In a perfect world, a person's word would be his bond. Whether doing business with your next-door neighbor or on the other side of the world, you would be confident of receiving payment for your product or service. Because business transactions can't be built on trust alone, however, bank guarantees (BGs) have become a valuable part of commerce. BGs reduce risk for both parties by assuring the transaction will be completed on time and for the agreed upon price. For a fee, a bank agrees to pay the necessary amount to complete the transaction, if necessary. Bank guarantees are frequently used in international trade, when the parties don't know each other or the laws in the country where they're doing business.
A bank guarantee is a promise made by a lending institution that they will cover any debts not paid by the debtor.
The beneficiary is the party requesting the guarantee. For example, company A needs to build a building. Company B, one of many that may apply, is a contractor that company A chooses for the project. Company A does not know company B's creditworthiness or financial strength, two key factors that determine its ability to finish the job. Company A, the beneficiary, requires company B, the applicant, to get a BG from its bank as a condition of beginning work. The bank is the issuer, and in this case, would have to pay for the project to be completed if company B fails to do so. The limit is the maximum amount of the BG. The bank sets the limit by doing its own due diligence on the applicant.
Types of BGs
A financial guarantee assures the beneficiary of payment. The applicant, company B, only has to prove its creditworthiness to one party, its bank. The beneficiary does not have to analyze how financially sound the applicant is. Instead, it knows that if something goes wrong, the bank will pay. By requiring financial BGs, beneficiaries can be assured of payment without having to analyze the many companies it does business with. With a performance guarantee, the issuing bank, or guarantor, guarantees the applicant's ability to satisfactorily complete a contract. If the applicant fails, the bank will fulfill the BG by paying another party to finish the required work.
Enforcement of BGs
Enforcing a guarantee is when a beneficiary demands payment from the issuing bank. The bank will have placed certain conditions for payment in the guarantee agreement, and it will check to make sure these stipulations are met. Due diligence steps include verifying authorized signatures from the beneficiary, verifying timely submission by the beneficiary because the BG has an expiration date, and other steps that can vary depending on the nature of the transaction. Transactions involving parties in different countries, for example, would have more complex due diligence steps than a purely domestic arrangement.
Risks Associated with BGs
The applicant and issuing bank carry the risk in a guarantee-backed transaction. There is no risk to the beneficiary. To compensate for its risk, the bank usually will require collateral from the applicant. The applicant's risk is that his pledge of assets to the bank will be lost if the bank has to fund the BG.
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