Bank Guarantee: Uses, Eligibility & Process, Advantages

Bank Guarantee : Uses,
Eligibility & Process,

Advantages
Updated on : Apr 01, 2021 - 11:31:23 PM
14 min read.
A guarantee means giving something as security. A bank guarantee is when a bank

offers surety and guarantees for different business obligation on behalf of their
customers within certain regulations. The lending institutions provide a bank
guarantee which acts as a promises to cover the loss of the customer if he/she
defaults on a loan. It is an assurance to a beneficiary that the financial institution
will uphold the contract between the customer and third party if the customer is
unable to do so.
Meaning of Bank Guarantee

Bank Guarantee a promise made by the bank to any third person to undertake the
payment risk on behalf of its customers. Bank guarantee is given on a contractual
obligation between the bank and its customers. Such guarantees are widely used in
business and personal transactions to protect the third party from financial losses.
This guarantee helps a company to purchase things that it ordinarily could not, thus
helping business grow and promoting entrepreneurial activity.
For Example- Xyz company is a newly established textile factory that wants to
purchase Rs.1 crore fabric raw materials. The raw material vendor requires Xyz
company to provide a bank guarantee to cover payments before they ship the raw
material to Xyz company. Xyz company requests and obtains a guarantee from the
lending institution keeping its cash accounts. The bank essentially cosigns the
purchase contract with the vendor. If Xyz company defaults in payment, the vendor
can recover it from the bank.
Similarly, a large manufacturer of furniture wishes to enter into a contract with a

small woodshop vendor. The large manufacturer will require the small vendor to
provide a bank guarantee before entering into a contract for Rs.50 lakh worth of
wood material. In this case, the large manufacturer is the beneficiary who requires
a guarantee before entering into a contract. If the small vendor is unable to deliver
the wood material, the large manufacturer of furniture can claim the losses from
the bank.
Sample Bank Guarantee for

reference: https://www.nlcindia.com/tenders/format_bgp.pdf
Uses of Bank Guarantee
 When large companies purchases from small vendors, they generally

require the vendors to provide guarantee certificate from banks before
providing such business opportunities.
 Predominantly used in the purchase and sale of goods on credit basis, where
the seller is assured of payment from the bank in case of default by the
buyer.
 Helps in certifying the credibility of individuals, which in turn, enables

them in obtaining loans and also assists in business activities.
Though there are lots of uses from a bank guarantee for the applicant, the bank
should process the same only after ensuring the financial stability of the
applicant/business. The risk involved in providing such a guarantee must be
analysed thoroughly by the bank.
Advantages and Disadvantages of

Bank Guarantees
Bank guarantee has its own advantages and disadvantages. The advantages are:
 Bank guarantee reduces the financial risk involved in the business

transaction.
 Due to low risk, it encourages the seller/beneficiaries to expand their

business on a credit basis.
 Banks generally charge low fees for guarantees, which is beneficial to even
small-scale business.
 When banks analyse and certify the financial stability of the business, its
credibility increases and this, in turn, increase business opportunities.
 Mostly, the guarantee requires fewer documents and is processed quickly

by the banks (if all the documents are submitted).
On the flip side, there are some disadvantages such as:
 Sometimes, the banks are so rigid in assessing the financial position of the
business. This makes the process complicated and time-consuming.
 With the strict assessment of banks, it is very difficult to obtain a bank

guarantee by loss-making entities.
 For certain guarantees involving high-value or high-risk transactions, banks

will require collateral security to process the guarantee.
Types of Bank Guarantee

There are two major types of bank guarantee used in businesses, which are as
follows:
Financial Guarantee
These guarantees are generally issued in lieu of security deposits. Some contracts
may require a financial commitment from the buyer such as a security deposit. In
such cases, instead of depositing the money, the buyer can provide the seller with a
financial bank guarantee using which the seller can be compensated in case of any
loss.
Performance Guarantee
These guarantees are issued for the performance of a contract or an obligation. In

case, there is a default in the performance, non-performance or short performance
of a contract, the beneficiary’s loss will be made good by the bank.
For example, A enters into a contract with B for completion of a certain project and
the contract is supported by a bank guarantee. If A does not complete the project
on time and does not compensate B for the loss, B can claim the loss from the bank
with the bank guarantee provided.
Bank Guarantee (BG) Eligibility and

