Bank Guarantee – A Comprehensive Guide

A Bank Guarantee is a way for companies to prove their creditworthiness. It promotes confidence in a transaction that will greatly encourage the process. It is a ‘promise’ to make payment to a third party under certain circumstances – such as the failure of obligations from the buyer.

In action, the Bank Guarantee is relatively simple. If for example, Company A is a relatively small construction company that needs £1million worth of equipment. The seller may request a guarantee of payment in order to feel more secure in producing/ shipping the goods. The Bank Guarantee eliminates the risk of payment-failure and encourages trade on a mass scale.

The Bank Guarantee enables companies to purchase goods from suppliers which, without it, could have denied the buyer due to the risk surrounding a transaction with no guarantee of payment.

Bank Guarantee History:

Guarantee stems from the Spanish word ‘garante’, in the 17th Century, meaning a ‘person giving something as security’.

How can a bank guarantee help a business?

A bank guarantee is a broad term and there are several types of bank guarantee that can help businesses.
As an example, a small client is dealing with a multinational company on a project. They might require some form of a promise to have the relevant financial backing to complete that project. A bank would conduct due diligence on the small company and would act as a ‘guarantor’ to the multinational company; ensuring that the small client will complete the project on certain terms.

A bank guarantee is a ‘surety bond’. This bond is often addressed to a larger institution by which the bank pledges (and contractually agrees) to pay an agreed amount under particular conditions.

What is Different from a Letter of Credit?

Although Letters of Credit and Bank guarantees are similar, as both revolve around instilling confidence in the transaction, they do have dividing elements. The main difference, however, is that an LC ensures that a transaction goes ahead, whereas a BG reduces any loss incurred if the transaction does not go ahead.

Benefits of bank guarantees

• A Bank Guarantee allows SME’s to provide current and potential suppliers reassurance they can meet their financial obligations.
• Bank Guarantees offer financial credibility, being backed by a large institution such as a bank.
• Because the BG can be paid in different currencies, terms of the contract can be negotiated upon worldwide.

Types of bank guarantees

• Advanced Payment Guarantee – typically ensures the performance of a commercial contract.
• Loan Guarantee – promises to assume the debt obligation of the borrower if they face default.
• Performance Guarantee – ensures the full and due performance of the contract in line with the original contract.
• Deferred Payment Guarantee – this is a promise for a payment which has been postponed.
• Shipping Guarantee – a written guarantee which shows joint liability. Furthermore, it will be presented by the importer to the carrier in the event of goods arriving before the documents.
• Trade Credit Guarantee – This covers the providers of a good/ service against the risk of non (or late) payment.

Obtaining a Bank Guarantee:

To access a Guarantee, applicants must demonstrate creditworthiness to their bank. The bank would normally look at previous trading history, recent accounts, credit history, and liquidity. The bank would need to know how long the bank guarantee is required, the amount, currency, and beneficiary details. This is generally speaking of course, different guarantees will require different documentation. Moreover, a bank might ask for some security over the guarantee (e.g. liquid assets such as property or equipment it holds, and maybe a personal or directors guarantee).

It is important to note that in most cases, the business will use the Bank that holds it’s assets as it is often quicker due to the bank knowing the financial nature of the business.

The actual process is as follows:

• The BG applicant enters into a contract with a supplier (beneficiary) and establishes a Bank guarantee is required.
• The applicant goes to their bank and requests they raise a guarantee in favor of the beneficiary (supplier).
• The issuing bank will notify the bank of the beneficiary through paper and digital form.
• Once the beneficiary bank receives this, it will advise it’s client. The client will then go ahead happy and secure with the transaction.

Want to find out more about how a Bank Guarantee could work for your business? If you’re looking for a funder or bank to provide some form of guarantee or act as a guarantor on behalf of your company to allow you to fulfil larger contracts, offer confidence to an end buyer and grow, get in touch with our team or fill out the form here

BANK GUARANTEE

A Bank Guarantee is an alternative to providing a deposit or bond directly to a supplier or vendor.  It is an unconditional undertaking given by the bank, on behalf of our customer, to pay the recipient of the guarantee the amount of the guarantee on written demand.

Bank Guarantees require security in the form of cash held on deposit with the bank, or real estate of a type and value acceptable to the bank.

FEES

An Establishment Fee is payable once only on the day the bank issues the Bank Guarantee. An ongoing Service Fee is payable in advance every six months for the duration of the Bank Guarantee.  These fees can be automatically debited from your transaction account.

BENEFIT OF BANK GUARANTEE

What are the benefits of a Bank Guarantee?

1. You can meet your contractual obligations to a supplier or vendor, whilst having the comfort of your cash being held on deposit in your name with the bank. 

