What is Bank Guarantee? – Different Types of Guarantees

The scope of trade has been widely expanded in the modern world. There are many kinds of organizations, private and public which trade with each other.

A lot of the time, trades happen between big and small organizations and sometimes these trades happen when both parties are present in different countries.

In such cases, there is a likelihood that the business owner will be exposed to different types of credit risks.

The presence of these credit risks has provided commercial banks with an opportunity to expand their business and provide more value-added services to their customers.

A Bank guarantee is a type of banking product that is offered by commercial banks to help their customers deal with the problem of credit risks.

In this article, we will understand what a bank guarantee is and what are the different types of bank guarantees offered by commercial banks.

What Is a Bank Guarantee?

In order to understand the concept of bank guarantee, we first need to understand the concept of credit risk. Whenever one party provides goods or services to another party on credit, there is always a risk of non-performance involved.

It is quite possible that businesses might not be comfortable in undertaking a contract given the credit risk profile of their counterparty.

Banks, in general, tend to have a considerably high credit rating as compared to common financial counterparties.

Hence, if the banks were to guarantee the execution of a contract by co-signing it, the chances of non-performance are reduced drastically. This is what the concept of a bank guarantee is all about.

When a bank provides a bank guarantee, it assumes the credit risk of the entire transaction. The bank is guaranteeing the beneficiary that if the corporation is not able to execute the transaction, then the bank which is a much larger and more powerful financial body will execute the transaction on their behalf.

In return for providing this credit guarantee, banks are able to charge a significant fee.

Also, since banks have good visibility of the financial position of the company that they are providing the guarantee for, they are taking a calculated risk.

If the bank feels that the corporation is not creditworthy, then they might ask for collateral before they issue a bank guarantee.

Types of Bank Guarantees

There are various types of bank guarantees which are provided by commercial banks to their corporate clients. Some of the most commonly used types of bank guarantees have been mentioned below:

1. Direct Guarantee: A direct bank guarantee is the most commonly used bank guarantee. In the case of a direct bank guarantee, there are three parties involved in the transaction viz. the bank, the bank’s customer, and the beneficiary who will receive the funds.

   In a direct bank guarantee, the bank is guaranteeing the funds to the beneficiary if certain events take place. This means that if there is proof that the performance of certain predefined tasks has taken place, then the bank will make a payment to the beneficiary if the corporate customer fails to do so.

2. Indirect Guarantee: Direct bank guarantees are generally undertaken in the case of local trade.

   However, when it comes to international trade, there is a need to involve another party. This is because a supplier in a foreign country may not be comfortable with receiving the guarantee of a local bank.

   In the case of an indirect guarantee, there are four parties involved. There is a local buyer, local bank, foreign supplier, and foreign bank.

   The process is the same as above. However, the local bank issues a guarantee to the foreign bank which then issues the guarantee to the foreign supplier.

3. Payment Guarantee: Most bank guarantees are payment guarantees. This means that the bank is guaranteeing the payment in lieu of certain goods or services once they have been delivered.

   The bank does not play a role in guaranteeing any other aspect of the contract. Their guarantee is only limited to ensuring payments after certain conditions have been met.

4. Performance Guarantee: The performance guarantee, on the other hand, is much more comprehensive as compared to payment guarantees.

   Here the bank becomes liable even if the contract is not fulfilled.

   For instance, if one company gives a contract to a second company to produce something by a given date and also gives an advance, the guaranteeing bank would have to ensure that either the required goods or services have been delivered on time or the advance is returned along with any fines and penalties decided in the contract.

   These types of guarantees are quite complex since here the bank also has to be aware of the operational capabilities of the company apart from its financial capabilities.

5. Secured Guarantee: Bank guarantees can be secured if the bank already has received the payment or collateral before signing the guarantee.

   For instance, if the corporation has pledged an immovable asset in favor of the bank in order to receive a guarantee, then there is no risk for the bank. Such a guarantee is called a secured guarantee and is relatively cheaper to obtain.

6. Unsecured Guarantee: On the other hand, banks also provide guarantees without having any collateral. Such a guarantee can be thought of as being a loan that is secured by the credit of the buyer.

   Since such bank guarantees involve significant risk for the bank, they tend to charge a hefty fee to issue such a guarantee.

   In many parts of the world, regulators have placed restrictions on the number of unsecured bank guarantees that can be issued since they have the capability to destabilize a banking system.

The fact of the matter is that bank guarantees are a very important part of a commercial banking system and will continue to remain so. They are an important tool used by banks to attract corporate customers to use their services.