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What is Bank Guarantee? How Does It Work?

IndianMoney.com Research Team | Posted On Thursday, September 12,2019, 07:46 PM

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What is Bank Guarantee? How Does It Work?

 

 

Just like you owe the bank a repayment for a defaulted loan that you signed as a guarantor, a bank guarantee will act as the guarantor and undertake the financial obligation of an entity if it fails to make payments on time. If you want to unlock the concept of a bank guarantee than you have to understand what is a bank guarantee and how it works?

What is a Bank Guarantee?

A bank guarantee is an agreement between the buyer and a seller where the banks act as an intermediary. Bank guarantees are issued by the banks as a promise wherein if you fail to repay the loan then the bank will fulfil your financial obligations. You can assure the creditor through a bank guarantee that if you as the borrower will fail to pay or meet your liabilities, then the bank will make the payments on your behalf.

The bank guarantees are generally used between business entities. The buyer makes use of the bank guarantee and purchase equipments, machinery, raw materials or gets business funds for the business. The bank guarantee acts a promise that the payment will be made on time by the buyer. The bank will undertake the payment only if the obligation is not met on time.

Bank guarantee example:

A Canada based exporter called the SNG group seeks a bank guarantee for an importer AZ Pvt. Ltd. in India. In this case, the Indian importer will visit the SBI bank to give a bank guarantee to the exporter. Therefore, the AZ Pvt. Ltd IN India is the applicant seeking the bank guarantee and SNG group is the beneficiary and SBI is the issuing bank.

This bank guarantee acts as a promise that the bank would pay the specified amount in case of default in payment. Here the bank acts as a guarantor in case the AZ Pvt. Ltd is unable to meet its contractual liability. The banks here will undertake the financial obligations of the applicant as a guarantor if payment is not made as per the contract to SNG group.

Types of bank guarantee:

Let’s try to understand the various types of bank guarantee available in India and their functions:

Performance guarantee: a performance guarantee can be used as collateral where the transactions involve a buyer and a seller. Under the performance guarantee, the bank will make compensation payments if the goods or services are not delivered on time or as promised in the contract. To invoke a performance guarantee, the buyer must submit a written complaint stating that the seller has not fulfilled the obligation as per the contract.

Bid bond guarantee: the bid bond guarantee is a type of construction bond that helps to safeguard the owner during a construction bidding process. These are used while bidding for tenders to make sure the winning bidder accepts the contract and fulfils his obligation as per the contract. The bid bond guarantee promises to compensate the owner in case the bidder fails to honour the terms. This type of bond is used as a proof of guarantee and implies that the bidder must devise the project as per the terms of the bid contract.

Financial guarantee: The financial guarantee is an undertaking by the bank that promises to take care of the financial obligation of a company if the company is unable to meet its obligations. The financial guarantees are used by two related entities, for example, a partner company giving financial guarantee to a subsidiary company ensuring the financial obligations will be met when there is a delay in the project completion.

Advance payment guarantee: an advanced payment guarantee is only issued when advance payment is to be made to the seller. If the seller fails to deliver the goods or service as mentioned in the contract then the buyer has the right to invoke the advance payment and recover the full or partial advance payment made to the seller. These types of bank guarantees are generally used for global transactions and domestic trade where a large advance payment is made.

Deferred payment guarantee: a deferred payment guarantee is a guarantee for payment usually made in instalments that are deferred or delayed. This type of guarantee is issued for the purchase of goods or machinery for business. The seller generally offers it as credit and the buyer’s bank undertakes the payment on behalf of the buyer.

How to get a bank guarantee in India?

Getting a bank guarantee from a financial institution is quite easy. Bank in India issues a bank guarantee and will charge a guarantee fee for it. Before issuing the bank guarantee, the banker will undertake an investigation and will try to verify whether or not you are creditworthy. The bank may request for the submission of collateral and some additional documents for initiating the process of bank guarantee application.

Documents required for bank guarantee:

When a customer applies for such instruments the bank conducts thorough verification and issues such instruments only if it finds the customer is creditworthy. There is a threshold limit only up to which the bank guarantees payment on behalf of the customer.

To avail a bank guarantee the customer must have a CC account with the bank. While applying for the bank guarantee makes sure you provide these documents:

  • Duly filled application form for bank guarantee
  • Order copy stating the request for bank guarantee made by the beneficiary
  • Counter bank guarantee
  • Lien letter
  • Details of the collateral provided
  • Your covering letter requesting the financial institution to issue the bank guarantee
  • List of documents associated with the collateral

Bank guarantee and letter of credit:

People often get confused between the bank guarantee and a letter of credit. Both bank guarantee and letter of credit are guarantees made by financial institutions that assure the customer that the debt will be settled if the debtor cannot repay the debt. But the two instruments are used in separate circumstances and different ways. Let’s try to understand the difference between the two:

A bank guarantee refers to a type of guarantee from a lending institution. It is provided by banks that assure that guarantees the customer that the payment will be made in case the debtor fails to meet his obligations. In such scenarios, the bank is liable to make the payment on behalf of the debtor.

The letter of credit, on the other hand, is a promise or a guarantee made in writing by a financial institution. It ensures the seller that the payment will be made on behalf of the buyer if he fails to make a payment on the purchase. The banks guarantee the seller the recovery of the full amount owed.  However, the bank requires proof of transaction while making a payment on behalf of the buyer.

Letters of credit are crucial and are used in international trade. It works to reduce the risks involved in businesses due to the distance. On the other hand, bank guarantees are mainly used in real estate contracts and infrastructure projects.

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