What is Bank Guarantee? | Working, Types, Examples, Pros vs Cons

A guarantee means giving something as security. A lending organisation offers a bank guarantee that promises to pay for forfeiture if a debtor defaults on money or voids contract obligations within certain regulations.

The guarantee increases the company’s purchase power and, in turn, grows the business.

There are 2 primary kinds of assurances by the bank, namely direct (for the overseas transaction) and indirect (for export trading).

Key Takeaways

  1. A bank guarantee is a financial instrument used to assure a third party that a bank will pay on its client’s behalf.
  2. It is required in business transactions as collateral to minimize risks and secure payment obligations.
  3. Bank guarantees can come in various forms, such as performance, payment, and advance payment guarantees.

How does a bank guarantee work?

  1. A bank guarantee requires eligibility criteria that a person has a good financial track.
  2. The bank guarantee can be applied in any bank apart from the account holder’s.
  3. Any person who has a good financial bank record is eligible to apply for a bank guarantee.
  4. Transaction history, credit score, current assets, etc., determine the person’s eligibility criteria.
  5. Before approval, the bank also considers the bank guarantee period and beneficiary details value.
  6. In some rare cases, banks will require some form of collateral.
  7. After meeting the satisfaction criteria of the banking personnel, you’ll get the necessary approval for the guarantee.

Types of Bank guarantees:

A bank guarantee is applicable for a specific amount and a predetermined period.

Financial

The bank acts as a guarantor on behalf of the applicant. In case the applicant fails to repay, the bank repays on the behalf and charges a small initial fee.

Performance-based

The bank acts as a guarantor for completely fulfilling the contract’s obligations. In case of non-performance, the bank repays the beneficiary.

Advance payment

The bank acts as a guarantor and returns the advance payment in case of non-fulfilment of the contract terms.

Payment / Loan

The bank acts as a guarantor for payment/loan repayment. In the case of non-fulfilment of the payment, the banks pay the default amount.

Bid agreement

The bank is a guarantor for the bidder and ensures the contract is undertaken.

Foreign banks

The bank acts as a guarantor for the foreign beneficiaries.

Advantages and Disadvantages of Bank Guarantee

AdvantagesDisadvantages
Even small house-based businesses can use commercial banks. AdvantagesCommercial banking accounts are more expensive than traditional bank accounts Disadvantages.
Bank guarantee results in reducing the financial risk involved in the business transaction.The financial transactions and position of the business can be time-consuming.
Small businesses can secure loans/conduct business without worrying about potential risks.The banks don’t give a guarantee for loss-making or high-value transactions easily.  
Banks charge low fees for guarantees, 1% of the overall transaction.  Banks may need some form of collateral for certain transactions.  
The BG requires fewer documents and is processed faster by the banks.   
The transactions involving BG are considered more creditworthy.   
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The interest rate at which commercial banks can borrow money from the central bank is known as

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References
  1. https://www.manchesterhive.com/view/9781847799913/9781847799913.00016.xml
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