A bank guarantee serves as a promise from a commercial bank that it will assume liability for a particular debtor if its contractual obligations are not met. In other words, the bank offers to stand as the guarantor on behalf of a business customer in a transaction. Most bank guarantees carry a fee equal to a small percentage amount of the entire contract, normally 0.5 to 1.5 percent of the guaranteed amount.
Applying for a Bank Guarantee
Bank guarantees are not limited to business customers; individuals can apply for them as well. However, businesses do receive the vast majority of guarantees. In most cases, bank guarantees are not particularly difficult to obtain.
To request a guarantee, the account holder contacts the bank and fills out an application that identifies the amount of and reasons for the guarantee. Typical applications stipulate a specific period of time for which the guarantee should be valid, any special conditions for payment and details about the beneficiary.
Sometimes the bank requires collateral. This can be in the form of a pledge agreement for assets, such as stocks, bonds, or cash accounts. Illiquid assets are generally not acceptable as collateral.
How Bank Guarantees Work and Who Uses Them
There are several different kinds of bank guarantees, including:
- Performance guarantees
- Bid bond guarantees
- Financial guarantees
- Advance or deferred payment guarantees
Bank guarantees are often part of arrangements between a small firm and a large organization—public or private. The larger organization wants protection against counterparty risk, so it requires that the smaller party receive a bank guarantee in advance of work. A variety of parties can use bank guarantees for many reasons:
- Assure a seller that a purchase price will be paid on a specific date.
- Function as collateral for reimbursing advance payment from a buyer if the seller does not supply the specified goods per the contract.
- A credit security bond that serves as collateral for repaying a loan.
- Rental guarantee that serves as collateral for rental agreement payments.
- A confirmed payment order is an irrevocable obligation, in which a bank pays the beneficiary a set amount on a given date on the client’s behalf.
- Performance bond that serves as collateral for the buyer’s costs incurred if services or goods are not provided as contractually agreed.
- Warranty bond that functions as collateral, ensuring ordered goods are delivered, as agreed.
Differences Between Bank Guarantees and Letters of Credit
Letters of credit are usually used in international trade agreements, while bank guarantees are often used in real estate contracts and infrastructure projects.
Bank guarantees represent a much more significant commitment for banks than letters of credit. A bank guarantee, like a letter of credit, guarantees a sum of money to a beneficiary; however, unlike a letter of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.