Some facts related to bank guarantees

Dear Friends,

As you are aware that Bank Guarantee is a promise made by a Bank/Financial Institution to any third person to undertake payment risk on behalf of its customers. A BG is a irrevocable undertaking by a bank to pay certain sum of money to the beneficiary in the event of non-compliance /fulfillment of commitment by the client/borrower as spelt out in the guarantee within the specific period of time. It is generally issued on request of a customer of a bank/financial institution in favour of third party to protect third party in business or financial transactions with the requesting customer of the bank. The BG as a Financial Instrument is generally used as a surety and provide confidence of a big or large manufacturer or seller to deal with small and new clients. Since a large manufacturer generally wants a BG from small seller bank to protect its payment in case of dealing with new and small client.

A bank guarantee or also known as BG is a legal document issued by a bank or a financial institution to assure exporters/sellers/suppliers that they would be paid on time if the applicant/importer/buyer fails to pay the amount or fulfill the terms & conditions mentioned in the contract. Here, the issuing bank or the financial institution acts as a guarantor for the exporter to pay him with the whole or remaining amount as the case may be.

In other words, a bank guarantee is a legal promise made by an issuing bank or a financial institution to the exporters on behalf of their applicants that in the event if the importers are at default, they would be paid on time with a full-fledged amount by the issuing bank. It assures the exporter that they will get their amount for the delivered goods & services to the importer.

MAIN INGREDIENTS OF A BANK GUARANTEE

1. In a bank guarantee, a bank guarantee service provider promises to cover the loss if an applicant defaults on the loan or performance;
2. A bank guarantee is always issued for a specific amount;
3. The purpose of the guarantee is clearly stated in the bank guarantee agreement;
4. They are valid only for a specifically defined period;
5. There are additional risks for the lender in BG service, so these loans are issued with greater costs or interest rates.

Bank Guarantee such as Letter of Credit Facility, constitutes a good source of fee-based income for the bank. Bank Guarantee attracts risk weight and capital requirements as per BASEL Guidelines. Risk base is the fun action not only of external rating but also type of bank guarantee issued.

LET’S CONSIDER AN EXAMPLE

An exporter called ABC Ltd enters into a contract with an importer called XYZ ltd and requests for issuing a bank guarantee to secure its risk of non-payment. The importer approaches its bank to issue a bank guarantee on his behalf to the supplier. If the issuing bank finds the credit history and financial stability of the applicant appropriate, it issues a BG to the importer. Now if the importer makes any default in paying or fulfilling the terms & conditions of the BG contract, the supplier can recover the amount from the issuing bank. The bank here undertakes the responsibility to pay the exporter if the importer is unable to do so.

The bank guarantee facility is required by a business entity as part of its business and also to avoid outlay of cash such as Earnest Money Deposits (EMDs), retention money etc., These cash outlays can be replaced by bank guarantees by providing Cash Margins/Collaterals. Bank Guarantee may be required by a manufacturer or a service provider in favour of beneficiaries such as Customs/Excise Authorities , and release of retention money.

A Bank Guarantee constitutes “ Contingent Liability” for the bank due to the fact that through initially there is no outlay of funds , the bank is liable to honour the payment as per terms of the bank guarantee in the case of default by the borrower or buyer or seller in fulfilling the covenants of the guarantee.

TYPES OF BANK GUARANTEE

A bank guarantee is issued for a specific amount with a predetermined period under which the guarantee given by the bank applies to the contract.

Let’s understand the different types of bank guarantees. Here they are as follows:

1. FINANCIAL BANK GUARANTEE

Are direct credit substitutes wherein bank irrevocably undertakes to guarantee the repayment of a contractual financial obligation. By issuing a financial bank guarantee, the bank or a financial institution promises the exporters that the financial obligations of the BG contract will be met by the bank in case the importer is unable to pay the exporter for their rendered services.

These guarantees are generally issued in exchange for security deposits where a financial commitment is required from the importer. It means the importers can pay the exporters with a financial bank guarantee instead of depositing the money. The Financial BG generally issued by bank/financial institution for their creditworthy clients on the basis of history and relationship with the bank. Generally, Banks/Financial Institutions issued Financial BG against 100% or 110% FD or other Deposits by the client with the bank. In case of known clients or a client which has good relationship with the bank and the bank know his/her creditworthiness, then Financial BG will be issued by taking marginal money @10 to 15% of the Bank Guarantee Amount. The Financial Guarantees essentially carry same risk as a direct extension of credit, that is the risk of loss is directly linked to the creditworthiness of the counterparts against whom a potential claim is acquired

SOME EXAMPLES OF FINANCIAL GUARANTEES

1. Guarantee for Credit Facilities;
2. Guarantee in lieu of repayment of financial securities;
3. Guarantees in lieu of margin requirements of exchanges;
4. Guarantee for mobilisation advance, advance money before the commencement of a project and for money to be received in various stages of project implementation;
5. Guarantees towards revenue dues, duties, levies etc., in favour of tax/ customers/port/excise authorities and for disputed liabilities , in case of litigation pending in court;
6. Credit Enhancement;
7. Liquidity facilities for securitisation transactions;
8. Acceptances;

2. PERFORMANCE BG

Are essentially transaction-related contingencies that involve an irrevocable undertaking to pay a third party when the counterparts fails to fulfil or perform a contractual non-financial obligation. In such transactions, the risk of loss depends on the event that need not necessary be related to creditworthiness of the counterparts involved. A performance bank guarantee is issued by a bank or a financial institution to assure that the terms & conditions of the BG contract will be fulfilled by the bank in case the importer makes a default. In simple words, the bank will pay the compensation to the exporter if the ordered goods or services are not delivered on time as mentioned in the contract. To avail of a performance guarantee, the buyer is required to submit proof about the same.

