Why Use Bank Guarantees in Long-Term Project Contracts?

When it comes to managing the risk and safety of long-term projects, a bank guarantee promises that if the company carrying out the project defaults on any of its loans, the bank will cover the costs or losses. This guarantee work clause increases the confidence of the vendors who need to give large amounts of their products or services, usually on credit, to complete their part of the project.

Key Takeaways

  • In a long-term project, vendors usually have to make a significant outlay of either materials or money (usually on credit) before getting paid for the completion of a project.
  • Bank guarantees are extended by banks in long-term projects to provide vendors with comfort if the project management company defaults or closes operations before the vendor is paid.
  • A bank guarantee is a promissory provision on a loan indicating that if the borrower of the loan defaults on repayment, the bank will cover the amount of default.
  • Bank guarantees make it possible for a project to move to the next stage, allowing multiple companies to work together to complete a large-scale project.

The Importance of Bank Guarantees

A bank guarantee is essentially a promissory provision on a loan indicating that if the borrower of the loan defaults on repayment, the bank will cover the amount of default. This is a crucial provision to convince multiple companies to work together to complete a long-term project.

This guarantee work clause can be essential for allowing a project or venture to move to the next stage. With the backing of the bank, all parties are covered in the worst-case scenario, if payments do not come through.

Financial Bank Guarantee

There are a variety of bank guarantees that can be taken out for various circumstances. The bank guarantee that makes the most sense for vendors for long-term projects is a financial bank guarantee.

A financial bank guarantee ensures that the vendor will be paid if the company managing the project that hired the vendor is not able to do so. In this scenario, the bank will cover the financial burden. Exactly what is covered in the guarantee will depend on what is agreed upon by the vendor and the project management company.

The amount of the bank guarantee can be included in the bid that a vendor provides to a project management company.

This can include covering the cost of the materials already bought, work already performed, and possibly the entire cost that the vendor was hired for because it could not take on other jobs due to contracting with this specific job. The more money in the guarantee the more of a fee the project management company will have to pay for it.

Example of a Bank Guarantee

For example, if a construction company takes on the long-term project of building an office tower, that company needs to hire vendors and subcontractors to complete the project. In this example, the construction company that's overseeing the project could specialize in framing the office building, but it needs to subcontract with another company to install the thousands of window panes needed to complete the project.

The construction company might not be paid for its work until the end of the project. It needs to hire the window installation company on credit through a loan since the thousands of window panes could cost more than a million dollars. This puts a lot of risk on the window installation company. The project could take longer than anticipated, or it could be scrapped due to a lack of funding from the group paying for the construction of the office building.

Having a bank guarantee in place reduces the risk to the window installation company because it knows that, no matter what happens, it will receive payment.

What Are the Types of Bank Guarantees?

There are different types of bank guarantees for different purposes. The most common types of bank guarantees are financial bank guarantees, performance bank guarantees, advance or deferred payment bank guarantees, and bid-bond bank guarantees.

What Is the Advantage of a Bank Guarantee?

The primary advantage of a bank guarantee is the reduction of financial risk. A vendor can feel comfortable in growing its business and taking on a project, which is usually done via credit (taking out loans) with the knowledge that if the company that hired them can't make payment, the bank guarantee will cover any liabilities.

What Is the Risk of a Bank Guarantee?

There is zero risk of a bank guarantee. The total risk of a bank guarantee lies with the bank that issued the guarantee. If a bank guarantee is exercised, the beneficiary receives payment and the payment comes from the bank. The applicant of the bank guarantee does have to pay a fee for having a bank guarantee issued, but otherwise is not liable for any costs.

The Bottom Line

Long-term projects, such as construction projects, are large in scale and costly. They require many vendors to work together to complete a specific goal. Projects can run out of money, go over budget, or shut unexpectedly, possibly leaving vendors out of money if they've already begun work.

Bank guarantees provide comfort to vendors for any foreseeable financial loss and allow projects to move forward to completion.

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