Bank Guarantee -Definition, Example, Types & Benefits

Apr 19, 2021 - 10:17 AMAuthor - Kenneth

bank-guarantee-definition-example-types-benefits

If you are an importer or exporter dealing in an international trade transaction, entering into frequent trade deals is your primary business activity where you come in touch with the unfamiliar parties-to-the-contract. To avoid the associated overseas risks such as different laws & rules or non-payment & non-fulfillment, you apply for a range of trade finance instruments and a Bank Guarantee is one of them.

If you are also a global trader and want to know what a bank guarantee is and how it works, this blog can help you.

What Is A Bank Guarantee?

A bank guarantee or also known as BG is a legal document issued by a bank or a financial institution to assure exporters/sellers/suppliers that they would be paid on time if the applicant/importer/buyer fails to pay the amount or fulfill the terms & conditions mentioned in the contract. Here, the issuing bank or the financial institution acts as a guarantor for the exporter to pay him with the whole or remaining amount as the case may be.

In other words, a bank guarantee is a legal promise made by an issuing bank or a financial institution to the exporters on behalf of their applicants that in the event if the importers are at default, they would be paid on time with a full-fledged amount by the issuing bank. It assures the exporter that they will get their amount for the delivered goods & services to the importer.

Key Takeaways For BG:

1. In a bank guarantee, a bank guarantee service provider promises to cover the loss if an applicant defaults on the loan.
2. A bank guarantee is always issued for a specific amount.
3. The purpose of the guarantee is clearly stated.
4. They are valid only for a specifically defined period.
5. There are additional risks for the lender in BG service, so these loans are issued with greater costs or interest rates.

Understanding Bank Guarantee With An Example

An exporter called ABC Ltd enters into a contract with an importer called XYZ ltd and requests for issuing a bank guarantee to secure its risk of non-payment. The importer approaches its bank to issue a bank guarantee on his behalf to the supplier. If the issuing bank finds the credit history and financial stability of the applicant appropriate, it issues a BG to the importer. Now if the importer makes any default in paying or fulfilling the terms & conditions of the BG contract, the supplier can recover the amount from the issuing bank. The bank here undertakes the responsibility to pay the exporter if the importer is unable to do so.

Types of Bank Guarantee

A bank guarantee is issued for a specific amount with a predetermined period under which the guarantee given by the bank applies to the contract. Let’s understand the different types of bank guarantees. Here they are as follows:

1. Financial BG - By issuing a financial bank guarantee, the bank or a financial institution promises the exporters that the financial obligations of the BG contract will be met by the bank in case the importer is unable to pay the exporter for their rendered services. These guarantees are generally issued in exchange for security deposits where a financial commitment is required from the importer. It means the importers can pay the exporters with a financial bank guarantee instead of depositing the money.

2. Performance BG - A performance bank guarantee is issued by a bank or a financial institution to assure that the terms & conditions of the BG contract will be fulfilled by the bank in case the importer makes a default. In simple words, the bank will pay the compensation to the exporter if the ordered goods or services are not delivered on time as mentioned in the contract. To avail of a performance guarantee, the buyer is required to submit proof about the same.

3. Advance Payment Guarantee - An Advance Payment Guarantee is issued by the bank when the seller is paid with an advance amount. According to BG terms, if the seller is unable to deliver the goods or services to the buyer as mentioned in the contract, the buyer will be returned or recovered with the advance payment made to the seller. 

4. Bid Bond Guarantee - A bid bond guarantee is issued to safeguard the interest of the owner while inviting bidders to bid on a construction project being held by him. Under this type of guarantee, the owner is assured that the bidder will undertake the contract as per the mentioned terms & conditions. In case if the bidder defaults, the owner of the project will be compensated by the bank. 

5. Deferred Payment Guarantee -This type of guarantee is issued when there is a payment being paid in installments that are deferred or delayed such as the purchase of goods or machinery, etc. The buyer’s bank undertakes the payment risks for the seller.

6. Foreign Bank Guarantee - A Foreign bank guarantee is issued by a bank for a foreign beneficiary.

How To Obtain A Bank Guarantee?

Obtaining a bank guarantee shares the same procedure as other trade finance instruments do. Any person who maintains a good credit score and a financial record are eligible to apply for a bank guarantee service. Many banks and private financial institutions are offering a range of international trade finance instruments at the best prices.

1. Before releasing a BG on request, the bank will thoroughly evaluate the applicant’s previous banking history, creditworthiness, CRISIL score as well as CIBIL rating.
2.The bank would also analyze the related bank guarantee issuance details such as the BG period, its value, and currency along with the beneficiary details.
3. In some cases, the issuing bank may also require security to be provided by the applicant to cover the BG amount.

Once the issuing bank is satisfied with the information provided by the applicant, it will issue a BG in the favor of the exporter.

Documents Required For BG

As mentioned above, when an applicant applies for a bank guarantee, they go through an extensive evaluation process in the hands of a particular bank. To obtain a bank guarantee, there are certain required documents which they are required to provide. Here they are as follows:

1. A BG application form
2. Order copy of the request of BG made by the beneficiary
3. Lien letter
4. Collateral details
5. Associated documents listed with the collateral etc.

Charges of Bank Guarantee

The charges that a BG service provider charges for the issue generally depends on the level of risk being borne by them. For example, a Financial BG contains more risks than a performance BG, hence they are expensive and are available with a higher fee. Depending on the type of BG, fees are usually charged on the BG value every quarter. Apart from this, you may also be charged with an application fee, documentation fee, and handling fee, etc. 

Recommended read : Bank Guarantee FAQs

What Are The Benefits Of A Bank Guarantee?

Here are the reasons which make bank guarantees one of the most important types of trade finance instruments for both importers & exporters. Here they are as follows:

1. Proof of Creditworthiness - Since a particular transaction in a bank guarantee is backed up with legal support, it reflects their sound financial stability to the suppliers.

2. Reduced Financial Risks - The increased numbers of defaults on the hands of the importer have given birth to the immense demand for a bank guarantee service. Sellers find it complex to deal with an unknown buyer residing overseas they are not familiar with. A bank guarantee addresses this issue by providing payment assurance to the suppliers.

3. Overseas Opportunities - A bank guarantee enables exporters to deal with unknown parties overseas without any stress due to the involvement of the guaranteeing bank. Hus, they can discover more global opportunities for their businesses without any payment threat.

4. Nominal Fees - Another benefit of applying for a bank guarantee is the small fee charged by the banks. 

5. Lesser Documentation - There is lesser documentation in the issuance of a BG. It only includes information about the concerned parties, the transaction, and the financials of the applicant demanded by the banks.

If you are a global businessman and looking for a bank guarantee service provider, keep this information in mind before applying for it. A bank guarantee is an effective type of payment guarantee trade finance instrument being used in international trade.

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