What is a Bank Guarantee?
A Bank Guarantee is where one Bank (the Issuing Bank) issues an indemnity to another Bank (the Beneficiary Bank) or directly to a Beneficiary, on behalf of its account holder. The Issuing Bank will expect its account holder to pledge ‘assets’ to the bank for its issue.
There are effectively two main types of Bank Guarantees, (1) A Direct Guarantee where the account holder instructs his bank to issue a Guarantee directly in favor of the Beneficiary, and (2) An Indirect Guarantee where a second bank is requested to issue a Guarantee in return for a counter-Guarantee. In this case, the Issuing Bank will indemnify losses made by this second bank in the event of a claim against the Guarantee.
A Bank Guarantee is considered a “Demand Guarantee” and as such is governed by the International Chamber of Commerce (ICC) Uniform Rules for Demand Guarantees (URDG).
Some Guarantees are written to guarantee rental payments; some are written to guarantee payments upon the meeting of certain conditions. Some are even issued to guarantee loans and credit lines. All of them are written for a specific purpose to a specific party.
Each Bank Guarantee will be worded for the purposes it is intended. Some may be ‘callable upon demand,’ or some may only be ‘callable’ when the Beneficiary provides notice of satisfaction of a pre-determined condition.
Currently, under the new Uniform Rules for Demand Guarantees (URDG 758), an underlying contract should be provided that states clearly the purpose of the Bank Guarantee and forms part of the Guarantee, for example, a Rent Agreement or Payment Obligation.
Characteristics of Bank Guarantees
Some important characteristics of Bank Guarantees should be noted:
Bank Guarantees are written specifically for a purpose, where an account holder will instruct his bank to issue a guarantee to another bank on behalf of their account holder.
The bank will hold adequate assets of the account holder as security for the Bank Guarantee.
They cannot be bought or sold.
They do not carry CUSIP or ISIN numbers and are not tradable securities.
They are issued for a specific time period. Upon Expiry, Bank Guarantees are terminated; they are not traded.
A Bank Guarantee has no end value and does not accumulate any investment element or maturity value.
They should not be considered as ‘investment notes.’
They should not be ‘touted’ on the open market as the issue of a Bank Guarantee is between closed parties (the Issuer and Beneficiary only).
Banks do not issue them to raise money and should not be confused with Medium Term Notes (MTNs).
The strength of a Bank Guarantee is limited to the financial standing (and rating) of the Issuing Bank.
Issuing A Bank Guarantee
Any person or a corporate entity with an account held at a mainstream bank can apply to issue a Bank Guarantee. Provided they hold adequate assets to their account, there should be no reason why a Bank will reject an application to issue a Bank Guarantee for bonafide business purposes.
The account holder will request his Bank to issue a Guarantee and supply them with the reasons behind its issue. The bank would have a simple application form for this service. The account holder will submit the bank the application containing details of the underlying commitment being entered into whilst supplying the bank with information such as; (a) how long the Guarantee should be for, (b) any conditions on the payment, (c) the amount and currency, and of course (d) details of the Beneficiary and their bank details, etc.
The Bank, in turn, will request that the account holder enters into some form of pledge agreement with them. This means that before the bank agrees to issue a Guarantee, the Bank would require a pledge or lien over the account holder's assets to secure the Guarantee. The assets acceptable for a bank to issue a Guarantee are generally liquid assets such as cash at the bank, stocks and shares, and bonds. In other words, assets that can be instantly liquidated. It is increasingly less common for banks to accept less liquid assets such as real estate property, although the decision to accept the asset is ultimately that of the bank.
In essence and for example, if an account holder wanted to issue a third party with a Bank Guarantee for US$50 million, it would be necessary to pledge cash, stocks, or bonds to his bank for a minimum of this amount. It is improbable that a bank would agree to issue a Guarantee on behalf of their account holder without holding assets of equal or higher value. It is ‘for value received…..’.
Once the bank has charged, lined, or blocked the assets on the account holder's bank account at the bank, the same bank will issue a Guarantee by their account holder's specifications.
The Issuing Bank will remit the Bank Guarantee to the Beneficiary Bank initially by SWIFT. See SWIFT
Normally, the Bank may pre-advise the Beneficiary Bank by sending a SWIFT MT799, which is only a notice outlining the Issuing Banks instructions to remit a Guarantee or verify information in advance of the issue.
The Issuing Bank will then send the Bank Guarantee also by SWIFT MT760. See MT799 and MT760.
Most banks will also send an original paper copy (which takes the appearance of a letter) by post to the Beneficiary Bank. It is courteous for the Beneficiary Bank to remit a message or letter back to the Issuing Bank confirming its safe receipt and acknowledgment.