2. Deposit funds held as security for a Bank Guarantee attract prevailing credit interest rates on the full amount of the deposit, with interest earned paid to your nominated  transaction account.  If you prefer to offer real estate as security, speak to a banking representative for more information about this option.

3. A Bank Guarantee can have an expiry date after which the guarantee automatically ceases. Alternatively, it can be open-ended, providing maximum flexibility where completion dates are not certain.  The vendor or supplier will advise you whether they require the Bank Guarantee to have an expiry date or to be open-ended.

4. For the supplier or vendor, a Bank Guarantee assures them of payment if they make a written demand to the bank on the Bank Guarantee.* There is no need for them to hold or manage individual bonds from their customers.

UNSECURED VS SECURED DEBTS: WHAT IS THE DIFFERENCE?

                    UNSECURED VS SECURED DEBTS: WHAT IS THE DIFFERENCE?

Loans and other financing methods available to consumers fall under two main categories: secured and unsecured debt. The primary difference between the two is the presence or absence of collateral—that is, backing for the debt, or something to be taken as security against non-repayment.

                          Unsecured Debt
Unsecured debt has no collateral backing: It requires no security, as its name implies. If the borrower defaults on this type of debt, the lender must initiate a lawsuit to collect what is owed.

Lenders issue funds in an unsecured loan based solely on the borrower's creditworthiness and promise to repay. Therefore, banks typically charge a higher interest rate on these so-called signature loans. Also, credit score and debt-to-income requirements are usually stricter for these types of loans, and they are only made available to the most credible borrowers.

Outside of loans from a bank, examples of unsecured debts include medical bills, certain retail installment contracts such as gym or tanning-club memberships, and the outstanding balances on your credit cards. When you acquire a piece of plastic, the credit card company is essentially issuing you a line of credit with no collateral requirements. But it charges hefty interest rates to justify the risk.

Because one's investment is backed only by the reliability and credit of the issuing entity, an unsecured debt instrument like a bond carries a higher level of risk than its asset-backed counterpart. Because the risk to the lender is increased relative to that of secured debt, interest rates on unsecured debt tend to be correspondingly higher.

However, the rate of interest on various debt instruments is largely dependent on the reliability of the issuing entity. An unsecured loan to an individual may carry astronomical interest rates because of the high risk of default, while government-issued Treasury bills (another common type of unsecured debt instrument) have much lower interest rates. Despite the fact that investors have no claim on government assets, the government has the power to mint additional dollars or raise taxes to pay off its obligations, making this kind of debt instrument virtually risk-free.

     *****An unsecured debt instrument like a bond carries a higher level of risk than its asset-backed counterpart.*****

                        Secured Debt
Secured debts are those in which the borrower, along with a promise to repay, puts up some asset as surety for the loan. A secured debt instrument simply means that in the event of default, the lender can use the asset to repay the funds it has advanced the borrower.

Common types of secured debt are mortgages and auto loans, in which the item being financed becomes the collateral for the financing. With a car loan, if the borrower fails to make timely payments, the loan issuer eventually acquires ownership of the vehicle. When an individual or business takes out a mortgage, the property in question is used to back the repayment terms; in fact, the lending institution maintains equity (financial interest) in the property until the mortgage is paid off in full. If the borrower defaults on the payments, the lender can seize the property and sell it to recoup the funds owed.

The risk of default on a secured debt, called the counterparty risk to the lender, tends to be relatively low since the borrower has so much more to lose by neglecting his financial obligation. So secured debt financing is typically easier for most consumers to obtain. As this type of loan carries less risk for the lender, interest rates are usually lower for a secured loan.

Lenders often require the asset to be maintained or insured under certain specifications to maintain its value. For example, a home mortgage lender often requires the borrower to take out homeowner's insurance. By protecting the property, the policy secures the asset's worth for the lender. For the same reason, a lender who issues an auto loan requires certain insurance coverage so that in the event the vehicle is involved in a crash the bank can still recover most, if not all, of the outstanding loan balance.

 *Unsecured debt has no collateral backing.

*Secured debts are those in which the borrower, along with a promise to repay, puts up some asset as surety for the loan.

*The risk of default on a secured debt, called the counterparty risk to the lender, tends to be relatively low.

REPO VS REVERSE REPO

The repurchase agreement (repo or RP) and the reverse repo agreement (RRP) are key tools used by many large financial institutions, banks, and some businesses. These short-term agreements provide temporary lending opportunities that help to fund ongoing operations. The Federal Reserve also uses the repo and reverse repo agreements as a method to control the money supply.

In short, a repo is an agreement between parties where the buyer agrees to temporarily purchase a basket or group of securities for a specified period. The buyer agrees to sell those same assets back to the original owner at a slightly higher price using a reverse repo agreement.

These agreements are termed as collateralize lending because a group of securities—most frequently U.S. government bonds—secures the short-term loan agreement. Further, both the repurchase and reverse repurchase portions of the contract are determined and agreed upon at the outset of the deal.