This type of Performance Guarantee generally issued in case of various types of projects ,such as construction, turnkey, real estate, etc. , in these projects a client who is new for a company or customer required to submit with its bid or papers a Performance Guarantee by its bankers that in case of non-performance or non-completion of projects within time the banker or the financial institution will compensate the customer for monetary loss to the customer.

Here bank guarantees performance of its client , and Performance Guarantee will be issued on the basis of relationship and history of client and their performance in earlier projects by the bank.

SOME EXAMPLES OF PERFORMANCE GUARANTEES

1. Bid Bonds;
2. Performance Bonds and Export Performance Guarantee;
3. Guarantee in lieu of Security Deposits/EMDs for participating in tenders;
4. Retention Money Guarantee;
5. Warranties, indemnities , and standby letters of credit related to a particular transaction.

3. ADVANCE PAYMENT GUARANTEE

An Advance Payment Guarantee is issued by the bank when the seller is paid with an advance amount. According to BG terms, if the seller is unable to deliver the goods or services to the buyer as mentioned in the contract, the buyer will be returned or recovered with the advance payment made to the seller.

4. BID BOND GUARANTEE

A bid bond guarantee is issued to safeguard the interest of the owner while inviting bidders to bid on a construction project being held by him. Under this type of guarantee, the owner is assured that the bidder will undertake the contract as per the mentioned terms & conditions. In case if the bidder defaults, the owner of the project will be compensated by the bank.

5. DEFERRED PAYMENT GUARANTEE

This type of guarantee is issued when there is a payment being paid in installments that are deferred or delayed such as the purchase of goods or machinery, etc. The buyer’s bank undertakes the payment risks for the seller.

6. FOREIGN BANK GUARANTEE

A Foreign bank guarantee is issued by a bank for a foreign beneficiary.

PLEASE NOTE THAT

1. Banks assess bank guarantee facility with the same rigor as with fund-based limits. Security available for fund-based facilities such as Cash Credit or WDCL , is extended to Letter of Credit and Bank Guarantee facilities also. In this case we cannot say that in case of Bank Guarantee there is no outlay of funds.

2. The process of obtaining a Bank Guarantee is the same as other financial facilities from the banks. The banks before issued a BG generally access the Creditworthiness of the client, banking history, CIBIL score and CRISIL Ratings ( if available) etc., according to their norms for issuing of BG. The banks along with history and creditworthiness of client also keep in mind the capacity , the commitment, experience of management in case of performance guarantee , the BG period and the amount involved in the BG. They also access various risk factors before issuing any BG to the client.

3. As in case of Letter of Credit (LC) , banks issue bank guarantee for a finite period only. Banks normally issue guarantee for a period of one -to- three years , but there can be deviations in case of guarantees based on thee requirements of specific cases.

4. The security that is available to banks for sanctioning Working Capital limits is

• Charge on inventory and receivables;
• Charge on fixed assets;
• Charge on other collaterals available is extended to non-fund based limits.
• Bank generally also insists on the client to deposit cash margin or for new one deposit full amount of Bank Guarantee by way FDs.

5. The charges that a BG service provider charges for the issue generally depends on the level of risk being borne by them. For example, a Financial BG contains more risks than a performance BG, hence they are expensive and are available with a higher fee. Depending on the type of BG, fees are usually charged on the BG value every quarter. Apart from this, you may also be charged with an application fee, documentation fee, and handling fee, etc.

CONCLUSION

A Bank Guarantee plays a vital role to prove creditworthiness and performance of a client in which behalf Bank Guarantee has issued. Since BGs are issued on the basis of rigorous study and keeping in mind various aspects and only after satisfying that the client will fulfil his commitments under a contract or BG Agreement. This means that a BG proves sound financial position of a client before the world. A seller against a BG from the buyers’ bank freely export of sale his/her/its goods ,without fearing the creditworthiness of the buyer or his financial position , because the buyers’ bank is acting as surety of payment to the seller in case of default made by buyer. In case of Performance BG a customer ( government departments, big real estate projects, turnkey projects etc.) may allot work to new contractor on the basis of Performance Guarantee given by his bank. The Bank Guarantee facility is a non-fund based facility and generally there is no outlay of funds of client against whom BG is issued. This is a good and better way of finance and surety provided by banks to their clients.

SOME ADVANTAGES ARE

1. A BG reduces financial risk;
2. Being a low risk instruments helps seller or buyer to expand their business and credit period of their business transaction;
3. The charges are low based on the banking norms and less documents are required for issue of a BG, than other facilities;
4. The BG will be issued on the basis of rigour scrutiny of business transactions, creditworthiness and history of a client is a certificate of proof that client has a good creditworthiness and is in a sound financial condition;

DISCLAIMER: The article produced here is only for information and knowledge of readers. The views expressed here are personal views of the author and same should not be considered as professional advise. In case of necessity do consult with professionals.