What is a Bank Guarantee?
A Bank Guarantee (BG) is a financial instrument issued by a bank on behalf of its customer (the applicant), guaranteeing payment to a third party (the beneficiary) in case the applicant fails to fulfill contractual obligations. It serves as a safety net that assures the beneficiary of financial compensation if the applicant defaults.
Bank guarantees are widely used across industries for various purposes including tender participation, performance assurance, advance payment security, and financial commitments. They play a crucial role in facilitating business transactions by mitigating counterparty risk.
Key Characteristics of Bank Guarantees
- Independent Undertaking: BG is a separate obligation from the underlying contract
- Bank's Primary Liability: Bank pays first, recovers from applicant later
- Conditional or Unconditional: May require proof of default or just a simple demand
- Specified Validity: Valid for a defined period with clear expiry date
- Specified Amount: Maximum liability is clearly stated in the guarantee
Bank Guarantee vs Letter of Credit
| Aspect | Bank Guarantee | Letter of Credit |
|---|---|---|
| Primary Purpose | Guarantees performance or payment | Facilitates trade payment |
| When Payment Made | Only on default/non-performance | On presentation of documents |
| Nature | Accessary to underlying contract | Independent of underlying contract |
| Usage | Contracts, tenders, projects | Domestic and international trade |
Types of Bank Guarantees
1. Performance Guarantee
Performance guarantees assure the beneficiary that the applicant will fulfill contractual obligations satisfactorily. If the applicant fails to perform, the bank pays the guarantee amount to compensate the beneficiary.
- • Commonly used in construction contracts and supply agreements
- • Usually 5-10% of contract value
- • Valid for contract period plus claim period (3-12 months)
2. Financial Guarantee
Financial guarantees assure repayment of money in case of default. Types include advance payment guarantees, loan repayment guarantees, and deferred payment guarantees.
3. Earnest Money Deposit (EMD) Guarantee
Also known as Bid Bond or Tender Guarantee, this secures the earnest money deposit required when submitting tenders. It ensures the bidder will sign the contract if awarded and furnish the required performance guarantee.
4. Advance Payment Guarantee
This guarantees repayment of advance amounts paid by the employer/contractor if the applicant fails to utilize the advance for the intended purpose. Common in construction and supply contracts where mobilization advances are given.
5. Retention Money Guarantee
Replaces the retention money (usually 5-10% of bill amount) held by employers from contractors. The contractor can get full payment by furnishing this guarantee, improving their cash flow.
6. Customs and GST Guarantee
Used for duty deferment, provisional assessment of customs duty, or GST compliance requirements. Enables businesses to clear goods without immediate payment of duties.
Parties Involved in Bank Guarantee
Applicant/Customer
The party who requests the bank to issue the guarantee. They have an obligation to the beneficiary that needs to be guaranteed.
Issuing Bank
The bank that issues the guarantee and undertakes to pay the beneficiary if the applicant defaults.
Beneficiary
The party in whose favor the guarantee is issued. They can invoke the guarantee if the applicant defaults.
Additional Parties (in some cases)
- Advising Bank: Bank that advises the guarantee to the beneficiary, usually in beneficiary's location
- Confirming Bank: Adds its own undertaking to pay, providing additional security to beneficiary
- Reinstating Bank: In revolving guarantees, handles automatic reinstatement after partial utilization
Margin Money Requirements
Banks require margin money as security against the risk of guarantee invocation. The margin percentage varies based on customer's creditworthiness, relationship with bank, and nature of the guarantee.
| Customer Category | Typical Margin | Remarks |
|---|---|---|
| Established with credit limits | 0-25% | Against existing CC/OD limits |
| Standard customers | 25-50% | Based on credit assessment |
| High-risk/new customers | 50-100% | Full cash cover may be required |
| Government tenders | 10-20% | Lower due to low invocation risk |
Forms of Margin Money
- Cash Deposit: Funds kept in current account with the bank
- Fixed Deposit: Lien marked FDs with the issuing bank
- Securities: NSC, KVP, insurance policies assigned to bank
- Collateral: Property, assets as additional security
Bank Guarantee Process
Stage 1: Application
- • Submit BG application with contract/tender documents
- • Provide prescribed format from beneficiary
- • Specify amount, validity period, and terms
Stage 2: Bank Assessment
- • Credit appraisal of applicant
- • Review of underlying contract
- • Assessment of margin requirement
Stage 3: Margin Deposit
- • Deposit required margin money
- • Execute security documents
- • Set limits in banking system
Stage 4: Issuance
- • Bank drafts guarantee as per format
- • Legal review of terms
- • Authorized signatories execute
Stage 5: Delivery
- • BG sent directly to beneficiary or through applicant
- • Swift message for international guarantees
- • Acknowledgment obtained
Validity and Renewal
Standard Validity Periods
- EMD Guarantee: Tender validity plus 28-90 days
- Performance Guarantee: Contract period plus 3-12 months claim period
- Advance Payment Guarantee: Until advance is recovered
- Financial Guarantees: As per loan/obligation tenure
Extension and Renewal
When a guarantee nears expiry but the underlying obligation continues, the applicant must request an extension. The bank charges extension fees (typically 0.25-0.50%) and may require additional margin.
Cancellation
To cancel a BG before expiry, the original guarantee must be returned to the bank by the beneficiary with a no-claim letter. The bank then releases the margin money to the applicant.
Risk Management
For Applicants
- • Ensure contract terms are clear and achievable
- • Negotiate conditional guarantees where possible
- • Maintain adequate margin and liquidity
- • Track expiry dates and arrange extensions timely
- • Include BG return clauses in contracts
For Beneficiaries
- • Verify issuing bank's creditworthiness
- • Ensure guarantee format allows easy invocation
- • Check validity covers the risk period adequately
- • Confirm governing law and jurisdiction
- • Store original guarantee securely
Legal Framework
Bank guarantees in India are governed by:
Indian Contract Act, 1872
BGs are contracts of guarantee under Section 126. Defines rights and obligations of surety (bank), principal debtor (applicant), and creditor (beneficiary).
RBI Guidelines
RBI prescribes norms for BG issuance including maximum validity, margin requirements, and reporting requirements for banks.
URDG 758
The Uniform Rules for Demand Guarantees (URDG 758) by ICC provides international standards for demand guarantees. While not mandatory, parties can agree to apply URDG 758 to their guarantees for international transactions.
Conclusion
Bank guarantees are essential instruments for businesses to participate in tenders, secure contracts, and provide assurance to counterparties. While they involve costs and margin requirements, the benefits of enhanced credibility and business opportunities often outweigh these expenses.
Understanding the types, process, and risks associated with bank guarantees helps businesses use them effectively while managing their financial exposure. Maintaining a good relationship with your banker, negotiating favorable terms, and diligently tracking guarantee portfolios are key to effective BG management.
Whether you are bidding for government contracts, undertaking construction projects, or securing advance payments, choosing the right type of bank guarantee with appropriate terms is crucial for business success and financial security.