What is a Bank Guarantee?
A bank guarantee is primarily a contract between a lender and a debtor where the lender agrees to compensate for a debtor’s liability in case certain contractual obligations fail to be met. For example, a newly established restaurant chain requires purchasing a large amount of kitchen equipment. However, the kitchen equipment vendor would most likely request a bank guarantee as the products to be delivered are cost-extensive. Hence, the bank will sign a contract with the vendor to ensure timely delivery of the equipment and the debt will compensate the restaurant in case the deliverables are not met.
Why do you need a bank guarantee?
A bank guarantee can be used by either an individual or a business for several reasons. Here are some reasons as to why you may need a bank guarantee.
- Bank guarantees thereby reduce the financial risk associated with transactions in the business and provide a financial guarantee.
- This promotes the expansion of the establishment or business and gives the business more opportunities.
- Further, as banks provide guarantees to a company, the company’s credibility increases thereby attracting more clients or customers based on the nature of the business.
- Finally, the risks associated with the individual/business are reduced as the bank assures to cover the liabilities in case the applicant defaults.
- Small establishments and companies can avail loans that may otherwise not be possible due to the potential risk they bring along with them.
- When a Bank Guarantee is issued against collateral such as Fixed Deposit, the applicant can get a lucrative rate of interest and commission.
Key points to be considered while availing a BG from a bank
- Cost of issuance – BG Issuance commission
- Cost of amendment & Claim processing
- Other related costs – SWIFT and Courier charges
- Collateral requirement
- Interest rates offered on the Fixed Deposit as collateral
- Ease of documentation
- Faster issuance time
- Acceptance of Issued BGs by corporates and Govt agencies
Types of bank guarantees
1. Performance Guarantee
Performance bank guarantees involve both a buyer and a seller. This helps when the seller does not deliver the product as discussed in the contract so that the buyer can reclaim the compensation for the debt from the bank.
2. Financial Guarantee
Typically, financial guarantees are offered instead of security deposits. In simple words, the bank promises compensation for the company’s debt if the financial obligations are not met.
3. Bid bond Guarantee
These types of guarantees are typically used for a construction job or that have a bid-based process of selection. A bid bond will guarantee compensation in case the bidder does not begin the project under any circumstance. The range of amounts covered by this bond is the difference between the highest and the lowest bid.
4. Advance payment guarantee
An advance payment bank guarantee is typically used when the seller requires an advance payment to be made. In case the seller does not hold their side of the contract by not fulfilling the deliverables, the buyer can recover the advance partially or completely. For example, in cases of a domestic trade or a global transaction, this type of bank guarantee is used.
Remember these 3 factors while availing of a bank guarantee:
While bank guarantees come along with several benefits, here are 3 main factors you should keep in mind before availing one.
- In cases of a low-value transaction, the bank guarantees work seamlessly. However, when it comes to high-value transactions, the bank may not readily offer a bank guarantee and may require collateral from the individual/business.
- In some cases, the entire process of obtaining a bank guarantee can be both complex and time-consuming.
- The initial screening process of the banks is quite strict, thereby causing a roadblock to many.
How can you apply for a bank guarantee?
It is a common misconception that only businessmen and enterprises can apply for a bank guarantee. Although, it is true that a vast majority of guarantees are received by businesses but that does not mean that no individuals can apply for the same, as guarantees are available for individuals too, basis fulfillment of required criteria.
Before you take a step towards applying for a bank guarantee, ensure that you have a good financial and credit record. The first step to applying for a bank guarantee is to reach out to the home branch of your bank and request an application form. Once that has been filled out, the banks will validate your bank activity, transaction history, CIBIL score, liquidity, and other such factors.
Bank Guarantees vs Letters of Credit
Many usually get confused between a bank guarantee and a letter of credit. Both are made by financial institutions to provide financial guarantees by ensuring that the debt will be compensated for the customer in case the debtor fails to deliver. But, these are used in different circumstances.
A bank guarantee has its primary debtor as the applicant or the buyer. Compensation for the debt will be provided by the bank in case the debtor/seller fails to meet their contractual promises. In the case of letters of credit, it is curated for the seller to ensure that the payment would be successfully processed by the buyer.
A bank guarantee can be availed by both businesses and individuals for several reasons like reducing the financial risk of business transactions, exploring more opportunities, expanding the business, etc. The process of applying for a bank guarantee is fairly simple and can contribute to reducing your financial risks drastically.