Introduction:
A Bank Guarantee (BG) is an obligation issued by the bank on the guaranteed party’s behalf, in favor of the contractual partner: as the guarantor, the bank agrees to compensate your partner for you, if necessary. Bank guarantees generally serve as collateral, covering the fulfilment of contractual obligations in international transactions. If breach of contract occurs, the beneficiary can demand payment in accordance with the terms and conditions of the Bank Guarantee. The Advisor Bank aside, a Bank Guarantee is a contract between 3 different parties and they include:
- The applicant (the party that requests a bank guarantee from the bank and borrows from a creditor)
- The beneficiary (the party that receives a partial guarantee)
- The Guarantor Bank (the party that agrees to sign and assures payment in case the applicant fails to repay the loan)
Types:
As it was mentioned before, Bank Guarantee (BG) is a guarantee made by a bank on behalf of a customer, should it fail to deliver the payment, fundamentally making the bank a co-signer for one of its customer’s purchases. Guarantees are important tools used to lessen the dangers that are involved in commercial contracts. The bank guarantee is one such innovative financial instrument whereby, if the beneficiary notices that there has been a breach of contract, he can encash the guarantee and avail of the amount immediately, without having to endure the disturbances of litigation. There are two BGs:
- Absolute guarantee: If payment is demanded, the guarantor bank’s payment decision will depend on whether the guaranteed party is in breach of contract.
- First demand bank guarantee: If payment is demanded, the payment decision will only depend on whether the beneficiary’s demand is covered by the formal terms of the guarantee obligation. First demand bank guarantees are the main type of guarantee used in international commerce. The International Chamber of Commerce has enacted Demand Guarantee Rules (URDG 758), which cover first demand guarantees. The ICC’s rules apply if they are mentioned in the text of the guarantee.
However, there is another way of categorizing BGs:
- Financial Guarantees: This type of Bank Guarantee is issued by the bank and furnished by the bank’s customer instead of earnest money or the security to be deposited with the beneficiary of the Bank Guarantee for the performance of a contract.
- Performance Guarantee: These types of guarantees are issued regarding performance of a contract or obligation. The bank cannot perform the contract itself but by this Bank Guarantee the bank undertakes to reimburse the loss incurred by the beneficiary due to non-performance.
Procedure:
First, an applicant will ask for a loan from a beneficiary or creditor or participate in a commercial transaction. However, while applying for the loan, these 2 parties will decide that a bank guarantee is essential. Hence, the applicant will request a bank to provide a bank guarantee for the loan taken from the creditor. The bank guarantee will be taken on behalf of the creditor. The bank will now offer the bank guarantee to the applicant and send a financial instruction to an advising bank. Nevertheless, if the buyer is incapable of paying the money to the seller or creditor, then the bank pays the fixed amount to the seller.
In Conclusion:
The bank guarantee letter is the document by which the guarantor bank, will conclusively commit to pay a certain amount of money to a beneficiary, if the principal debtor fails to do the act. However, through this bank guarantee letter, the beneficiary can always claim the amount of money owed by the principal debtor. If the debtor fails to comply with the terms and conditions of the contract, then it is the bank that will have to pay the beneficiary the amounts of money stated in the guarantee letter. The use of bank guarantee letters, safeguards business contracts between companies, the main result being the generation of positive cash flows, which allows entrepreneurs to resort to bank credits to a lesser extent.