A Bank Guarantee is an assurance from a financial institution that, if one party defaults on their debt or obligations, they will cover the loss of the other.
The Key Takeaways
- A bank guarantee guarantees that, in the event of a party failing to meet their obligations or debts with whom you are under contract, a bank would cover your loss.
- Bank guarantees come in different forms, such as shipping, advance payment, deferred payment and loan guarantees.
- A bank will not intervene in a letter-of-credit unless a party fails to meet their obligations or debt.
Definition and examples of a bank guarantee
A bank guarantee is a contract between a lender and two parties. Usually, this would be a buyer or a seller. The bank guarantees the debt if the other party fails to do so. Bank guarantees can encourage small and startup businesses to explore new business opportunities and take on risks that they would not otherwise be able.
Imagine you are a furniture maker and that your usual vendor is local. You’re approached one day by a vendor from another country who offers you an amazing deal. You’re looking to save money so you go ahead with the vendor.
You ask the vendor to provide a bank guarantee to the contract in order to reduce the risk associated with doing business with an unfamiliar firm. You can sue the bank who provided the guarantee if the new vendor does not deliver on their promises.
Note:
A bank guarantee may give the buyer more confidence but it can also complicate the contract between buyer and seller.
How a Bank Garanty Works
A bank guarantee is a contract. In the contract, a party may promise to repay a debt or provide a certain service. The bank will fulfill the contract if the debt or obligation isn’t met.
The bank guarantee will specify a certain amount and time frame. The bank guarantee will clearly state the bank’s responsibilities and what it will do in case a party defaults or does not provide a service.
Bank guarantees can be affordable. Most banks charge between 1.5% and 2.5% for transactions that are high-risk or of high value. The bank may require that you provide collateral, or that you use an asset you own.
Note:
U.S. Banks offer standby letters instead of bank guarantees. Standby Letters of Credit is a legal document that banks use to guarantee payment to a seller in the event the buyer does not follow through on the agreement.
Bank Guarantees Types
There are several different bank guarantees. These include:
- Shipping Guarantees: These are given to carriers when shipments arrive without any documentation.
- Loan Guarantees: The lender promises to cover the costs of a loan default if the borrower does not repay it.
- Advance payment guarantees : If a seller fails to deliver goods to the buyer, this guarantee reimburses their payment.
- Guarantees of deferred payments: These promises are for deferred payments.
Bank Guarantee vs. Letter of Credit
Banks will usually only intervene if a buyer does not meet his or her obligations. A bank is unlikely to intervene after one late payment or project delay. A letter-of-credit allows the buyer or seller to make a claim against the bank.
A letter credit is a more involved and can give you peace of mind. You know that your debt will be paid on time, or that the obligations will be met. A bank will take a more passive approach when it comes to bank guarantees. Before they can get involved, there must be proof of non-fulfillment.
