What is a Bank Guarantee?
A Bank Guarantee is a an assurance given by a financial institution (usually a bank) to pay on behalf of its client (buyer/importer/borrower) who is obligated to pay money to a seller of some goods and services or a lender or anyone who is to be paid for a certain transaction that is going to take place. Bank Guarantee can be claimed only when the seller has performed his part of the contract and the issuing bank’s client (buyer) has failed to make the payment.In other words, it is always the obligation of the buyer to pay for the purchase/borrowing and only if he is unable to make the payment on the date of payment, the bank guarantee can be put to use. In such a case the bank will pay the amount to the seller’s bank and later collect the amount from its client. There is no interest charged to the applicant unless the bank has had to pay the money to the seller. Bank Guarantees are issued for a commission on the contract value.
Parties involved in a Bank Guarantee
There are usually 4 parties in a BG. They are-
- A buyer/importer/borrower- the applicant
- The buyer’s/ importer’s/borrower’s bank- the issuing bank
- The seller/exporter/lender- the beneficiary
- The seller’s/exporter’s/lender bank’s- the advisory bank
But in case of large contracts like real estate and infrastructure projects the seller/builder also needs to present a Bank Guarantee from his bank to prove his credit worthiness to the purchaser to be able to perform his part of the contract without delay as these contracts require a huge amount of money to be executed efficiently.
Process of Bank Guarantee using an example
Imagine that James makes a purchase order for 1000 tables for his school from M&S. A& Co. for $20,000. M&S.A& Co. wants an assurance from James that he will not default the payment for the order. So, James goes to his bank, say, XYZ Bank and applies for a Bank Guarantee. The bank upon receiving the application does a thorough background and credit worthiness check of James and approves to issue a Bank Guarantee. James provides the details to M&S. A& Co. who then passes this on to its bank, say, ABC bank where the authenticity of the BG is verified and accepted. BG provides M&S. A& Co. to claim for the payment from XYZ Bank in case of a default by James. Now, suppose that M&S. A& Co. has delivered the tables as per the contract on time to James and he is unable to meet the payment due to some reason. Then, M&S.A&Co. makes a claim for payment from XYZ bank. After satisfying itself regarding the fulfilment of the seller’s part of the contract, XYZ Bank releases the amount. Later on, XYZ Bank collects the amount from James along with an interest on the money paid to M&S. A&Co. and a commission on the contract value for the Bank Guarantee service.
- Bank Guarantees provide a security from credit risk to the seller/exporter/lender.
- Bank Guarantees are intended to protect the interests of both the buyer and the seller as explained above regarding large scale contracts.
- Bank Guarantees are majorly used in real estate and infrastructure projects.
- The primary obligation to pay for the contract is on the buyer (applicant) while the secondary obligation to pay is on the buyer’s bank (issuing bank).