In one of our previous articles we wrote about a letter of credit, a trade finance tool that is most commonly used in international trade. In this article we will discuss about another trade finance tool – a bank guarantee.
A bank guarantee is a type of guarantee from a lending institution, usually banks. A bank guarantee means a bank ensures that the liabilities of a debtor (buyer) will be met. In other words, if the debtor fails to settle a debt, the bank will cover it.
A bank guarantee and a letter of credit are similar in many ways but they are two different things. Letters of credit ensure a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction doesn’t go as planned. While letters of credit are used mostly in international trade agreements, bank guarantees are often used in real estate contracts and infrastructure projects.
Bank guarantees represent a more significant contractual obligation for banks than letters of credit. A bank guarantee, like a letter of credit, guarantees a sum of money to a beneficiary. However, unlike a letter of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.
There are different kinds of bank guarantees, including direct and indirect guarantees. Banks typically use direct guarantees in foreign or domestic business, issued directly to the beneficiary. The term direct guarantee applies when the bank’s security does not rely on the existence, validity and enforceability of the main obligation. Individuals often choose guarantees for international and cross-border transactions, which can be more easily adapted to foreign legal systems and practices due to not having form requirements. Indirect guarantees occur most often in the export business, especially when government agencies or public entities are the beneficiaries of the guarantee.
Banks, since they are agreeing to take on risk, thoroughly screen buyers interested in bank guarantee. After the bank has determined that the buyer is a reasonable risk, a monetary limit is placed on the agreement. The bank agrees to be obligated up to, but not exceeding, the limit. This protects the bank by providing a specific threshold of risk. Creditworthy buyers are then issued a bank guarantee.