Bank guarantee is provided by a bank to a business or an individual which specifies that the bank will pay the pre-specified outstanding amount if the business or individual defaults on the same. These are mainly used as collateral by businesses or individuals to gain trust and win different contracts in domestic as well as foreign country.
Sometimes the other party involved in the business and contract asks for bank guarantee to secure its investment and mitigate default risk. It helps to win contracts in foreign countries where the foreign entity or the main party can only trust a bank guarantee.
Types of Guarantees
Different types of bank guarantees are issued by a bank. The main types are specified below.
Tender Guarantee: This bank guarantee provides protection against the additional costs involved in tender if the winning party fails to take up the contract. This is usually very nominal amount and sufficient enough to fund awarding the same contract to another party or ask for new tender.
Performance Guarantee: Here the bank pays the guarantee amount, specified in the contract, if the contractor fails to satisfy the performance criteria. The beneficiary may use the amount to improve the performance by awarding a new contract to another vendor. The performance guarantee amount covers the performance improvement charges which usually 10-15% of the total contract amount.
Advance Payment Guarantee: Here the bank provides guarantee to refund the advance amount that the beneficiary has already paid to the contractor but the contractor failed to take up the project and defaults on the advance payment refund. This protects the beneficiaries from losing the advance amount already paid to the contractor.
Maintenance Guarantee: Here the bank provides the guarantee to ensure proper maintenance after completion of the project. If the contractor fails to provide the necessary maintenance, the bank pays the maintenance charges to the beneficiary so that he can assign the maintenance task to some other contractor.
Customs Guarantee: This is used to provide guarantee to the customs department so that the necessary customs duty can be recovered from the bank if the importer failed to oblige any customs duty exemption rule while importing any equipment from overseas.
Banks earn fee either as a percentage of guaranteed amount or some flat amount. This is a widely used whole sale product by the banks and mostly used by businesses, contractors etc.