                  Repo
A repurchase agreement (RP) is a short-term loan where both parties agree to the sale and future repurchase of assets within a specified contract period. The seller sells a Treasury bill or other government security with a promise to buy it back at a specific date and at a price that includes an interest payment.

Repurchase agreements are typically short-term transactions, often literally overnight. However, some contracts are open and have no set maturity date, but the reverse transaction usually occurs within a year.

Dealers who buy repo contracts are generally raising cash for short-term purposes. Managers of hedge funds and other leveraged accounts, insurance companies, and money market mutual funds are among those active in such transactions.

  ****A repurchase agreement involves a sale of assets. However, for tax and accounting purposes it is treated as a loan.****


               Securing the Repo
The repo is a form of collateralized lending. A basket of securities acts as the underlying collateral for the loan. Legal title to the securities passes from the seller to the buyer and returns to the original owner at the completion of the contract. The collateral most commonly used in this market consists of U.S. Treasury securities. However, any government bonds, agency securities, mortgage-backed securities, corporate bonds, or even equities may be used in a repurchase agreement.

The value of the collateral is generally greater than the purchase price of the securities. The buyer agrees not to sell the collateral unless the seller defaults on their part of the agreement. At the contract specified date, the seller must repurchase the securities including the agreed upon interest or repo rate.

In some cases, the underlying collateral may lose market value during the period of the repo agreement. The buyer may require the seller to fund a margin account where the difference in price is made up.

        The Federal Reserve Use of Repo Agreements
Standard and reverse repurchase agreements are the most commonly used instruments of open market operations for the Federal Reserve.

The Central Bank can boost the overall money supply by buying Treasury bonds or other government debt instruments from commercial banks. This action infuses the bank with cash and increases its reserves of cash in the short term. The Central Bank will then resell the securities back to the banks.

When the Central Bank wants to tighten the money supply—removing money from the cash flow—it sells the bonds to the commercial banks using a repurchase agreement, or repo for short. Later, they will buy back the securities through a reverse repo, returning money to the system.

             Disadvantages of Repos
Repo agreements carry a risk profile similar to any securities lending transaction. That is, they are relatively safe transactions as they are collateralized loans, generally using a third party as a custodian.

The real risk of repo transactions is that the marketplace for them has the reputation of sometimes operating on a fast-and-loose basis without much scrutiny of the financial strength of the counterparties involved, so, some default risk is inherent.

There also is the risk that the securities involved will depreciate before the maturity date, in which case the lender may lose money on the transaction. This risk of time is why the shortest transactions in repurchases carry the most favorable returns.

           Reverse Repo
A reverse repurchase agreement (RRP) is an act of buying securities with the intention of returning—reselling—those same assets back in the future at a profit. This process is the opposite side of the coin to the repurchase agreement and is simply a matter of perspective. To the party selling the security with the agreement to buy it back, it is a repurchase agreement. To the party buying the security and agreeing to sell it back, it is a reverse repurchase agreement. The reverse repo is the final step in the repurchase agreement closing the contract.

In a repurchase agreement, a dealer sells securities to a counterparty with the agreement to buy them back at a higher price at a later date. The dealer is raising short-term funds at a favorable interest rate with little risk of loss. The transaction is completed with a reverse repo. That is, the counterparty has sold them back to the dealer as agreed.

The counterparty earns interest on the transaction in the form of the higher price of selling the securities back to the dealer. The counterparty also gets the temporary use of the securities.

        Special Considerations
The purpose of the repo is to borrow money, yet it is not technically a loan. Ownership of the securities involved actually passes back and forth between the parties involved.

Nevertheless, they are very short-term transactions with a guarantee of repurchase. Thus, for tax and accounting purposes repo agreements are generally treated as loans.

          KEY TAKEAWAYS

The repurchase agreement is a form of short-term borrowing used in the money markets.

Although it is considered a loan, the repurchase agreement involves the sale of an asset that is held as collateral until it the seller repurchases it at a premium.

The seller is making a repurchase agreement. In money markets lingo, the buyer is making a reverse repurchase agreement.

DIFFERENT TYPES OF LETTERS OF CREDIT

Letters of credit are important assurances or guarantees to sellers that they will be paid for a large transaction, particularly with international exchanges. Think of them as a form of payment insurance from a financial institution or another accredited party to the transaction. The very first letters of credit, common in the 18th century, were known as travelers' credits. The most common contemporary letters of credit are commercial letters of credit, standby letters of credit, revocable letters of credit, irrevocable letters of credit, revolving letters of credit and red clause letters of credit, although there are several others.

