A bank guarantee is a promise by a financial institution that it will assume liability for a business contract if one party fails to uphold its obligation to another. In this way, the bank acts like a cosigner for a buyer or borrower on a business agreement, reducing the risk for the seller or lender.
This can be a valuable assurance for organizations that are conducting financial transactions. For a small fee, bank guarantees often enable small businesses to enter into contracts with larger companies with which they otherwise would not be able to do business. Read on to learn more about how bank guarantees work and their pros and cons.
What Is a Bank Guarantee?
A bank guarantee promises that, if one party in a business agreement fails to meet its obligations, the bank will cover its debts. By backing up a transaction, it adds confidence to riskier deals.
Bank guarantees involve a thorough review of the business applicant’s finances and credentials. If, after this due diligence, a commercial bank feels confident that an applicant (the debtor) will be able to uphold their contractual obligations, the bank may offer the guarantee to the other party (the beneficiary). This can lead to greater assurance that the transaction will go smoothly.
Bank guarantees are usually a part of more complex financial transactions between businesses. The average borrower won’t need to worry about bank guarantees for auto loans, mortgages, or personal loans.
A little more detail on bank guarantees for business clients of a financial institution:
• Companies often use bank guarantees for complicated contracts involving goods and services. If a vendor fails to provide goods or services that have already been paid for, a bank guarantee ensures reimbursement for the business using that vendor.
If, on the other hand, a buyer fails to pay for goods or services that have already been delivered or rendered, the bank guarantee covers the unpaid balance for the seller.
• Because a bank guarantee might protect a buyer or a seller, it may be easier to think of them in terms of the beneficiary (the company that requires a bank guarantee to feel protected and move forward with a contract) and an applicant (the company that must apply for the bank guarantee to close the deal).
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How Do Bank Guarantees Work?
If a contract includes a bank guarantee, that guarantee will specify an amount to be repaid (or the goods or services to be delivered) and a set timeframe in which the transaction will happen. The contract will also spell out the bank’s responsibility should the applicant fail to meet their contractual obligations.
To assume this risk, banks charge applicants a fee for the guarantee, expressed as a percentage of the cost or value of the transaction, typically around 0.5% to 1.5%.
If the bank deems a contract particularly risky, it might require the applicant to offer collateral. Unlike with secured personal loans, where a house or car might serve as collateral, bank guarantee collateral is typically liquid assets, like stocks or bonds.
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Types of Bank Guarantees
There are two main types of bank guarantees: financial bank guarantees and performance guarantees.
Financial Bank Guarantee
With a financial bank guarantee, a bank promises to repay a debt if the borrower (or buyer) defaults on the agreement. For example, an applicant may purchase goods and services from a large company, receive said goods and services, and never pay the bill. In this instance, the bank would settle the debt with the large company since the funds can’t come out of the borrower’s bank account.
What Is a Performance Guarantee?
In this situation, if an applicant fails to perform the obligations laid out in contract (e.g., supplying parts to a company), the beneficiary can make a claim with the bank for the losses incurred from the non-performance of contractual obligations.
Performance failure might also mean that, though the goods or services were delivered, they did not meet quality standards specified in the contract. In these situations, the bank would step in to offset those losses.
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Examples of Bank Guarantees
Bank guarantees can serve many purposes, usually between two businesses. Here are a few of the guarantees that banks often issue:
Rental Guarantee
A rental guarantee protects a landlord when entering into a contract with a company (like a restaurant or retailer) that wants to lease a space. This guarantee serves as collateral for a rental lease.
Advanced Payment Guarantee
An advanced guarantee protects a company that has paid in advance for goods or services that weren’t delivered. You may also hear this referred to as a cash guarantee. If the deal isn’t satisfied, the company that has paid out in advance will be refunded.
Performance Bond Guarantee
A performance bond is a kind of financial guarantee for a business deal, to protect against one party failing to meet its obligations. You may also hear this called a contract bond. If, say, a contractor doesn’t complete the work they agreed to do, a performance bond guarantee can protect the party paying for the project. That entity would be compensated for their loss.
Warranty Bond Guarantee
When a bank provides a warranty bond guarantee, that protects the buyer in a transaction, ensuring that goods are delivered as specified. This could refer to the quality and condition of the items as well as the timing of their arrival.
You may also hear this term used in another situation. Sometimes referred to as a maintenance bond, a warranty bond guarantee can be a financial guarantee in which a builder promises to protect the owner of a construction project from problems with workmanship or faults with materials that could occur after the project’s completion. A financial institution or insurer will back up this promise.
Payment Guarantee
A payment guarantee is quite simply what it sounds like: It guarantees that, if, say, a buyer fails to send adequate funds for a purchase, the bank will step in and cover the shortfall. It allows a seller to feel confident that they will be paid in full on a predetermined date.
Recommended: Bank Guarantees vs Letters of Credit: What’s the Difference?
Pros and Cons of Bank Guarantees
Here’s what you need to know about the upsides and downsides of bank guarantees.
Pros
Among the most important advantages or a bank guarantee are the following:
• Reduced costs: While not free, a bank guarantee can be a cost-effective way to encourage confidence and help a deal go through. It may be less expensive to obtain, say, than taking out a small business loan to cover a potential debt.
• Reduced risk: A bank guarantee reduces risk since the bank promises to pay if one party doesn’t hold up their end of the deal. In this way, a bank guarantee can open up new opportunities for businesses, especially those without a long or solid credit history.
• Quick activation: It typically takes only a few days to obtain a bank guarantee.
• Enhanced credibility: Before offering a guarantee, a bank does a comprehensive assessment of an applicant’s financial standing. Earning a bank’s backing through a guarantee demonstrates that the bank finds the applicant company to be credible.
Cons
Next, the potential drawbacks of bank guarantees to be aware of:
• Stringent approval guidelines: Bank guarantees aren’t given to just any entity. A business must show that it merits this backing. Not every applicant will qualify.
• Collateral requirement: If a venture seems particularly risky, banks may require collateral from applicants; this can be risky for startups with limited funding.
• Complex regulations: There have been scams involving bank guarantees in some international transactions. Using a bank guarantee for an international deal may therefore require many complex steps and assurances before it moves forward.
The Takeaway
In business transactions, a bank guarantee promises that the financial institution will cover any debts to one party if the other party does not meet its obligations. Larger companies often require small businesses and startups to obtain a bank guarantee before doing business with them. These guarantees can help a small or new business secure large deals since the bank has shown confidence in them.
That said, if you’re focused on your personal finances and are considering your options, see what SoFi offers.
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FAQ
What is the difference between bank guarantees and letters of credit?
Both bank guarantees and letters of credit add confidence to business deals, with slight differences. With a bank guarantee, the financial institution promises to step in and pay debts, if needed, for the party they guaranteed. A letter of credit, useful in international trade, substitutes the bank’s credit for a business’. The bank will guarantee payment if the business defaults on their obligation, but only once certain criteria are met.
What is the purpose of a bank guarantee?
The purpose of a bank guarantee is to add confidence to a contract between two parties. If one party fails to uphold its contractual obligations or defaults on a loan, the bank promises to step in and uphold the contract and pay the debt that may result.
How can I get a bank guarantee?
If a business is requiring a bank guarantee to enter into a contract, contact your bank (or your business’ bank) and request an application. The bank will then review the completed application to determine your creditworthiness, typically within a few business days.
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