Bank guarantees are part of non-fund-based credit facilities provided by the bank to the customers. Bank issue bank guarantee on behalf of his client as a commitment to third party assuring her/him to honour the claim against the guarantee in the event of the non-performance by the bank’s customer.
Banks issue different types of guarantees, on behalf of their customers
- Financial Guarantee: The banker issues guarantee in favour of a government department against caution deposit or earnest money to be deposited by bank’s client. At the request of his customer, in lieu of a caution deposit/earnest money, the banker issues a guarantee in favour of the government department. This is an example of a Financial Guarantee. This type of guarantee helps the bank’s customer to bid for the contract without depositing actual money. In case, the contractor does not take up the awarded contract, then the government department would invoke the guarantee and claim the money from the bank.
- Performance Guarantee: Performance Guarantees are issued by banks on behalf of his client to assure the third party to complete some work on time or as per the terms of contract between the parties. If the work is not completed as per the term of contract then the third party can request the bank to invoke the bank guarantee and make payment for default.
- Deferred Payment Guarantee(DPG): It is clear from the name of the Bank guarantee that under this guarantee, the banker guarantees payments of instalments payable by the buyer of capital goods such as machinery, on long term credit given by the supplier. Normally advance payment of 10 to 15% of the price of the capital goods is made by the borrower(margin). The balance amount with interest is payable in instalments spread over may be 1 to 5 years.
Some of the purposes for which Bank Guarantees are issued are:
- Due performance of a specific contract undertaken by a customer in favour of Govt. bodies, for e.g Supply of materials, Construction of Roads, Buildings, Dams, Civil Work, etc.
- To secure any claims by the buyer on the seller arising from default in delivery or performance of the terms of the contract(e.g. construction, assembly, execution).
- Due performance of an equipment/project after completion for a specific period due to possible defects appearing after delivery during warranty period of the equipment.
- Execution of Long- Term Infrastructure Projects such as Seaports, Airports, Road Construction, Bridges, Sanitation and Sewerage Projects, Telecommunication Services, Construction of Educational Institutions and Hospitals, Generation/ Transmission/ Distribution of Power, etc.
- Deferred Payment Guarantee: It is clear from the name of the Bank guarantee that under this guarantee, the banker guarantees payments of instalments spread over a period of time.
Bank Guarantee vs Letter of Credit
- A bank guarantee is a promise made by a lending institution that the bank will step up if a debtor is unable to repay a debt.
- Letters of credit, which are financial promises made on behalf of one party in a transaction, are particularly important in international trade.
- Bank guarantees are frequently used in real estate contracts and infrastructure projects, whereas letters of credit are mostly used in international transactions.
Bank guarantees and letters of credit both work to reduce risk in a business agreement or transaction. When a letter of credit or bank guarantee is in place, the parties are more likely to agree to the transaction.
These agreements are especially important and useful in transactions that would otherwise be risky, such as certain real estate and international trade contracts.
Clients who are interested in one of these documents are thoroughly screened by banks. A monetary limit is placed on the agreement after the bank determines that the applicant is creditworthy and poses a reasonable risk.
The bank agrees to be obligated up to the limit but not beyond it. This protects the bank by setting a specific risk threshold.
Another significant distinction between bank guarantees and letters of credit is the parties who use them. Contractors who bid on large projects typically use bank guarantees. The contractor demonstrates its financial credibility by providing a bank guarantee.
In essence, the guarantee assures the entity behind the project that it is financially stable enough to take on the project from start to finish. Letters of credit, on the other hand, are commonly used by businesses that import and export goods on a regular basis.