Bank Guarantee

What is a Bank Guarantee (BG / PG)?

A Bank Guarantee / Performance Guarantee (BG / PG) is a guarantee that is made by a bank on behalf of a client, which ensures payment will be made even if their client cannot fulfil the payment. It is a payment of last resort from the bank, and ideally, is never meant to be used.

How can a contractual BG be used?

An BG is frequently used as a safety mechanism for the beneficiary, in an attempt to hedge out risks associated with the trade. Simplistically, it is a guarantee of payment which will be issued by a bank on the behalf of a client. It is also perceived as a “payment of last resort” due to the circumstances under which it is called upon. The BG prevents contracts from going unfulfilled if a business declares bankruptcy or cannot otherwise meet financial obligations.

Furthermore, the presence of an BG is usually seen as a sign of good faith as it provides proof of the buyer’s credit quality and the ability to make payment. In order to set this up, a short underwriting duty is performed to ensure the credit quality of the party that is looking for a letter of credit. Once this has been performed, a notification is then sent to the bank of the party who requested the Letter of Credit  (typically the seller).

In the case of a default, the counter-party may have part of the finance paid back by the issuing bank under an BG. Bank Guarantee’s are used to promote confidence in companies because of this.

How can you apply for a Bank Guarantee?

There are many aspects that a bank will take into consideration when applying for a Bank Guarantee, however, the main part will be whether the amount that is being guaranteed can be repaid. Essentially, it is an insurance mechanism to the company that is being contracted with.

As it is insurance, there may be collateral that is needed in order to protect the bank in a default scenario – this may be with cash or assets such as property. The level of collateral required by the bank and by the size of the BG will largely depend on the risk involved, and the strength of the business.

Other Application steps

There are other standard due diligence questions asked, as well as information requests regarding assets of the business and even possibly the owners. Upon receipt and review of the documentation, the bank will typically provide a letter to the business owner. Once the letter has been provided, a fee is then payable by the business owner for each yeah that the Bank Guarantee remains outstanding.

What are the fees for Bank Guarantee?

It is standard for a fee to be between 1-10% of the BG value. In the event that the business meets the contractual obligations prior to the due date, it is possible for an BG to be ended with no further charges.

What is the difference between BGs and LCs?

A Bank Guarantee is different from a Letter of Credit. An BG is paid when called on after conditions have not been fulfilled. However, a Letter of Credit is the guarantee of payment when certain specifications are met and documents received from the selling party.

Letters of credit promote trust in a transaction, due to the nature of international dealings, distance, knowledge of another party and legal differences.

How do BGs work in Cross-Border trade?

Where goods are sold to a counter-party in another country, they may have used an BG to ensure their seller will be paid. In the event that there is non-payment, the seller will present the BG to the buyer’s bank so that payment is received.

A performance BG makes sure that the criteria surrounding the trade such as suitability and quality of goods are met.

We sometimes see BGs in construction contracts as the build must fulfill many quality and time specifications. In the event that the contractor does not fulfill these specifications then there is no need to prove loss or have long protracted negotiations; the BG is provided to the bank and payment is then received.