A bank guarantee is a modern commercial instrument ensuring payment security in business deals. In this article, we learn all about how a bank assures the original creditor that it will fulfil contractual obligations if the borrower fails.
In the contemporary business landscape, challenges such as geographical distances and the difficulty of accurately assessing the creditworthiness of business partners have become prevalent. To tackle these issues, the concept of bank guarantee has emerged as a valuable solution, assuring payment in various business transactions.
It essentially represents a commitment made by banks or other financial institutions. It serves as a safeguard, assuring that if a borrower fails to meet their payment obligations, the bank or financial entity will bear the associated losses. In essence, this acts as a form of assurance from the bank, stepping in to fulfil obligations in the event of a debtor’s non-compliance.
This mechanism involves a third party conducting thorough due diligence and assuming responsibilities on behalf of the debtor, typically in exchange for some form of consideration. In the current business landscape, this financial instrument has evolved into a crucial component of organizational dealings, playing a vital role in various transactions. This article aims to shed light on the intricacies of this financial instrument in India and the process of availing them.
Parties Involved in the Process
- Applicant: This is the party initiating the request for the guarantee of the bank. Typically, the applicant is the entity seeking credit and making the request.
- Bank: The bank plays a crucial role by undertaking the responsibility of making payments in the event of nonpayment by the applicant. The bank essentially provides a financial guarantee on behalf of the applicant.
- Beneficiary: The beneficiary is the party set to receive the benefits of the guarantee, often in the form of partial assurance.
Commercial transactions often rely on financial backing or assurances. These forms of support empower customers, borrowers, and businesses to acquire equipment, raw materials, additional funds, and more for various commercial purposes. The significance also lies in assuring businesses that the loan amount will be repaid through the bank in the event of any challenges faced by the organization in repaying the loan promptly.
Procedure for Obtaining a Bank Guarantee
The procedural steps are as follows:
- Loan Application: The process begins when the applicant applies for a loan from a creditor or beneficiary.
- Agreement: Both the applicant and the creditor agree on the need for a guarantee as part of the loan agreement.
- Request for Guarantee: The applicant formally asks for a guarantee to be issued by a bank in relation to the loan received from the creditor. This guarantee is issued on behalf of the creditor.
- Issuance of Guarantee: Upon request, the bank issues the guarantee to the applicant, confirming the financial commitment and backing provided by the bank.
Examples
Here’s an illustration which outlines the workings of a bank guarantee:
- Let’s say Company A is awarded a construction contract by Company B. As part of the contract, Company B requires Company A to provide a bank guarantee.
- Company A thereafter, approaches its bank and requests a bank guarantee in favor of Company B.
- The bank, after conducting its due diligence on Company A, issues a bank guarantee to Company B, promising to pay a specified amount in the event that Company A fails to fulfill its obligations under the contract.
This provides Company B with the assurance that it will receive compensation if Company A does not meet its contractual commitments.
Types of Bank Guarantee
It comes in various forms, each tailored to specific transactional scenarios. Here’s an analysis of some common types:
- Deferred Payment Guarantee:
This guarantee is extended to the exporter for a deferred or specific period, typically provided when a purchaser buys capital goods or machinery. The bank ensures payment in installments to the seller in case of any failure in the supply of goods or machinery.
- Performance Guarantee:
Employed as collateral, a performance guarantee is utilized in transactions involving a purchaser and a seller. If the seller fails to deliver products or services as contracted, the beneficiary can invoke this guarantee by declaring in writing that contractual obligations are not being met promptly.
- Financial Guarantee:
This guarantee assures repayment by the bank if a party fails to complete a specific project or operation. It is often established between two connected parties, with a partner entity offering a financial guarantee to a subsidiary company.
- Foreign Bank Guarantee:
Utilized in international trade, a foreign bank guarantee is provided by the bank on behalf of the borrower for an overseas beneficiary or creditor.
- Bid Bond Assurance:
In bidding processes, bid bond guarantees are common. Contractors guarantee that the highest bidder will complete the project as per specifications. The bid bond serves as evidence to the project owner, ensuring the project is carried out according to the bid contract.
- Advance Payment Guarantee:
Implemented to protect the advance payment made by the purchaser to the seller. This guarantee is invoked if there is a failure by the seller to deliver products or services as per the trade transaction terms, leading to the recovery of a complete or partial payment provided in advance.
Steps Involved in Obtaining Bank Guarantees in India
Obtaining a guarantee from bank in India involves a straightforward process facilitated by the bank in exchange for a guarantee fee. Here are the key steps and documents required:
- Bank Guarantee Text:
The applicant must familiarize themself with the text, understanding the terms and conditions stipulated by the bank.
