Use bank guarantees, bonds and indemnities to reduce risk — when trading both domestically and internationally.
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What is a bank guarantee?
Bank guarantees (BGs) are contractual agreements that act to mitigate risk and lessen the losses — if things do not go as planned.
Guarantees are backed by guarantors (typically a bank) and should there be a breach of contract — some sort of compensation is paid to the beneficiary.
Bank guarantees are an important part of trade finance. They can allow businesses to acquire goods, purchase equipment or draw down a loan.
Bank guarantees are also known as bank bonds.
Bank guarantee — considerations
Bonds, guarantees and indemnities are used by companies to show their customers, that they can meet their contractual obligations. In other words, they demonstrate a business’s financial credibility and in the process — helps open up more trading opportunities.
Bank guarantees can be used for both domestic and international contracts, for any amount and in any freely traded currency. They are usually tailored to suit each specific situation — taking into account the unique aspects of the transaction.
As an alternative to making cash deposits — bank guarantees have become ever more popular. BGs enable companies to deploy cash, that would have otherwise been tied up as deposit, elsewhere in their business. They may also be used as a means of offsetting or even deferring payments.
Both bank guarantees, letters of credit (LCs) and standby letters of credit (SBLCs) work to reduce or mitigate the risks in a trade deal or business arrangement. Parties to a deal are more likely to agree to the transaction, as they have less liability — when BGs, LCs and/or SBLCs are in effect.
The major difference between a bank guarantee and a letter of credit — is the parties that utilize them.
Bank guarantees are regularly used by contractors — as proof of their financial capability. This is due to bank guarantees mainly being concerned with financial performance. On the other hand, letters of credit are commonly used by companies that import and export products.
Bank guarantees are often used in complex real estate contracts, as well as infrastructure projects.
How do bank guarantees work?
Different bank guarantees are required under different circumstances.
Your business may be required to have a bank guarantee — as a condition for a particular trade. Generally, the terms that are to be secured by guarantees, are defined once parties have agreed on contractual arrangements. These terms are normally unique to the particular trade in question.
Should you need a bank guarantee, you would need to make an application either to a suitable bank — or some other type of financial institution. Banks would need to vet your business — so you will need to provide extensive documentation e.g. trading history, statement of accounts etc.
Depending on the arrangement — information will also be sought on the other parties to the guarantee e.g. the shipping company, exporter, importer, customs etc.
If you are found to be creditworthy and have a reasonable level of risk — a bank may agree to a guarantee. The bank guarantee will highlight all the needed terms and conditions, and will also place a monetary limit on any potential claim. This exposes the bank to only a certain level of risk.
Any bank guarantee issued may be a direct guarantee or an indirect guarantee. With a director guarantee the obligator’s bank issues this directly to the beneficiary. Indirect guarantees involve an intermediary bank, when additional protection is sought — from the creditworthiness of the intermediary bank or the country risk.
Types of bank guarantee
Shipping guarantees allow you to take possession of goods — without the transportation documents e.g. bill of lading.
A performance guarantee protects the importer — should the performance of an exporter be below par.
With a loan guarantee, a financial institution pledges to take on the financial obligation — if a borrower defaults.
An advanced payment guarantee ensures an importer is repaid — if the exporter does not fulfill its contractual obligations.
Confirmed payment guarantees are irrevocable obligations, where a bank is to pay a stipulated amount of money — to a beneficiary (on behalf of a client) by a certain date.
A warranty guarantee covers a buyer after goods are delivered, or work is completed — during the agreed warranty period.
Customs guarantees are Issued in favor of customs offices, as collateral for the payment of any customs duties — by an importer.
Bid or tender
The purpose of a bid or tender bond/guarantee, is to cover the risk that a business will not abide by its offer, or be able to deliver the required performance.
Benefits of bank guarantees
- Reduced financial risk
- Lets companies access more trading opportunities
- Enhances business credibility
- Buyers can defer payment — optimizing cash flow
- Sellers are protected from non-payment
Limitations of bank guarantees
- Strict qualifying criteria
- Only suitable for relatively large value transactions
- Collateral may be needed
- Parties need to ensure any agreement is worded properly — to avoid any potential future disputes
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