Receiving A Bank Guarantee
If you are lucky enough to have a Bank Guarantee issued to you, you will certainly know what it is for. Most commonly, landlords may receive Bank Guarantees for rent deposits from their tenants, for example. If you have entered into a separate contract for an investor to issue you a Bank Guarantee to secure a credit line, then you would have certainly executed contracts with them by this stage.
It is improbable that a Bank Guarantee will pop onto your bank account by surprise! If you do receive a Bank Guarantee and have no idea why you should contact your bank immediately.
In receiving a Bank Guarantee, your bank will generally notify you and send you a copy of it (normally a SWIFT terminal printout) for your information. They will also inform you that it is verified and valid and will await your further instructions.
If you plan to receive a Bank Guarantee, you must bank with a multi-national bank that understands them and can offer you a ‘private’ banking service. Generally, we would advise working with Swiss Banks who operate the procedure well.
If you intend to receive a Bank Guarantee from an ‘investor’ to secure a credit line or loan, it is important to negotiate this facility with your bank before the Bank Guarantee arrives. This will save time and expenses.
The Bank Guarantee will normally be posted to a separate account in your name that the bank will open upon its arrival. It will be held on this account until it is either called for payment or it expires.
Financial Bank Guarantee and Performance Bank Guarantee
It helps to have a third party’s vetting for your business.
When running a business, you might come across a situation where your client may ask you to provide a third party's financial guarantee.
In such circumstances, approach your bank and ask it to stand as a guarantor on your behalf. This concept is known as a bank guarantee (BG).
This is usually seen when a small company deals with a much larger entity or even a government across the border. Let us take an example of a company, XYZ, bags a project from, say, Ethiopia's Government to build 200 power transmission towers.
In this case, companies all over the world would have applied. The selection would be made based on the lowest cost and track record as submitted in the proposal form. However, the government has limited ability to assess all companies for financial stability and creditworthiness.
To ensure the project is done satisfactorily and on time, the government puts a condition that company XYZ will have to furnish a guarantee given by one or more banks. In banking nomenclature, company XYZ is an applicant, its bank is the issuing bank, and Ethiopia's Government is the beneficiary.
Usually, the BG is for a specified amount, a percentage of the total money required for the contract.
Obviously, the bank will not just issue such a guarantee with its own due diligence. The bank does its own thorough analysis of company XYZ's financial well-being to assess the amount of guarantee it can issue. After all, the bank is at risk, too, in case the client defaults. This amount is called a limit.
Here too, there is a catch. The bank will issue a guarantee provided the company has not exceeded its overall limit for BGs. And if the Government of Ethiopia is not satisfied with the contract's performance at a later date, it can invoke the BG.
In this situation, the bank will have to release the BG amount to the government immediately.
BGs can be broadly classified into Performance and Financial BGs. As the name suggests, Performance BGs are the ones by which the issuing bank, also known as the Guarantor, guarantees the applicant's ability to perform a contract to the satisfaction of the beneficiary.
VARIATIONS
Let us continue with our earlier example to understand the different types of performance BGs. XYZ might need to give a BG that guarantees it has the capability to do the project on winning the bid. This ensures only serious bidders are in the fray for the project. This is called a bid-bond guarantee. XYZ also might be getting an advance payment for buying materials, etc. Again, it will have to furnish a BG to the extent of the advance, called an advance payment BG. To secure the project even further, the Government of Ethiopia might insist on stage payment guarantees. This would have milestones like 20 percent, 40 percent, etc., and a period in which these have to be done. As and when XYZ does that part of the work, the BG would expire, thus freeing its limits with the bank (banks also charge for these services, typically as a small percentage of the BG amount, even as little as 0.05 percent).
Another interesting use of the performance BG is in importing materials into the country. In this case, an importer might want to contest the amount of duty levied by the customs, and until the duties are paid, the goods are not released. In this case, the importer can present a BG for the amount of the duty (also known as customs guarantee) and get his goods released. Once the final decision is taken, the import duty is paid, and the BG is released.
The other broader types of BGs are financial guarantees. These are used to secure a financial commitment such as a loan, a security deposit, etc. For example, guarantees of margin money for stock exchanges. These are issued on behalf of brokers instead of the security deposit that needs to be paid when becoming a member of the exchange.
The applicant, XYZ, has to prove creditworthiness only to one party, his bank, and can bid for projects worldwide. The beneficiary, the Government of Ethiopia, does not have to analyze how financially sound the companies are and knows that in case something goes wrong, the bank will pay him.