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A bank guarantee is essentially a commitment from a bank to cover any losses in case the borrower fails to meet financial obligations. This instrument is often used in large business transactions, contracts, and international trade.
Before providing a guarantee, the bank typically conducts a thorough assessment of the borrower’s financial status. The various types of bank guarantees include performance guarantees, financial guarantees, and advance payment guarantees, each serving a distinct purpose.
With benefits like minimising default risks, a bank guarantee helps businesses progress without the concern of debt-related issues.
A bank guarantee is a promise a bank makes to a third party, ensuring that the bank will cover financial obligations in case the borrower defaults. It is a formal agreement between the bank and its customer, designed to protect third parties from potential losses in business transactions.
Bank guarantees are vital in supporting business development and fostering entrepreneurship, as they allow companies to engage in transactions without the constant concern of debt repayment. For example, a business purchasing raw materials from a small vendor may be asked for a bank guarantee.
This ensures payment security before the goods are dispatched. The bank assesses the company's financials and issues the guarantee, facilitating the transaction. In case the business defaults on payment, the vendor can recover the amount directly from the bank.
Here is an overview of the bank guarantee process:
When you apply for a bank guarantee, the bank assesses your business's financial health
The evaluation includes reviewing your creditworthiness, banking history, liquidity, and credit scores from agencies like CIBIL and CRISIL
The bank examines the details of the beneficiary and any necessary documentation
The bank also considers the guarantee's duration, required amount, and currency
To mitigate risk, the bank may ask you to provide collateral or security for the guarantee amount
Once the bank is satisfied with all the details, it approves the guarantee contract
There are different guarantee types in a bank, each serving specific purposes in different transactions. Below are the key types of bank guarantees and their use cases in India.
Performance Guarantee
A performance guarantee serves as collateral in contracts between a buyer and a seller, ensuring that the seller meets their obligations. The buyer can invoke the guarantee in writing if the seller fails to deliver goods or services as agreed, backed by proof of non-performance.
Financial Guarantee
A financial guarantee is a commitment by a bank to cover a company's financial obligations if it does not meet its responsibilities. These guarantees are commonly issued between interrelated parties, such as a partner company offering a guarantee to a subsidiary.
Advance Payment Guarantee
This guarantee protects a buyer's upfront payment to a seller. In case the seller fails to deliver goods or services as agreed, the buyer can invoke the guarantee to recover all or part of the advance payment.
It is applicable for both domestic and international transactions, especially where larger advance payments are involved.
Foreign Bank Guarantee
A foreign bank guarantee is used in international trade to assure the foreign beneficiary that a bank will fulfil the financial obligations of a borrower or creditor. It serves as security for cross-border transactions.
Deferred Payment Guarantee
This guarantee is employed when payments are scheduled for future dates. It assures the seller that the bank will cover the payment if the buyer defaults. Should the debtor fail to pay on time, the guarantee can be invoked to recover the outstanding amount.
Bid Bond Guarantee
A bid bond guarantee is issued during the bidding process for a project or supply contract. It assures the bank that the bidder is serious and capable of undertaking the project if selected.
If the winning bidder withdraws or fails to begin the project, the bank will cover the loss under the guarantee.
A bank guarantee offers several advantages, such as reducing financial risks and providing low-fee benefits for small-scale businesses. However, it also has drawbacks, including rigid assessments and the requirement for collateral security. Here is an overview of both:
Advantages
Reduces financial risks in business transactions
Encourages business expansion by providing credit
Small businesses benefit from lower fees
Enhances credibility and business opportunities with bank assessments
Faster processing due to fewer document requirements
Disadvantages
The approval process can be slow and complex due to stringent assessments
It may be difficult to access a bank guarantee if a business incurs losses
Collateral security may be required for high-risk, high-value transactions
A bank guarantee is generally provided by any banking institution to businesses with a strong financial history and standing. Businesses can apply for this guarantee through their own bank or any other institution offering such services. Before approval, the bank requires you to meet the eligibility criteria and submit some essential documents.
The bank reviews the financial records, including creditworthiness, liquidity, and credit ratings. Eligibility criteria vary across banks, and you need to check the criteria before applying. Some banks may require an annual turnover of ₹500 Crore or more.
Joint-stock companies may also need to submit a board resolution authorising the guarantee. Other institutions may have simpler criteria, such as the applicant being over 18 years old, a regular bank customer, and the owner of a firm, company, trust, or society.
