What Is a Bank Guarantee? How They Work, Types, and Example

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What Is a Bank Guarantee?

A bank guarantee is a financial backstop offered by a financial institution promising to cover a financial obligation if one party in a transaction fails to hold up their end of a contract. Generally used outside the United States, a bank guarantee enables the bank's client to acquire goods, buy equipment, or perform international trade. If the client fails to settle a debt or deliver promised goods, the bank will cover it.

Key Takeaways

• A bank guarantee is a promise by a financial institution to meet the liabilities of a business or individual if they don't fulfill their obligations in a contractual transaction.
• Bank guarantees are largely used outside the U.S. and are similar to American standby letters of credit.
• Bank guarantees are mostly seen in international business transactions, although they may also individuals may need a guarantee to rent property in some countries.
• Different types of guarantees include a performance bond guarantee, an advance payment guarantee, a warrantee bond guarantee, and a rental guarantee.

Understanding Bank Guarantees

A bank guarantee is a promise by a lending institution to cover a loss if a business transaction doesn't unfold as planned. The buyer receives compensation if a party doesn't deliver goods or services as agreed or fulfill contractual obligations.

Non-U.S. financial institutions and intermediaries in countries such as Spain, the U.K., and elsewhere may more heavily rely on bank guarantees in commercial transactions. But sometimes, a bank guarantee may help an individual rent a property.

A bank guarantee may also be called a standby letter of credit or be referred to as a bond. Bank guarantees from a reputable institution can help you establish business relationships, increase your access to cash flow and capital, protect your business from losses, and set you up for international opportunities.

Another type of guarantee is the loan guarantee from the Export-Import Bank of the U.S. This guarantees creditworthy foreign buyers of financing for U.S. capital goods and services purchases. U.S. companies receive payment when the product is shipped from the U.S. to a foreign buyer.

The U.S. Securities and Exchange Commission (SEC) warns investors to be wary of secretive "high-yield" investments marketed as as a "Prime Bank" program or "Prime World Bank" financial instrument. These fraudulent investments may involve legitimate-sounding language such as "bank guarantee" or "standby letter of credit."

Examples of Bank Guarantees

Here are several kinds of bank guarantees that cover various risks, including:

• Performance bond guarantee: Serves as collateral for the buyer’s costs if services or goods are not provided as agreed in the contract.
• Advance paymentguarantee: Acts as collateral for reimbursing the buyer's advance payment if the seller does not supply the specified goods per the contract.
• Warranty bond guarantee: Serves as collateral, ensuring ordered goods are delivered as agreed.
• Payment guarantee: Assures a seller the purchase price is paid on a set date.
• Rental guarantee: Serves as collateral for rental agreement payments.
  

For example, the World Bank offers a bank guarantee program for projects. These guarantees provide commercial lenders security against payment default or failure to meet performance obligations by governments.

What Are the Different Types of Bank Guarantees?

Two key types of bank guarantees include a tender bank guarantee (bid bond) and a performance guarantee. The tender bank guarantees to reimburse the buyer (who has already supplied some funding) if you, the supplier, don't sign a contract or fulfill conditions. Performance-based guarantees are for obligations laid out in a contract, such as particular tasks.

What Is the Financial Instrument for a Bank Guarantee?

The financial instrument used in a bank guarantee is called a banker's acceptance.

Do Banks in the U.S. Issue Bank Guarantees?

Banks in the U.S. often do not issue bank guarantees. Instead, they issue standby letters of credit serving the same purpose.

Bottom Line

Guarantees help protect international trade relationships by mitigating risks if a contract falls through, suppliers don't perform according to a contract's terms, or a buyer won't pay for goods. While bank guarantees are not common in the U.S., you should be able to get a similar guarantee via a standby letter of credit.

1. Platinum Global Bridging Finance. "Bank Guarantee and Standby Letter of Credit."
2. Santander. "Bank Guarantee."
3. Lloyds Bank. "Bonds and Guarantees."
4. OCBC Bank. "Understanding the Purpose and Benefits of a Banker's Guarantee."
5. EXIM. "Medium and Long-Term Loan Guarantee."
6. Investor.gov. "'Prime Bank' Investments."
7. World Bank. "Guarantees Program."
8. HSBC. "International Business Guarantees."
9. HSBC. "Guarantees."

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A letter of credit is a letter from a bank guaranteeing that a buyer’s payment will be received on time and for the correct amount. Here’s how letters of credit work.

A performance bond is issued to one party of a contract as a guarantee against the failure of the other party to meet obligations in the contract.

An irrevocable letter of credit is a bank guarantee for payment by the party requesting the letter. It cannot be revoked.

Trade finance represents the financial instruments and products that are used by companies to facilitate international trade and commerce.

Credit is a contractual agreement in which a borrower receives something of value immediately and agrees to pay for it later, usually with interest.

A standby line of credit is a sum of money that a business or individual borrower can draw from as needed, either partially or in full.

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