- Board Resolution:
For private limited company or limited companies, a board resolution is essential. This resolution serves as an official authorization for the company to request such services.
- Request Letter:
A formal request letter from the applicant is a fundamental document. This letter outlines the specifics of the requested guarantee and provides the necessary details.
| Note – The bank, before issuing the guarantee, typically conducts due diligence on the applicant. This may involve assessing the financial stability and creditworthiness of the requesting party. Additionally, collateral security may be required to secure the guarantee. |
The Takeaway
In conclusion, a BG play a crucial role in various business transactions, providing assurance and risk mitigation. By understanding the necessary documents and procedures, businesses can navigate the process more effectively.
For comprehensive information and assistance, Vakilsearch offers valuable insights to facilitate the acquisition. Reach out to us today!
FAQs
What is the maximum tenure of a BG?
There is no single maximum tenure for a BG. The duration depends on the specific agreement between the applicant (the party requesting the BG), the bank issuing the BG, and the beneficiary (the party receiving the guarantee). Typically, BGs range from a few months to several years, but some BGs can even extend for longer periods depending on the underlying transaction.
What is the maximum guarantee of a bank?
There is also no universal maximum guarantee amount. Banks consider various factors when determining the maximum guarantee limit, including the applicant's financial health, creditworthiness, collateral offered, and the nature of the transaction. They also have internal risk management policies that set limits on individual guarantees.
How is a BG calculated?
The bank charges a fee for issuing the BG, usually calculated as a percentage of the guaranteed amount. Additionally, the bank may require collateral from the applicant to cover the guaranteed sum in case they need to pay out to the beneficiary. There is no specific formula for calculating the cost, but it usually depends on the risk the bank perceives in the transaction
Who is eligible for a bank guarantee?
Any individual or entity with a legitimate business need and a good credit standing can apply for a BG. However, banks may have specific eligibility criteria depending on the type of BG and the underlying transaction.
What is the minimum period of a bank guarantee?
Similarly to the maximum tenure, there is no set minimum period for a BG. It depends on the specific requirements of the transaction and the agreement between the parties involved. However, BGs typically cover a specific period related to the underlying obligation, such as the completion of a project or the fulfilment of a contract.
What documents are required for a bank guarantee?
The required documents can vary depending on the bank and the nature of the transaction. However, common documents include:
- Application form for the BG
- Applicant's financial statements
- Details of the underlying transaction
- Collateral documents (if required)
- Proof of identity and address (for individual applicants)
Is a bank guarantee a legal document?
Yes, a bank guarantee is a legally binding document. It creates a contractual obligation for the issuing bank to pay the guaranteed amount to the beneficiary if the conditions specified in the BG are met.
Who is the principal in a bank guarantee?
The principal in a bank guarantee is the applicant, the party who requests the BG and promises to fulfill a certain obligation. The bank acts as the guarantor, promising to pay the beneficiary if the principal fails to fulfill their obligation.
Is the maximum tenure of a BG (Bank Guarantee)?
The maximum tenure of a Bank Guarantee (BG) can vary depending on the bank and the specific type of guarantee. However, it typically ranges from 1 year to 5 years.
What is the maximum guarantee amount a bank can offer?
The maximum guarantee amount offered by a bank depends on several factors, including:
- The bank's capital adequacy ratio
- Your creditworthiness
- The nature of the underlying transaction
- Regulatory limitations
- Banks typically have internal limits based on these factors, and exceeding them may require special approvals.
How is a bank guarantee calculated?
The cost of it typically involves a fee that is calculated as a percentage of the guaranteed amount and the duration of the guarantee. The specific fee structure varies between banks
Who is eligible for a bank guarantee?
Individuals and businesses with a good credit history and a legitimate need for the guarantee are generally eligible. The specific eligibility criteria may vary depending on the bank and the type of guarantee.
What is the minimum period for a bank guarantee?
The minimum period can also vary depending on the bank and the specific circumstances. However, it is generally shorter than the maximum tenure and may be as low as a few months.
What documents are required for a bank guarantee?
The required documents typically include:
Is a bank guarantee a legal document?
Yes, a BG is a legally binding document. It outlines the terms and conditions of the guarantee, including the obligations of all parties involved.
Who is the principal in a bank guarantee?
The applicant who requests the guarantee from the bank is considered the principal. They are the party ultimately responsible for fulfilling the underlying obligation.
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