Bank Guarantee Meaning Types How Does It Work

Bank Guarantee Meaning

Types of Bank Guarantee

There are two types: performance and financial guarantee.

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Performance Guarantee: It is regarding the performance of an act in the contract. If the applicant cannot perform as per contract, the loss to accrue to the beneficiary will be recovered by the issuer bank.
Financial Guarantee: This guarantee is used in those contracts where the applicant must furnish security to the beneficiary. Thus, the applicant provides the beneficiary with a financial guarantee when financial security is given.

How Does it Work?

Usually, a person applies for the guarantee with his regular banker, though he can also use the same with any other banker. Before issuing it, any bank assures itself of its creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more by applying for bank assurance. Creditworthiness can be checked by running CIBIL score, past financial statements, past banking behavior, and projected financials.

Sometimes, a bank may also require the applicant to furnish some security instead of a bank guarantee. That is usually done by covering the amount of bank assurance by the issue of a fixed deposit on which a lien is created, and he cannot liquidate the same without the consent of the bank and the person in whose favor it is issued.

The person who is issued works as a security and ensures that bank assurance covers his financesFinancesFinance is a broad term that essentially refers to money management or channeling money for various purposes.read more.

Examples of Bank Guarantee

Let us look at a few examples that will explain what financial and performance guarantee looks like.

Example #1

ABC Ltd. enters into a supply contract with XYZ Ltd. where XYZ Ltd. is required to make a regular supply of raw materialsRaw MaterialsRaw materials refer to unfinished substances or unrefined natural resources used to manufacture finished goods.read more to ABC Ltd. In addition, ABC Ltd. asks XYZ Ltd. to furnish financial security for the contract to adjust any deficiencies in raw materials.

Here, XYZ Ltd. can apply for a financial guarantee as it is required to provide financial security.

Example #2

Mr. X contracts with Mr. Y to complete the project within a stipulated time. In addition, Mr. Y must furnish a bank guarantee so that if the project is not completed within said time, they can recover the loss incurred by Mr. X.

In this case, Mr. Y shall apply for a performance guarantee as it is linked to the performance of the contract.

Why is it important?

It is considered to be important owing to the following reasons: –

It is a security for the beneficiary since his funds flow from the applicant are secured.When small vendorsVendorsA vendor refers to an individual or an entity that sells products and services to businesses or consumers. It receives payments in exchange for making items available to end-users. They constitute an integral part of the supply chain management for providing raw materials to manufacturers and finished goods to customers.read more deal with larger business players, they must furnish a bank guarantee. Thus, to ensure business, it becomes necessary for them.Getting a security issue shows a bank’s trust in the applicant. Thus, his credibility increases.

Bank Guarantee Charges

For providing the service of issuing a bank guarantee to the applicant, the applicant is charged certain fees based on the amount involved in bank assurance. Also, for providing the service of issuing bank guarantees to the applicant, the applicant is charged certain fees based on the amount involved in bank assurance. Also, charges for financial guaranteeFinancial GuaranteeA financial guarantee is a promise undertaken by a third party to cover any financial obligation of another organization or individual, acting as a guarantor for any unpaid financial debts. If the concerned party is unavailable, authorities contact guarantors.read more are more than performance guarantee as the same is comparatively riskier.

Bank Guarantee vs Letter of Credit

The financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more issues a letter of creditLetter Of CreditA Letter of Credit (LC) is issued by a buyer’s bank to ensure timely, full payment to the seller. If the buyers default, the bank pays the sellers on their behalf.read more on the applicant’s request after receiving the services or goods. Thus, after the buyer accepts the services or goods, the bank makes the payment to the seller based on a letter of credit, and the amount paid is recovered by the bank later along with applicable charges. The buyer usually opts for the letter of credit in cases where there is a short-term financial shortage.

On the other hand, a bank guarantee promises that if the applicant fails to pay the amount under contract or does not fulfill the performance criteria, the bank will pay the amount to the beneficiary. Thus, in a bank guarantee liability of the banker is secondary and arises only on the applicant’s failure.

Advantages

The beneficiary is saved from the financial riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more involved in a contract.It helps a person secure more contracts since the financial risk is reduced.The credibility of the applicant increases on the issuance of the guarantee.Ensuring it is an easy process and requires minimal documents.

Disadvantages

Some banks follow a very rigorous process to assess the applicant’s financial credibility; in such situations, issuing a bank guarantee can be lengthy.Banks look for profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more while assessing financial credibility. Thus, allocating a guarantee can be difficult for loss-making enterprises.One may be required to furnish security against the issue of guarantee.

Conclusion

It offers financial security to the beneficiary, encouraging him to enter into contracts with the applicant without worrying about the financial loss since such risks are secured by a bank guarantee.