difficult to purchase in the absence of a bank guarantee. In other words, it helps in the enhancement of business activities as well as expanding entrepreneurial activities.
How it Works (Example)
Below are two examples of how a bank of guarantee works:
For instance, let’s assume that a construction company and a cement supplier enters a new contract to build a mall. In this case, both parties may be required to obtain a bank guarantee from their banks as a way of proving their financial capability. If a supplier is late in delivering cement in time as specified in the contract, the construction company can let the bank know. The bank will then come in to cover for the default as per the bank guarantee specification.
Let’s assume that there a new gym that wants to purchase gym equipment worth $2 million. The vendor then demands that the gym owner should first obtain a bank guarantee that will assure payment before effecting the shipment. The gym owner will request a bank guarantee from his bank.
The bank will assess and make a judgment whether its customer deserves the bank guarantee and his capacity to repay. The bank will use information from the assessment to gauge the appropriate amount for the bank guarantee. If the deal involves too much risk, then the bank will ensure that it sets a bank guarantee with a higher fee.
A Difference Between a Bank Guarantee Differs from a Letter of Credit
It is worth noting that a bank guarantee differs from a letter of credit. However, the common thing with the two documents is that the issuing bank accepts liability should its customer defaults in honoring part of their contract deal.
When it comes to a bank guarantee, the claim of the seller will be on the buyer. If the buyer fails to honor his part of the deal as per the contract, then the claim is passed on to the buyer’s bank. With a letter of credit, the claim of the seller is first passed on to the bank and not the purchaser. There is assurance in both cases that the seller will receive payment. However, a letter of credit gives more assurance to the seller than a bank guarantee.
Bank of Guarantee Features
- The duration a bank guarantee should hold.
- Amount in the bank guarantee
- The purpose of the bank guarantee
- The grace period for enforcing guarantee rights
- Events under which a bank guarantee can be enforced
Bank Guarantee Types
- Performance guarantee: The issuing of this type of guarantee is to ensure that a party entrusted with a given project completes the task as per the contract’s specification.
- Financial guarantee: This type of guarantee ensures that the applicant will meet its financial obligation. Where the borrower defaults on its repayment obligation, the guarantor will step in to pay.
- Advance payment guarantee: It gives assurance that the amount a party gives as advance will be returned should there be a failure in honoring the contract.
- Loan Guarantee: This type of guarantee assures loan repayment even if the borrower fails to do so. It means that the guarantor has to pay the loan on behalf of the borrower.
- Bid Bond Guarantee: It gives assurance that the bidding process will honor the contract he or she has bid for as per the terms specified in the contract.
- Foreign Bank Guarantee: It gives assurance to those parties taking part in foreign transactions that each party will fulfill part of their deal in the contract.
- Shipping Guarantee: This type of guarantee gives protection to the shipping company from financial risks in case a customer fails to pay for the goods. In such a situation, the document allows it to repossess the goods.
Importance of a Bank Guarantee
- Confidence of Performance
A bank guarantee provides confidence when it comes to doing business. It removes obstacles that can interfere with smooth business transactions such as lack of payment or delivery of goods and services.
- Adds to creditworthiness
A bank of guarantees portrays the confidence that a bank has in your business. In other words, it indirectly verifies how sound your business is.
- Risk Reduction
A bank guarantee for advance payment protects the buyer. It ensures that the buyer recovers the advance made to the seller, should he or she fail to deliver the services or goods.
- Assessment of business
It is a complicated process when it comes to assessing the credibility of parties when it comes to foreign transactions. So, parties can use a bank of guarantee in such a situation to assess each other’s creditworthiness as well as financial stability.
Does a Bank Guarantee have any limits?
Banks have limits when it comes to issuing bank guarantees. The limit for each business entity depends is based on factors such as:
- The financial position of the business
- Their business track record
- Business’ security in place