Bank Guarantee Meaning
The term “Bank Guarantee” as the name suggests is the guarantee or assurance given by the financial institution to an external party that in case the borrower is not able to repay the debt or meet its financial liability, then in such an event bank will repay such amount to the party to whom the guarantee is issued.
Types of Bank Guarantee
There are basically two types, namely performance and financial guarantee.
- Performance Guarantee: It is regarding the performance of an act in the contract. In case the applicant is unable to perform as per contract, the loss that is to accrue to the beneficiary will be recovered to him by the issuer bank.
- Financial Guarantee: This guarantee is used in those contracts where the applicant is required to furnish security to the beneficiary. Thus, when financial security is to be furnished, the applicant provides the beneficiary with a financial guarantee.
How Does it Work?
Usually, a person applies for the guarantee with his regular banker, though, the same can be applied with any other banker also. Before issuing it, any bank assures itself of the creditworthiness of the person applying for the bank assurance. Creditworthiness can be checked by running CIBIL score, past financial statements, past banking behavior, and projected financials.
In some cases, a bank may also require the applicant to furnish some security in lieu of a bank guarantee. This is usually done by covering the amount of bank assurance by way of issue of fixed deposit on which lien is created and the same can’t be liquidated without the consent of the bank and the person in whose favor it is issued.
For the person to whom it is issued, it works as a security and ensures him of his finances as his finances are now covered by way of bank assurance.
Examples of Bank Guarantee
Let us have a look at a few examples which will explain how financial and performance guarantee looks like.
ABC Ltd enters into a supplies contract with XYZ Ltd where XYZ Ltd is required to make a regular supply of raw material to ABC Ltd. ABC Ltd asks XYZ Ltd to furnish financial security for the contract so that any deficiency that may arise in raw material can be adjusted through it.
Here XYZ Ltd can apply for a financial guarantee as it is required to provide financial security.
Mr. X enters into a contract with Mr. Y for completion of the project within a stipulated time. Mr. Y is required to furnish a bank guarantee so that in case the project is not completed within said time, the loss incurred by Mr. X can be recovered.
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 acts as a security for the beneficiary since his funds flow from the applicant are secured.
- When small vendors deal with larger business players, they are required to furnish a bank guarantee. Thus, in order to secure business, it becomes necessary for them.
- Getting a guarantee issued shows the trust that a bank holds upon the applicant. Thus, his credibility increases.
Bank Guarantee Charges
For providing the service of issuing bank guarantee to the applicant, the applicant is charged certain fees that are based on the amount involved in bank assurance. Also, charges for financial guarantee are more than performance guarantee as the same is comparatively riskier.
Bank Guarantee vs Letter of Credit
A letter of credit is being issued by the financial institution on request of the applicant after he receives the services or goods. Thus, after the services or goods have been received to the buyer, 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 opts for the letter of credit usually in those cases where there is a short-term financial shortage.
On the other hand, a bank guarantee is a promise that in case the applicant fails to pay the amount under contract or doesn’t fulfill the performance criteria, the bank will be liable to pay the amount to the beneficiary. Thus, in bank guarantee liability of the banker is secondary and arises only on the failure of the applicant.
- The beneficiary is saved from the financial risk that is involved in a contract.
- It helps a person to secure more contracts since the financial risk is reduced.
- The credibility of the applicant increases on the issuance of the guarantee.
- Securing it is an easy process and requires minimal documents.
- Some banks follow a very rigorous process to assess the financial credibility of the applicant, and in such situations issuance of a bank, guarantee can be a lengthy process.
- Banks look for profitability while assessing financial credibility. Thus, getting a guarantee issued can be a difficult task for loss-making enterprises.
- One may be required to furnish security against the issue of guarantee.
It offers financial security to the beneficiary which encourages him to enter into contracts with the applicant without worrying the financial loss he may incur since such risks are secured by way of bank guarantee.
This has been a guide to Bank Guarantee and its meaning. Here we discuss types of bank guarantee, how does it work, examples, importance, and its differences with letter of credit. You may refer to the following articles to learn more about finance –