A bank guarantee is a form of financial insurance offered by the lending bank to both parties in a contract. It covers the payment obligation of the applicant in case of default. It serves as collateral to the beneficiary of the payment. Essentially, it serves as a risk mitigation tool for both parties in the contract and the beneficiary in particular.
What is a Bank Guarantee?
A bank guarantee is a financial insurance provided by the bank to cover the default risk of the applicant. It is an assurance for both parties in the contract for the fulfillment of the payment clause.
It can take several forms depending on the contract nature and requirements of both parties. A key feature of the bank guarantee is that it works as collateral for the non-performance in the contract only.
How Does Bank Guarantee Work?
When two parties want to enter into a trade contract, they require some sort of financial assurance. It is often a case in international trade contracts. The exporter (or seller) wants assurance of the full payment if they oblige the contract terms. The bank provides that financial assurance and bridges the trust deficit between both parties.
The importer (or buyer) is the applicant for the issuance of the bank guarantee. The bank assesses the creditworthiness of the applicant. Depending on the contract or specific requirement, the bank may issue a guarantee for the full or partial contract payment. Once a bank issues a bank guarantee it endorses the creditworthiness of the applicant.
The buyer can send the bank guarantee to the seller. The seller can now proceed with the contract order. Once goods are shipped, the seller can demand the payment. If the buyer fails to make the payment, the seller can proceed with the bank guarantee.
In case of the buyer’s default on the payment, the bank will make the payment to the seller. The bank will recover the amount of guarantee through the pledged assets (usually cash) as collateral.
Important Points to note with a Bank Guarantee
It serves the purpose of financial security for both parties in a trade contract. The buyer remains an applicant of the bank guarantee and the seller is usually the direct beneficiary of the instrument. It can take several types and forms depending on the needs of both parties in the trade contract. However, the bank acts as the third-party facilitator and assures only the financial payment obligation terms.
Here are some key points to note in a bank guarantee arrangement:
- Bank guarantee acts as financial security and the bank obliges the payment upon presentation of documents or demand as agreed upon in the contract.
- It is a separate document from the trade contract, and the bank only concerns with the financial payment obligation, regardless of the contract terms.
- It works as a secondary obligatory instrument and will enforce only on the default of the buyer.
- Unlike a documentary credit, it does not require the presentation of shipment documents in detail. The bank can proceed only with the simple demand letter for the payment.
Important Types of Bank Guarantee
Broadly it can be of the form of financial or performance-based. It predetermines the amount and timeframe for the payment and clearly states the terms under which it will become payable to the beneficiary.
Both parties can agree on different terms and may need a specific type of bank guarantee. Here are a few important types of bank guarantees.
It is the default guarantee for the seller. In case the buyer fails to make the payment, the bank will make the payment to the beneficiary.
Advance Payment Guarantee
It serves the buyer for the reimbursement of the advance payments in case the seller does not fulfill the contract terms. It is issued along with the advance payment of the contract.
Confirmed Payment Guarantee
It works as an irrevocable payment instrument. The bank makes confirmed payment to the beneficiary on a set date and for the agreed amount.
Performance Bond or Guarantee
It secures the buyer’s interests against the non-performance of the supplier. It provides security to the buyer if the seller does not provide goods as agreed in the contract.
It is issued against the default of rental payments of the tenant. It may include the rental amounts and the costs of damages to the property as well.
It serves the buyer as an assurance or warranty that the goods will be delivered on time as agreed in the contract terms.
It is issued in favor of a third-party lender for the credit guarantee of the applicant. It serves as collateral for the repayment of the loan.
Suppose a buyer company Green Star in Germany approaches a seller company Blue Tech in China. Both parties agree on the supply of electronic goods. Blue Tech demands assurance for the payment terms of the contract. The full amount of the contract is $ 300,000.
The buyer approaches a bank ABC in Germany to issue a bank guarantee in favor of Blue Tech. For further security, Green Star can issue different bank guarantees. Once the contract proceeds, Green Star will have to make payment at a certain point (usually through a Letter of Credit). If Green Star fails to make the payment somehow, Blue Tech can demand payment from ABC bank.
Advantages of a Bank Guarantee
A bank guarantee serves different advantages to both parties in the contract.
- It assures the sellers of the payment confirmation in case of default of the buyer.
- The buyer can easily avail credit that would otherwise be difficult to obtain.
- It incurs lower costs than documentary credits.
- Buyers can secure the terms with a performance or advance payment guarantee as well.
- It reduces the trust deficit between both parties in a trade contract.
Disadvantages of a Bank Guarantee
A bank guarantee provides a lot of financial security to both parties in a trade contract. However, it comes with some limitations too.
- It acts as the secondary payment obligation and enforces only on the non-performance of either party in the contract.
- It can complicate and delay the trade arrangements.
- The applicant may not possess sufficient creditworthiness or collateral to avail the bank guarantee.
A bank guarantee provides financial security to both parties in a trade contract. Both parties can secure their financial interests by issuing different forms of bank guarantees. It acts as a great tool and facilitator for international trade.