A bank guarantee is a promise from a bank that if a party defaults on a debt or obligation, the bank will cover the other party’s loss.
Let’s dive deeper into what a bank guarantee is and how it works. We’ll also discuss the types of bank guarantees that exist as well as how a bank guarantee differs from a letter of credit.
Definition and Examples of a Bank Guarantee
You can think of a bank guarantee as a contract from a bank to two parties, usually a buyer and a seller. It helps manage risk, as the bank will fulfill the debt or obligation listed in the contract if, for any reason, the liable party doesn’t. A bank guarantee can encourage startups and small businesses to take risks and explore business opportunities that they wouldn’t be able to otherwise.
Let’s say you’re a furniture manufacturer and typically work with local vendors. One day you're approached by a vendor in another country that offers you a great deal. You want to save some money, so you decide to move forward with them.
In an effort to minimize the risk of doing business with a firm you are unfamiliar with, you ask the new vendor to back the contract with a bank guarantee. If the new vendor fails to deliver what they promised, you can claim the loss from the bank that provided the guarantee.
While a bank guarantee can give a buyer confidence, it can also add an element of complexity to the contract between the buyer and seller.
How a Bank Guarantee Works
A bank guarantee involves a contract. The contract may state that a party promises to repay a loan or provide a service. If the debt is not repaid or the obligation is not met, the bank will do its job and fulfill it.
Once the bank guarantee has been created, it will include a specific amount and a set time period. The guarantee will also clearly outline the bank’s responsibility and what they’ll do if a party defaults on a loan or fails to provide a service.
Fortunately, bank guarantees are usually affordable, as most banks charge 1.5% to 2.5% of the cost or value of the transaction. If you apply for a bank guarantee that is particularly risky or high in value, the bank may ask that you put up collateral or an asset that you own.
Bank guarantees aren’t typically seen at U.S. banks, as they offer standby letters of credit instead. Standby letters of credit are legal documents banks use to guarantee the payment of a specified amount of money to a seller if the buyer fails to follow through with the agreement.
Types of Bank Guarantees
There are a number of different types of bank guarantees, including:
- Shipping guarantees: These are distributed to carriers for shipments that arrive before any documents have been received.
- Loan guarantees: Lenders promise to pay for the cost of a loss if the borrower fails to repay the loan.
- Advanced payment guarantees: In the event that a seller doesn’t supply goods to a buyer, these guarantees reimburse their prior payment.
- Deferred payment guarantees: These are promises for postponed payment.
Bank Guarantee vs. Letter of Credit
In most cases, the bank will only take action if the buyer fails to repay their debt or meet their obligation. It’s unlikely for a bank to step in after a single late payment or delay in the project. With a letter of credit, however, the buyer or seller will make an initial claim to the bank.
Since a letter of credit comes with greater bank involvement, it can provide peace of mind that the debt will be repaid on time or that the obligation will be handled as promised. When it comes to a bank guarantee, a bank takes a far more hands-off approach. There must be proof that the contract is not being fulfilled before they get involved.
- A bank guarantee promises that if a party with whom you have a contract fails to fulfill their debt or obligation, a bank will cover the loss.
- There are different types of bank guarantees, including shipping, loan, advanced payment, and deferred payment guarantees.
- Unlike with a letter of credit, a bank will only intervene if a party defaults on their debt or obligation.