A bank guarantee is a promise from a lending institution that guarantees a corporate customer’s payment obligation or loan. Bank guarantees allow companies to carry out business deals and hedge financial risks without putting up collateral or making ample cash outlays.
If you’re a business owner exploring financing options, here’s what you need to know about bank guarantees.
What is a Bank Guarantee?
A bank guarantee, known formally as a bank letter of guarantee, is given by a bank on behalf of a customer (usually a company) who is obligated to pay another party. The bank promises to cover the payment if the customer fails to do so.
How Do Bank Guarantees Work?
Here are the basics of how a bank guarantee works:
- Company A requires Company B to provide proof before doing business together. This could be for a loan, credit payment, contract bid, security deposit, etc.
- Company B asks its bank to provide a guarantee letter to Company A.
- The bank reviews Company B and agrees to issue the guarantee on its behalf.
- Company B gives the guarantee letter to Company A. This obligates the bank to pay Company A if Company B defaults on its obligation.
- Company A can claim payment from the bank if Company B fails to fulfill its duty.
Why Get a Bank Guarantee?
There are several reasons a company may need a bank guarantee:
Win Project Bids
Bidding on significant infrastructure, engineering, and construction projects often requires a bank guarantee. This shows the project owner you can financially back up your proposal.
Secure Business Loans
Lenders sometimes require a bank guarantee to approve large business loans. This assures the bank will get repaid if you default.
Meet Contractual Obligations
Your business partners may need a guarantee that you can pay for goods or services contracted. A bank guarantee provides that assurance.
Obtain Trade Credit
Suppliers may extend more favorable credit terms if you have a bank guarantee. This can improve short-term cash flow.
Support Financial Transactions
Guarantees can facilitate commercial and financial exchanges like securities underwriting, payment transfers, and release of escrow funds.
What Are The Benefits of Bank Guarantees?
Bank guarantees offer companies several advantages:
- Avoid tying up capital – Guarantees allow you to take on obligations and pursue deals without putting up cash collateral. This preserves working capital.
- Establish credibility – A guarantee from a reputable bank demonstrates your financial standing to business partners.
- Access better terms – Guarantees can help you get lower interest rates on loans and qualify for higher credit lines.
- Reduce risk – Guarantees shift risk off your business and onto the issuing bank.
- Flexible financing – Guarantees tap bank capital without diluting company ownership like equity financing.
- Quick and convenient – Guarantees can be arranged faster than securing a business loan.
What Are The Costs?
Banks charge a fee for providing guarantees. Prices often range from 0.5% to 5% per year based on the guarantee amount, customer credit profile, risk level, and other factors.
For a $1 million guarantee, a 2% annual fee would cost $20,000. Higher-risk customers can expect to pay higher guarantee fees. There may also be upfront processing fees.
Compare rates from multiple banks to get the best deal. However, a higher fee may be worthwhile if it allows you to win business and improve cash flow.
What Collateral is Required?
Banks will require collateral to issue guarantees, but requirements vary. Strong companies with solid credit history and financials may get unsecured deposits.
Startups and higher-risk firms will need to pledge assets to back the guarantee. Typical collateral includes cash deposits, business/personal real estate, and securities. Collateral worth 110-150% of the guarantee amount is commonly required.
How To Get a Bank Guarantee
Here are some tips on obtaining a bank guarantee facility:
- Maintain a strong banking relationship – Banks favor existing customers over unknown firms.
- Present a specific business need – Quantify how much financing you need and exactly what the guarantee is for.
- Provide financial statements – Banks will analyze your income, balance sheet, cash flow, and future projections.
- Offer adequate collateral – Assets pledged should equal or exceed the requested guarantee amount.
- Know your credit rating – Better personal/business credit scores can help you get approved and lower fees.
- Shop around – Compare terms from several banks to get the best guarantee facility.
Critical Guarantee Terms to Understand
Here are critical legal and financial terms to analyze in any bank guarantee:
- Guarantee amount – The total dollar amount guaranteed.
- Expiry date – When the contract expires. Make sure it covers your obligation term.
- Claims period – The deadline to make a claim, often 30-90 days after expiry.
- Fees – Upfront and annual guarantee fees.
- Auto-renewal – Whether the guaranteed auto-renews upon expiry.
- Collateral – What assets are pledged, and what collateral margins are required?
- Claim procedures – Steps the bank needs to make a claim.
- Governing law – Legal jurisdiction that regulates the guarantee.
Alternatives to Bank Guarantees
Bank guarantees aren’t the only option to secure obligations. Here are two alternatives to consider:
Surety Bonds
These are three-party agreements where a surety company guarantees you’ll fulfill an obligation. Surety bonds may cost less than bank guarantees for some firms.
Letters of Credit
A letter of credit from a bank guarantees payment to a beneficiary. The big difference from a guarantee is the bank pays the beneficiary from your company’s funds rather than the bank’s money.
Conclusion
A bank guarantee can provide a valuable funding solution for any business that needs to demonstrate financial credibility, bid on contracts, or take on client obligations. While promises come at a cost, the benefits often outweigh the fees and can enable profitable growth. Carefully weigh the advantages against the risks before obtaining a guarantee – and clearly understand the terms. With the backing of a bank guarantee facility, companies can seamlessly pursue new opportunities and scale up operations.
FAQs
Q: Do bank guarantees require collateral?
A: Often, yes, banks will require 110-150% worth of pledged collateral assets from the company getting the guarantee. Substantial firms may get unsecured deposits.
Q: How long does it take to get a bank guarantee?
A: Typically 1-2 weeks but can vary. Existing bank customers can get approved faster than unknown applicants.
Q: Can bank guarantees be canceled?
A: Guarantees can be canceled before expiry but often involve cancellation penalties. Both parties must consent.
Q: Are bank guarantee fees tax deductible?
A: Generally, guarantee fees are tax deductible as business expenses or interest payments. Consult an accountant.
Q: What recourse does a bank have after paying a claim?
A: The bank can seize the guaranteed company’s collateral assets and pursue legal action to recover losses.
