A bank guarantee is a promise by a financial institution that it will assume liability for a contract if one external 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.
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. In this article, we’ll explore:
• How bank guarantees work
• The different types of bank guarantees
• The benefits and downsides of bank guarantees
• How they differ from letters of credit.
What Is a Bank Guarantee?
Here’s what a bank guarantee is: It’s a financial instrument that adds confidence to riskier business deals. If, after doing its due diligence, a bank feels confident that an applicant (the debtor) will be able to uphold their contractual obligations, the bank will offer the guarantee to the other party (the beneficiary).
And if the applicant fails to fulfill that obligation to the beneficiary? The bank will cover the loss.
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.
Instead, companies utilize bank guarantees for much more complicated contracts around the provision of 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. Conversely, if 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’s easier to think of them in terms of the beneficiary (the company that requires a bank guarantee to move forward with a contract) and an applicant (the company that must apply for the bank guarantee to close the deal).
How Do Bank Guarantees Work?
If a contract includes a bank guarantee, that guarantee will specify an amount to be repaid (or goods or services to be delivered) and a set timeframe for that to happen. In addition, the contract will articulate 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. While the fee will vary (perhaps from 0.5% to 2.5%), it is typically around 1%.
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.
Types of Bank Guarantees
There are two main types of bank guarantees: financial bank guarantees and performance guarantees.
What Is a Financial Bank Guarantee?
With a financial bank guarantee, a bank has promised to repay a debt if the borrower (or buyer) defaults on the loan, meaning the payment. 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 it can’t come out of the borrower’s bank account.
What Is a Performance Guarantee?
A performance guarantee is just the opposite: 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 kinds of 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 will be refunded.
Shipping Guarantee
A shipping guarantee protects a carrier when a shipment (i.e., import) arrives before required documentation. It is designed to smooth this kind of transaction when the documents have not yet become available.
Pros of a Bank Guarantee
When considering bank guarantees, you’ll see the term “beneficiary.” Don’t jump to conclusions about which party that might be. Bank guarantees can provide benefits for both the beneficiary and the applicant.
Benefits for the Beneficiary
First, let’s consider how a bank guarantee can help the beneficiary.
• Reduced costs: A large, international company might save money in a specific region or country by doing business with a local vendor who does not have an international presence. By requiring that vendor to acquire a bank guarantee, the large company can feel confident about the decision while reducing costs.
• Reduced risk: As mentioned above, the bank guarantee reduces the risk for the beneficiary. If the applicant fails to pay or to provide services or goods as outlined in the contract, the beneficiary can expect reimbursement from the bank.
Benefits for the Applicant
Now, here’s how a bank guarantee can benefit the applicant.
• Increased opportunity: Bank guarantees let smaller companies and startups earn business they might not otherwise. Their newness in an industry might otherwise elicit hesitation from potential customers; a bank guarantee is often the boost needed to get business deals rolling.
• Low cost option: All things considered, typical bank guarantee fees are low, especially when small business owners are used to dealing with higher interest rates (5.5% to 11.25%) on their small business loans, according to Experian, one of the major credit reporting agencies.
• Credibility: Before offering a guarantee, a bank does a comprehensive, accurate 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 of a Bank Guarantee
Both beneficiaries and applicants may encounter drawbacks to bank guarantees when initiating a contract.
Added complexity
First and foremost, a bank guarantee adds a layer of complexity to deal-making and may slow down business decisions. Companies operating in fast-paced markets may not be able to afford the delay.
Collateral requirement
If a venture seems particularly risky, banks may require collateral from applicants; this can be risky for startups with limited funding.
Lack of guarantee
Ultimately, a bank may not offer a guarantee, which means the beneficiary needs to be ready to continue its search for a new company to partner with.
Bank Guarantees vs Letters of Credit
Bank guarantees, as we’ve mentioned above, are typically used by companies bidding on large projects. The bank guarantee can underscore the business’ financial credibility. It provides assurance that a company has the financial means to complete the project in question.
Though they share some similarities with bank guarantees, letters of credit are more common in international trade. With a letter of credit, the bank is involved to a greater extent. Essentially, the bank releases the funds that the buyer owes the seller only when the seller has completed its contractual obligation (i.e., shipment has been received.)
Letters of credit instill confidence in sellers (exporters) that they will receive payment once they have shipped their goods. Likewise, importers only have to make payments (to their bank) after they have received the goods, so their funds aren’t tied up with no goods to show for it.
The Takeaway
A bank guarantee is a useful financial instrument that instills confidence between two external parties entering into a contract together. Such bank guarantees promise 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.
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FAQ
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.
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 application to determine your creditworthiness.
What are the types of bank guarantee?
There are two main types of bank guarantees: financial bank guarantees and performance guarantees. In a financial bank guarantee, the bank assures that a buyer will repay any debts owed to a seller. If the buyer does not, the bank will take on the debt. In a performance guarantee, the bank assures that the applicant will fulfill the tasks laid out in a contract. If the applicant does not, the bank will compensate the beneficiary to cover losses from the lack of contractual fulfillment.
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