            Common Types
Commercial letters of credit, sometimes referred to as import/export letters of credit, are prominent in completing international trades. The International Chamber of Commerce published a Uniform Customs and Practice for Documentary Credits (UCP), with which the majority of commercial letters of credit comply.

Standby letters of credit work slightly differently than most other types of letters of credit. If a transaction fails and one party is not compensated as it should have been, the standby letter is payable when the beneficiary can prove it did not receive what was promised. This is used more as insurance and less as a means of facilitating an exchange.

Revocable letters of credit create leverage for the issuer. It is contractually legal for one party to either amend or cancel the exchange at any time, normally without the consent of the beneficiary. These types of letters are not seen very frequently since most beneficiaries do not agree to them, and the UCP has no provision for them.

Irrevocable letters of credit are more common than revocable ones. These stipulate that no amendments or cancellations can occur without the consent of all parties involved. Irrevocable letters of credit can either be confirmed or unconfirmed. Confirmed letters require that another financial institution guarantees the payment, which is usually the case when the beneficiary does not trust the other party's bank.

Revolving letters of credit are designed for multiple uses. They can be used for a series of payments. These are common among individuals or businesses that expect to do business together on an ongoing basis. There is usually an expiration date attached to these letters of credit, often one year.

Red clause letters of credit contain an unsecured loan made by the buyer, which acts as an advance on the rest of the contract. Sometimes one party requests a red clause letter of credit to obtain the funding necessary to buy, manufacture or transport the goods involved in the transaction.

       Agreed to By Both Parties

Every letter of credit, regardless of type, is written in an official document agreed to by both parties before it is submitted to the guaranteeing financial institution for review. Before you acquire a letter of credit for any transaction, make sure that you communicate with the other party in detail before either of you submit an application. Ask for a copy of any application so that you can review the terms and conditions. Be aware of deadlines, including the expiration date of the credit and any time allowance granted between the dispatch and presentation.

Even though most letters of credit involve international exchange, they can be used to help facilitate any kind of trade. Before agreeing to back a letter of credit, a financial institution is likely to review your credit history, assets, and liabilities and attempt to identify proof that the seller has a legitimate operation. The buyer often has an existing relationship with the bank. The bank is therefore aware of the party's creditworthiness and general financial status. If the buyer is unable to pay the seller, the bank is responsible for making the full payment. If the buyer has made a portion of the payment, the bank is responsible for paying the remainder.

REASONS FOR BANK GUARANTEES AND HOW TO GET ONE

                     REASONS FOR BANK GUARANTEES AND HOW TO GET ONE

A bank guarantee serves as a promise from a commercial bank that it will assume liability for a particular debtor if its contractual obligations are not met. In other words, the bank offers to stand as the guarantor on behalf of a business customer in a transaction. Most bank guarantees carry a fee equal to a small percentage amount of the entire contract, normally 0.5 to 1.5 percent of the guaranteed amount.

Applying for a Bank Guarantee
Bank guarantees are not limited to business customers; individuals can apply for them as well. However, businesses do receive the vast majority of guarantees. In most cases, bank guarantees are not particularly difficult to obtain.

To request a guarantee, the account holder contacts the bank and fills out an application that identifies the amount of and reasons for the guarantee. Typical applications stipulate a specific period of time for which the guarantee should be valid, any special conditions for payment and details about the beneficiary.

Sometimes the bank requires collateral. This can be in the form of a pledge agreement for assets, such as stocks, bonds or cash accounts. Illiquid assets are generally not acceptable as collateral.

How Bank Guarantees Work and Who Uses Them
There are several different kinds of bank guarantees, including:

 Performance guarantees

 Bid bond guarantees

 Financial guarantees

 Advance or deferred payment guarantees

Bank guarantees are often part of arrangements between a small firm and a large organization – public or private. The larger organization wants protection against counterpart risk, so it requires that the smaller party receive a bank guarantee in advance of work. Bank guarantees can be used by a variety of parties for many reasons:

Assure a seller that a purchase price will be paid on a specific date.
Function as collateral for reimbursing advance payment from a buyer if the seller does not supply the specified goods per the contract.

A credit security bond that serves as collateral for repaying a loan.

Rental guarantee that serves as collateral for rental agreement payments.

A confirmed payment order – an irrevocable obligation, in which a bank pays the beneficiary a set amount on a given date on the client’s behalf.

Performance bond that serves as collateral for the buyer’s costs incurred if services or goods are not provided as contractually agreed.

Warranty bond that functions as collateral, ensuring ordered goods are delivered, as agreed.

          Differences Between Bank Guarantees and Letters of Credit

Letters of credit are usually used in international trade agreements while bank guarantees are often used in real estate contracts and infrastructure projects.

Bank guarantees represent a much more significant commitment for banks than letters of credit. A bank guarantee, like a letter of credit, guarantees a sum of money to a beneficiary; however, unlike a letter of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.