The Investopedia defines a Bank Guarantee as:
“a guarantee from a lending institution ensuring the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank covers it. It enables the customer, or debtor, to acquire goods, buy equipment or draw down loans, and thereby expand business activity.”
The Financial Dictionary also defines Bank Guarantee as:
“A promise made by a bank to provide payment to another bank or lender on a bond, loan, or other liability in the event of default. Banks often make guarantees on behalf of certain clients to promise payment on loans. Bank guarantees reduce the risk to loans and liabilities and usually improve the credit agency ratings of bonds.”
A Bank Guarantee (BG) is a promise made by a bank on behalf of its customer that the bank will be responsible for whatever financial loss is suffered in the course of business engagement with the other party if the bank customer is unable to pay.
The extent of the bank’s liability is pre-defined and can only be activated if the bank’s customer fails or unable to fulfill its own part of a contract agreement upon successful confirmation of same or otherwise as stated in the guarantee document.
Bank Guarantee can be direct or indirect. A direct BG is the one issued by the bank in favor of its customer to facilitate business between it and its business partner while and indirect BG is issued as a counter guarantee in favor of another bank to provide financial confidence on a transaction.
Bank Guarantees are contingent liabilities on the bank and as a result may not crystallize.
The bank customer’s request for bank guarantee goes through an approval process and security may vary from one bank to another. Cash security is the most common security acceptable for BG.
Bank Guarantee may also be referred to as a bond.
Types of BG
1. Advance Payment Guarantee
Advance payment Guarantee (APG) is a form of guarantee issues by a bank to provide confidence to a principal that the advanced amount made on a job awarded to the bank customer will be used for the purpose for which the advance was made.
The bank’s liabilities on this type of guarantee ends when the advanced amount is used and verified by the principal. The advanced amount also referred to as Advance Payment Sum (APS) is a percentage of the contract sum paid to the contractor in advance.
2. Performance Guarantee or Performance Bond
Performance Bond is issued by a bank at the request of its customer to give comfort to its business partner that the bank customer will perform as expected on a job.
It is issued at the instance of the principal who want a form of guarantee that the contractor will perform on a job awarded to them. This form of BG has the longest tenure as it is for the total duration of the contracted period. It is mostly used in construction contracts.
3. Bid Guarantee or Bid Bond
Bid bond is requested by the principal who is about to award a contract to interested contractors as a form of assurance that the job will be executed once the contractor is eventually awarded the job.
It is part of the contract bidding documents to be supplied by the willing contractors. If the contractor eventually wins the job and he is unable to execute it, the principal will crystallize the bid bond and call on the bank to compensate them for the inability of the contractor to execute the job.
The bid bond becomes null if the contractor is not the preferred bidder.
4. Payment Guarantee or Comfort Letter
Payment Guarantee or comfort letter is a form of comfort issued by a bank on behalf of its customer and in favor of a third party. It is issued to give comfort that the bank will make payment to the third party on behalf of its customer after some conditions have been met.
Such conditions may include delivery of good in right quality and quantity or successful completion of a job awarded.
Why and when do you need a BG?
• As a principal awarding a contract or a Job Order, there will be need for a bank guarantee when you are in doubt about the ability of your contractors to deliver on a job. With a BG you can delay payment till the job is completed to your satisfaction
• When a principal is advancing payment to a person to perform a job. APG from a bank will give you comfort that your advanced money is secured till you have value for your advance payment.
• When you are awarding a contract and you want to ensure that the successful bidder performs on the job after the bidding process has been completed
• When making orders for supplies and you want to be sure that what you will get is what you ordered. Comfort letter or payment guarantee will give some comfort to the supplier till you confirm the supplies are of the right quality and quantity.
• After you already awarded a job to a successful contractor and you want to ensure he performs on the job. A percentage of the contract sum may be requested as performance bond to ensure performance.
READ ALSO: Short term loan for small businesses