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How bank guarantees work

Anil Rego  |  Mumbai 

It helps to have a third party’s vetting for your business.

When running a business, you might come across a situation that your client may ask you to provide a financial guarantee from a third party.

In such circumstances, approach your bank and ask it to stand as a guarantor on your behalf. This concept is known as bank guarantee (BG).

This is usually seen when a small company is dealing with much larger entity or even a government across border.Let us take an example of a company XYZ bags a project from, say, the Government of Ethiopia to build 200 power transmission towers.

In this case, companies all over the world would have applied. The selection would be made on the basis of lowest cost and track record as submitted in the proposal form.

However, the government has limited ability to assess all companies for financial stability and credit worthiness.

To ensure the project is done satisfactorily and on time, the government puts a condition that company XYZ will have to furnish a guarantee given by one or more banks.

In banking nomenclature, company XYZ is an applicant, its bank is the issuing bank and the Government of Ethiopia is the beneficiary.

Usually, the BG is for a specified amount, which is a percentage of the total money required for the contract.

Obviously, the bank will not just issue such guarantee with its own due diligence. The bank does its own thorough analysis of the financial well being of company XYZ to assess the amount of guarantee it can issue. After all, the bank is at a risk too, in case the client defaults. This amount is called a limit.

Here too there is a catch. The bank will issue guarantee provided the company has not exceeded its overall limit for BGs. And if the Government of Ethiopia is not satisfied with the performance of the contract at a later date, it can invoke the BG.

In this situation, the bank will have to immediately release the amount of the BG to the government.

BGs can be broadly classified into Performance and Financial BGs. As the name suggests, Performance BGs are the ones by which the issuing bank, also known as the Guarantor, guarantees the ability of the applicant to perform a contract, to the satisfaction of the beneficiary.

Let us continue with our earlier example, to understand the different types of performance BGs. XYZ might need to give a BG that guarantees it has the capability to do the project, on winning the bid. This ensures only serious bidders are in the fray for the project. This is called a bid-bond guarantee. XYZ also might be getting an advance payment for buying materials, etc. Again, it will have to furnish a BG to the extent of the advance, called an advance payment BG. To secure the project even further, the Government of Ethiopia might insist on stage payment guarantees. This would have milestones like 20 per cent, 40 per cent, etc and a period in which these have to be done. As and when XYZ does that part of the work, the BG would expire, thus freeing its limits with the bank (banks also charge for these services, typically as a small percentage of the BG amount, even as little as 0.05 per cent).

Another interesting use of the performance BG is in importing materials into the country. In this case, an importer might want to contest the amount of duty levied by the customs and until the duties are paid, the goods are not released. The importer can, in this case, present a BG for the amount of the duty (also known as customs guarantee) and get his goods released. Once the final decision is taken, the import duty is paid and the BG released.

The other broader types of BGs are financial guarantees. These are used to secure a financial commitment such as a loan, a security deposit, etc. For example, guarantees of margin money for stock exchanges. These are issued on behalf of brokers, in lieu of the security deposit that needs to be paid at the time of becoming a member of the exchange.

The applicant, XYZ, has to prove credit worthiness only to one party, his bank, and can bid for projects across the world. The beneficiary, Government of Ethiopia, does not have to analyse how financially sound the companies are and knows that in case something goes wrong, the bank will pay him.

The writer works for  

First Published: Sun, August 29 2010. 00:33 IST