Process
Any person who has a good financial record is eligible to apply for BG. BG can be
applied by a business in his bank or any other bank offering such services. Before
approving the BG, the bank will analyse the previous banking history,
creditworthiness, liquidity, CRISIL, and CIBIL rating of the applicant.
The bank would also examine the BG period, value, beneficiary details, and
currency as required for the approval. In certain cases, banks will require security
to be provided by the applicant to cover the BG value. Once the banking officials
are satisfied with all the criteria, they will provide the necessary approvals required
for the BG processing.
Bank Guarantee Charges

Generally, BG charges are based on the risk assumed by the bank in each
transaction. For example, a financial BG is considered to assume more risk than a
performance BG. Hence, the fee for financial BG will be higher than the fee
charged for performance BG. Based on the type of the BG, fees are generally
charged on a quarterly basis on the BG value of 0.75% or 0.50% during the BG
validity period.
Apart from this, the bank may also charge the application processing fee,
documentation fee, and handling fee. In some cases, security is required by the
bank from its applicant, which is generally 100% of the BG value. In certain cases,
collateral security or cash margin may also be accepted by the issuing bank.
Difference between BG & Letter of

Credit (LOC)
LOC is a financial document which imposes an obligation on the bank to make
payment to the beneficiary on completion of certain services as required by the
applicant. LOC is issued by the bank when the buyer requests his bank to make
payment to the seller on the receipt of certain goods or services. That is, when the
buyer runs into cash flow difficulties or similar situations and thus cannot make
immediate payment to the seller, he will approach his bank to make the payment to
the seller on submission of certain documents.
The bank will later recover the amount paid from the buyer along with the required
charges. On the other hand, under BG, the bank is required to make payment to the
third-party only if the applicant fails to make the payment to the third-party or does
not fulfil the required obligations under the contract.
A BG is essentially used to ensure a seller from loss or damage due to the non-
performance by the other party in a contract. LOC is generally misunderstood as
BG since they share some common characteristics. They both play a significant
role in trade financing when the parties to the transactions don’t have established
the business relationships. However, there are a lot of differences between LOC
and BG.
Major differences between Letter of Credit (LOC) and Bank Guarantee (BG) are as
follows:
Particulars LOC BG
Nature LOC is an obligation accepted by a BG is an

bank to make payment to a assurance
beneficiary if certain services are given by the
performed. bank to the
beneficiary to
make the
specified
payment in
case of default
by the
applicant.
Primary liability Bank retains the primary liability to The bank

make the payment and later collects assumes to
the same from the customer. make the
payment only
when the
customer
defaults to
make
payment.
Payment Bank makes the payment to the Only when the

beneficiary as and when it is due. It customer
need not wait for a default to be made defaults the
by the customer. payment to
the
beneficiary,
the bank
makes the
payment.
Way of working LOC ensures that the amount will be BG assures to

paid as long as the services are compensate
performed as per the agreed terms. for the loss if
the applicant
does not
satisfy the
specified
conditions.
Number of There are multiple parties involved There are only

parties involved here – LOC Issuing bank, its three parties
customer, the beneficiary (third involved –
party), and advising bank. banker, its
customer, and
the
beneficiary
(third party).
Suitability Generally, this is more appropriate Suits any
during the import and export of goods business or
and services. personal
transactions.
Risk Bank assumes more risk than the Customer

customer. assumes the
primary risk.

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Bank Guarantee : Uses,

Eligibility & Process,

A guarantee means giving something as security. A bank guarantee is when a bank

Meaning of Bank Guarantee

Similarly, a large manufacturer of furniture wishes to enter into a contract with a

Sample Bank Guarantee for

Uses of Bank Guarantee

 When large companies purchases from small vendors, they generally

 Helps in certifying the credibility of individuals, which in turn, enables

Advantages and Disadvantages of

 Bank guarantee reduces the financial risk involved in the business

 Due to low risk, it encourages the seller/beneficiaries to expand their

 Mostly, the guarantee requires fewer documents and is processed quickly

 With the strict assessment of banks, it is very difficult to obtain a bank

 For certain guarantees involving high-value or high-risk transactions, banks

Types of Bank Guarantee

These guarantees are issued for the performance of a contract or an obligation. In

Bank Guarantee (BG) Eligibility and

Bank Guarantee Charges

Difference between BG & Letter of

Nature LOC is an obligation accepted by a BG is an

Primary liability Bank retains the primary liability to The bank

Payment Bank makes the payment to the Only when the

Way of working LOC ensures that the amount will be BG assures to

Number of There are multiple parties involved There are only

Risk Bank assumes more risk than the Customer

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