Bank Guarantee

Overview

Lack of adequate financial resources or inability to manage resources properly is a common struggle for most businesses. Delayed payments, sluggish growth, or massive debt could not only hamper business growth but also prevent potential opportunities that could risk a business’s viability. Therefore, business entities unable to secure funds could use a Bank Guarantee. 

Bank Guarantee – Meaning and Purpose

A Bank Guarantee is essentially an assurance of repayment either through a bank or financial institution in pursuance of a contract between two external parties i.e. creditor and debtor or in furtherance of a guarantee between a customer and the beneficiary. They serve the vital purpose of offering credibility as a viable business via thorough due diligence for the business guarantee. 

Bank guarantees are a risk management tool for the borrower since in the event of failure of repayment, the bank assumes debt liability in the event of default by the borrower helping a business to access funds or resources even in circumstances which would otherwise be a little more risk. 

For example, when an equipment manufacturing company enters into a contract with a small vendor for supply of certain machine parts worth Rs. 4L. Such a small vendor could obtain a bank guarantee and if it obtains the bank guarantee, then the large manufacturing company could make payments in advance with a certain timeline for delivery of products. If the vendor fails to perform his contract-related obligation, the large manufacturer entity could claim losses from the concerned bank. 

Bank Guarantee and Its Importance in Business Credit

Types of Bank Guarantee

Generally, bank guarantees are limited to a specific sum and for a limited period usually pre-determined at the time of entering into a contract. Therefore, such primary agreements in pursuance of a bank guarantee are either as a performance-based guarantee or financial more described below –

Performance-based Guarantee / Performance Bond

Known as a performance bond or performance guarantee, it is a category of bank guarantee that assures the performance of a contract-related obligation on the part of the borrower as per the agreed terms of a contract specifying the period of fulfillment and the standard of performance as required by the other party. 

Hence, the liability for the bank/financial institution offering a guarantee arises only in the event the contractor fails to perform his obligation on time or the quality of the product fails to meet the requisite criteria. The bank guarantee enables the beneficiary to seek compensation for the losses suffered and get financial protection against any potential loss or any unnecessary delays caused due to non-compliance.

For example, where a construction firm has provided a performance guarantee on the timely completion of the project within a pre-agreed timeline but is unable to fulfill its part of the promise, then the client could seek compensation to hire an alternate contractor to fulfill the work on time and ensure no unreasonable delays or any further financial strain on them.

Financial Guarantee

As the name suggests, a financial guarantee is a type of bank guarantee that assures the creditor of fulfilling payment obligation where the debtor is unable to repay the debts. 

Generally, financial guarantees are applied where there is uncertainty regarding the creditworthiness of the debtor and certain assurance is required to enable the transaction to mitigate risks. Therefore, such risk factors could be eliminated by bringing in a credible third party who reassures repayment and agrees to make good the loss suffered under specific circumstances. 

For example, where a business entity has submitted a financial guarantee while seeking funds for any specific business project, any failure to repay the loans will lead the bank to step up for repayment of the pre-agreed obligation. Smaller businesses or start-ups with scalable business ideas could benefit from financial guarantees that not only protect the investors but also make them eligible to seek loans which would be a little too risky otherwise.  

Bid Bond Guarantee

Generally provided under construction contracts, a bid bond guarantee assures the beneficiary that the bid owner will win the contract and start the project as per the proposed terms, and if he fails the beneficiary will be awarded compensation. 

Advance Payment Guarantee

Where the beneficiary requires certain upfront payments in pursuance of a contract, the advance payment guarantee assures the return of advance payments to the beneficiary on the failure of the agreed terms.

Benefits of Bank Guarantee

1. 1. Tool for Risk Management: Certain businesses or individuals with insufficient or inadequate credit history are generally not preferred by creditors for extending credit facilities due to the potential risks of default. Thus, a bank guarantee offers the necessary assurance for repayment and credibility to the borrower minimizing the overall risk associated with the transaction. 
   2. Cost Efficiency: Further, bank guarantees are also beneficial in the sense that they are a cost-effective way to augment the creditworthiness of a business and do not cost much. Generally, banks charge a guarantee fee which can be in the range of 0.5-1 percent of the total guarantee fee. Thus, these lower transaction costs do not put any extra burden on the borrower enabling businesses to improve their products/services and grow their business. 
   3. Facilitates Trade: Generally, banks do thorough due diligence to verify the financial stability of the business before extending business guarantees which also opens doors to attractive growth opportunities which may not be available to small businesses otherwise. Not only this, Bank guarantees also improve the credibility of the business assuring investors and creditors while attracting potential growth opportunities. 
   4. Quick Processes: Customers having all the requisite documentation can process their bank guarantee application faster. 
   5. Ensures better Cash Flow Management: Bank guarantees also do away with any requirement of making payments in advance, which allows sellers to receive prompt payments for the supply of goods or services. This allows the business entities to manage their cash flows in an efficient manner, lowering working capital requirements, minimizing the total cost of capital, and accordingly improving business profits. 
   6. Builds Business Goodwill: Since banks undertake thorough investigations into the financial health of a borrower’s business, therefore approving a bank guarantee shows its credibility assuring lenders and investors that it will grow over time. 
   7. Promotes trust and confidence: Knowing that the banks would have done thorough research on the business entity, the lenders could enter into transactions without any stress.  Bank Guarantees add a safety net to the transaction which fosters trust and confidence among the parties. 

Drawbacks of Bank Guarantee

1. Not accessible for every borrower: smaller businesses or entities going through losses are ineligible to obtain bank guarantees. 
2. Lack of Flexibility: Since most of the financial guarantee’s sums are pre-determined for a limited period as prescribed in the contract, they are quite inflexible for any changes to be made later. 
3. Complexity in the transaction: Including a financial institution in a transaction between borrower and creditor adds complications to the process which could add an extra layer of complexity and bureaucracy.
4. Time-Consuming Process: Banks need to do a thorough evaluation of the party at the borrowing including its business model, business viability, financial health, etc, and more before approving the guarantee request. Hence, sometimes the process may be longer and time-consuming. 
5. Difficult to Obtain: Needless to mention, banks may only agree to provide bank guarantees in a seamless manner in cases where a business has robust financials and a viable business model. Therefore, for businesses dealing with financial struggles and witnessing uneven cash flows, or individual or business entities with inadequate or no credit history, the process could be challenging similar to bank loans. 
6. Banks may seek collateral: Many times, banks may also seek collateral from the borrower individual or entity to warrant repayments which may sometimes be as high as the total sum of the guarantee which could discourage borrowers from seeking bank guarantee. In this situation, the only advantage is that the borrower doesn’t have to liquidate the investment but could pledge to receive funding. Lack of collateral may sometimes also cause banks to reject the application altogether. 

Bank Guarantee vs Corporate Guarantee

Bank Guarantee vs. Letter of Credit 

Bank Guarantee vs Personal Guarantee 

Final Thoughts 

Therefore, getting a bank guarantee helps the beneficiary to minimize risks against any losses or damage happening due to the failure of performance on the part of the borrower. Hence, businesses with a bank guarantee have significantly higher chances to efficient cash flow management, lower working capital costs, better credibility, build long-lasting business relationships and improve their creditworthiness, and grab potential growth opportunities.