Once the required documents are submitted, the bank verifies the applicant's financial history, liquidity, and credit ratings. It also assesses the beneficiary details, guarantee amount, tenure, and currency. In some cases, security in the form of collateral may be required.
After reviewing all documents and criteria thoroughly, the bank issues the guarantee contract as approval.
The bank guarantee charges depend on the type of guarantee and the assured amount. A financial guarantee typically carries a higher risk compared to a performance guarantee, resulting in different fee structures.
These charges are generally applied on a quarterly basis throughout the validity period. Fees usually begin from 0.50%, and additional costs may include amendment and extension charges.
For instance, HDFC Bank applies a documentation fee of ₹1,500, a commission of 1.8% per annum, and SWIFT charges of ₹1,000. Punjab and Sind Bank charges 0.75% per quarter up to ₹5 Crores and 0.30% - 0.75% per quarter above ₹5 Crores.
Axis Bank, on the other hand, levies 2.50% per annum for both performance and financial guarantees on foreign bank guarantees. These charges vary across banks, so you need to review the fee structure with the respective institution before proceeding.
A Bank Guarantee (BG) and a Letter of Credit (LOC) are financial instruments used to secure transactions and reduce risk. However, they are applied for different purposes. A bank guarantee is commonly utilised in domestic transactions where assurance for payment or performance is required.
In contrast, an LOC represents a commitment by the buyer’s bank to pay the seller, provided that all stipulated terms and conditions are met. The fundamental difference between the two lies in the nature of the bank’s liability.
In a bank guarantee, the bank becomes liable only when the applicant fails to meet the obligations. In the case of a LOC, the bank assumes primary responsibility for payment and subsequently recovers the amount from the customer.
The risk in a BG is undertaken by the customer, whereas a LOC places greater risk on the bank. Bank guarantees are well suited for situations requiring compensation in the event of non-performance or non-fulfilment of specific conditions.
LOCs are intended to ensure payment is made once the agreed conditions of service or delivery are satisfied. A BG involves three parties: the banker, the customer, and the beneficiary. A LOC, however, typically involves several entities, such as the issuing bank, the advising bank, and the beneficiary.
There are various situations in which a bank guarantee is applicable. This can include a vendor requiring a firm to guarantee the value of raw material supply or a government agency demanding it as part of a contractual agreement. The following examples explain the concept of a bank guarantee:
Example 1: ABC Textiles
ABC Textiles, as a new garment manufacturing facility, wants to buy fabric raw materials worth ₹75 Lakhs. The supplier requests that ABC Textiles give a bank guarantee before delivering the goods as part of payment protection. ABC asks its bank for a guarantee by using its business accounts.
By doing this, the bank essentially co-signs the purchase contract. When ABC Textiles does not pay, the supplier can recover the amount from the bank.
Example 2: EG Imports
EG Imports, a home furnishings firm, is going to import wooden furniture costing ₹40 Lakhs from NC Ltd, an international supplier. To secure the order, NC insists that EG Imports execute a foreign bank guarantee promising payment on delivery.
EG approaches its bank, which arranges for NC through a correspondent bank. This allows the Swedish supplier to confidently process the order. If the EG is unable to pay, the Swedish bank will repay the amount under the guarantee.
Yes, it is possible to apply for a bank guarantee online. Many banking institutions permit businesses and individuals to submit applications for a BG through their official websites or mobile applications.
Yes, it is possible to opt for a BG with a savings account. Certain banks, such as ICICI Bank, allow applications for a BG even when the applicant holds only a savings account.
Some banks, such as ICICI Bank, issue a bank guarantee within 3 hours. However, other banking institutions may take between 3 to 5 working days to complete the process.
The documents required for bank guarantee vary by bank. Some common documents include:
A filled application form
KYC documents
Partnership deed
3-year ITR
Monthly sales and purchase
GST-filed sales returns
Debtors ageing
Other bank statements
To secure a BG, you may need to provide collateral in the form of a fixed deposit, a percentage of the guaranteed amount, or a cash margin.
Yes, a bank guarantee can be cancelled under certain conditions, typically once the obligation for which the guarantee was issued has been fulfilled.
No, bank guarantees do not earn interest. However, interest may be received on the margin money held as collateral, depending on the bank’s policy.
The three primary types of bank guarantees include:
Performance Guarantee
Financial Guarantee
Advance Payment Guarantee
No, a bank guarantee is not refundable. Once the underlying obligations are fulfilled and the guarantee expires, no refund is applicable.
A bank guarantee is generally valid for up to 10 years. Guarantees cannot be issued for periods exceeding ten years under any circumstances.
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