What is the Letter of Guarantee?
Letter of Guarantee is a written consent that is issued by the bank stating that if the concerned customer fails to make the payment for goods purchased from the supplier, then the bank will pay on the customer’s behalf. It helps the supplier to have confidence in the transaction and supply the product. The bank/party who will be assuming the responsibility to pay is termed as guarantor.
Examples of Letter of Guarantee
Let’s discuss examples of letters of guarantee for better understanding.
Example #1 – Overseas Trade
Say there is a supplier for expensive antique products in Brazil. A customer from London wants to buy products from the supplier. The customer will not be willing to make the payment before the delivery of the product as he is thinking, what if the supplier doesn’t supply after receiving the payment. The supplier is also thinking the same way as to what if the customer doesn’t pay after receiving the product.
So what the customer can do it, he can go to a bank and apply for a “letter of guarantee.” In this letter, it will be written that if the customer doesn’t pay the money, then the bank is guaranteeing that the bank will pay. Once the customer has the letter, then he can send it to the supplier, and in return, the supplier will send the goods to the customer as he will not have to worry about the default in payment. Bank will charge a fee for this service from the customer.
Example #2 – New Supplier in Business
When a supplier knows its customer very well, then he is fine in supplying goods to the customer without worrying. In the case of new suppliers, the supplier may want a guarantee that he will be paid once the customer receives the product. So, in this case, the customer will have to reach a bank and apply for a “letter of guarantee.”
Example #3 – Companies at Start-Up Stage
Companies during the start-up stage don’t have goodwill in the market. For them to get products from the supplier is difficult without full payments. So they rely on a letter of guarantee to get products delivered to them.
Example #4 – Call Writer
Incall writing, if the share price starts to increase, then there is a probability for unlimited loss. So in call writing broker asks for cash or equivalent securities as guarantees. Many institutional investors maintain an investment account with custodian banks. So say that an institutional investor holds 1000 shares of ABC company and is writing a call option on the shares.
So if the share price starts to rise, then he will lose money on the contract that he has written. So for this, the broker needs the guarantee that he will pay when he incurs a loss. So the institutional investor can go to the custodian bank and ask for a letter of guarantee. As the custodian bank is holding the shares for the company, they can give a letter that if the share price rises, then they can pay on the institutional investor’s behalf.
Example #5 – Bond Issuance
When a company issues bonds with a “letter of guarantee” by the bank, then it is treated as a secured bond and trades at a premium. Here the bank may guarantee to pay the interest or principal or both in case of default. It is common in the case of bond issuance.
How to Get a “Letter of Guarantee”?
The following is the process to get a letter of guarantee.
Step 1:To get a letter of guarantee; one will have to write an application to the bank.
Step 2:When a bank receives an application; it will have to determine whether the applicant qualifies for the same.
Step 3:The bank does this by going through the transaction deeply; it will also check the previous transactions and every relevant material required to make the judgment.
Step 4:Bank charges fees to give this letter.
- It helps new businesses to grow as banks help them to get goods from suppliers.
- It helps in overseas trade and increases export and import.
- It protects the buyer of bonds from defaults.
Some of the disadvantages are as follows.
- It doesn’t guarantee 100% protection. If the claim amount is big, then the party who has acted as a guarantor may not be able to completely cover up the claim.
- As the bank acts as a guarantor, so it enables bond issuers to issue more bonds than required, and if they default, the bank will make the payment. So the default rate increases.
It is an important part of the economy now. It helps in the smooth running of the business across borders. A letter of guarantee has made the bond market more secure, and investors are willing to invest in risky bonds as well with bank guarantees.
This has been a guide to what is a letter of guarantee and its meaning. Here we discuss examples of letters of guarantee along with advantages and disadvantages. You can more about finance from the following articles –