What is Bank Guarantee? Meaning, Types | Charges and Process

Bank Guarantee:

bank guarantee
When the Central Government/ State Government or large companies float a tender or offers to purchase goods/ services/ equipment or any other instruments, the small vendors/ supplier or firms require to provide assurance from banks to ensure responsibility of vendors/ firms towards the tender or trade. The banks provide the guarantee of performance regarding trade or services on behalf of its customers.

Table of Contents:
  • What is the Bank Guarantee?
  • Types and Usage of Bank Guarantee.
  • Bank Guarantee Features.
  • Bank Guarantee Process.
  • Bank Guarantee Charges.

What is the Bank Guarantee?

“A Bank Guarantee refers to assurance/ guarantee provided by a bank on the behalf of its customers
(buyers/ service providers) to the third party (sellers/ tendering agencies) from which buyer purchases goods or offers to provide services.”
In other words, the Bank Guarantee is a type of financial document under certain conditions ensuring the financial obligation of the debtor will be fulfilled otherwise the bank will itself responsible to settle the liabilities of the debtor to the beneficiary.
The Bank Guarantee is issued for a certain amount as well as period of time on the behalf of its customers against equivalent securities such as FD or deposits as collateral. The bank charges fees to issue a bank guarantee.

Types and Usage of Bank Guarantee:

types of bank guarantee
The Bank Guarantee is classified according to the purpose and nature of trading and services. First, if bank guarantee is issued to help the trade of goods between two firms or individuals and the second one is used to perform any government contracts by the tendering companies or firms.

Financial Guarantee:

Financial bank guarantees are used during the sale or purchase of goods or commodities between two parties on a credit basis. If the buyer wishes to purchase some goods but doesn’t have ready cash to pay, he will approach to the bank to issue a bank guarantee to the supplier so that he can purchase the goods on credit. Such a bank guarantee is known as Financial Guarantee.
The financial bank guarantee assures the seller to supply the goods to the buyer on credit. Hence facilitates the transaction where the trust issues of buyer hesitate the seller to perform the deal.

Foreign Bank Guarantee:

If the bank guarantee issued during cross-border/ export and import between two parties, such types of bank guarantees is known as Foreign Bank Guarantee. The trustworthiness of buyer matters a lot during international trade because of distance and different legal requirements in case of any dispute. Hence the Foreign Bank Guarantee plays a vital role in international trade between two parties.

Deferred Payment Guarantee:

When the Bank Guarantee is issued of higher amount rather than actual billing amount, this is because the supplier charges the interest rates as well for the credit period. Such bank guarantees are known as Deferred Payment Guarantee.
The Bank Guarantee is classified on the basis of different states in the tender of Governments are as follows.

Bid Bond/ EMD (Earnest Money Deposit):

Bid Bond bank guarantee generally used when the government agencies or reputed companies issue tender regarding the purchase of products or services. The bid bonds of some proportion of tender value are required to participate in the tendering process.
In other words, the companies or vendors which want to participate in the tender, submit a bank guarantee of a few percentages of the tender value. Such bank guarantees are known as Bid Bond bank guarantees.
Let us consider an example to understand the above concept more clearly.
Example:
Suppose the Government of India has to construct a flyover in the city which can cost Rs 100 crores approximately. Hence the government will issue a tender notice and invite bids for the project. The Government demands a Bid Bond of 1% of the total tender value (Rs 1 crore) to participate in the tender.
Thus the constitution companies will approach their banks to issue a bank guarantee of Rs 1 crore. This bank guarantee is known as Bid Bond.

Advance Payment Guarantee:

This bank guarantee is issued when the companies require to take an advance payment from the tendering agency to initiate the awarded project.
Suppose a company X is allotted the above tender of Rs 100 crores. Now the company X needs immediate funds of Rs 10 crores to start the project. Hence the concerned department of the government of India will pay the advance funds (Rs 10 crores) but against a bank guarantee of 10 crores. Such bank guarantees are known as Advance Payment Guarantee.

Performance Bank Guarantee:

This bank guarantee is required to ensure the satisfactory performance of the company which has been awarded the tender. The tendering agencies advise the company to provide a bank guarantee of some proportion of tender value to ensure performance and minimize the risk if the company deny completing the project. Such a bank guarantee is known as Performance Bank Guarantee.
Let us continue with the above example. Suppose the company X is awarded the project. Now the tendering agency asks to provide a bank guarantee of 15% of the tender value. Therefore, the company X approaches to its bank to issue a bank guarantee of Rs 15 crores (15% of tender value). Thus such a bank guarantee is called Performance Bank Guarantee.

Bank Guarantee (BG) Features:

  • The Bank Guarantee minimizes the risks associated with payment recovery during trading of product or services and avoids the trust issues between buyer and seller.
  • Therefore, BG encourages the domestic, as well as international trade on credit basis as the liabilities of the buyer, is backed up by the banks.
  • Since BG is issued for a specific time period (3months, 5 months … up to 10 years), a specific value in favour of any individual or company or the government hence can be used for any purpose accordingly.
  • The banks usually charge nominal fees therefore small scale enterprise can also be benefited by the services offered under a bank guarantee.
  • The process of issuing a bank guarantee is hassle-free if the credential of business is appropriate, hence increase the business opportunities globally.
  • Most of the bank guarantee required lesser documents so processed quickly if all document are correct and submitted successfully to the banks.

Bank Guarantee Process:

The bank guaranty facility is not only for business organisations but also for an individual. Typically one who required to obtain a bank guarantee has to approach his bank or other banks which offers these facilities and fill the application form including necessary details like amount, beneficiary name, purpose and time-period of BG.
The banks would evaluate the previous track records (Repayment history), the creditworthiness of company or individuals (applicants), CBIL score and financial statements of the organisations etc to determine whether to approve the BG application or not.
The banks also examine the period, value, beneficiary details and purpose and under some circumstances bank can also require some securities such as bonds, FDs, mutual funds or cash before issuing a bank guaranty.

Bank Guarantee Charges:

The banks charge fees to issue a BG which generally depend on the risk predicted, nature and purpose of bank guarantee. This means if the bank assumes more risk, the charges of issuing a BG could be slightly higher than a low-risk assumed BG.
The fees are charged on a quarterly basis generally varies from 0.5 % to 0.75% of BG value depending upon the types of the bank guarantee. The banks also might charge an application fee, processing fees or documentation fees as well.
Final Words:

Hope you have gone through the above article and will be able to understand the whole concept of the Bank Guarantee. Thus it can be concluded that a BG eliminates the risk of defaults or damage of the merchants during a business trade. Hence it provides opportunities to the merchants to expand their business locally as well as globally.

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