Introduction to Bank Guarantees
Introduction: Commercial Banks extend various types of credit facilities to their principals, to allow them to carry out their commercial activities. These facilities can be broadly divided into two categories: funded and unfunded facilities.
Funded facilities are those where the banks actually part with the money. For example, a Bank sanctions a Term Loan to a Paper Manufacturing Company, for the purchase of machinery. The Bank would normally make the payment to the supplier of this machinery, on behalf of its borrower. In turn, the supplier delivers the machinery to the Paper Manufacturer. In the same way, the Bank may grant working capital to its borrower, to meet the daily operating expenses of the business.
Unfunded facilities, on the other hand, are those in which the Bank does not actually deliver money, but promises to do so, depending on the occurrence of certain events. Which means that, unless said event occurs, the Bank will not be called upon to dispose of money. The most common unfunded facilities offered by banks are letters of guarantee and letters of credit.
Warranty Definition: A Warranty is a contract, a legally binding agreement, made by one person, on behalf of another, to perform or perform the latter’s task, in the event of default. In the same way, it can also refer to the promise to free oneself from the responsibility of one person, for the other in case of breach of the first.
Types of Guarantees: There are two types of Guarantees, which are discussed in this article, namely, Financial and Performance Guarantees. Apart from these, there is a third type of Guarantee called the Deferred Payment Guarantee, which will be discussed later.
Performance Guarantee: This guarantee, as can be seen, relates to performance. In this type of guarantee, the Bank undertakes either to ensure the execution of the contract by its client, in whose name it has issued the guarantee, or to repair the loss suffered by the third party, or the beneficiary of the guarantee. , due to the non-compliance of the Bank’s client.
As an illustration, let’s say, M/s. A Wind Power (AWP) has a contract with the state of Arizona to supply and install 500 windmills throughout the state for a value of USD: 1 million. American Banking Corp., (ABC) the Banker to M/s. To Wind Power, it grants a guarantee, in favor of the State of Arizona, on behalf of its client, that AWP will supply and install the 500 windmills in Arizona, according to the terms of the contract between AWP and the State of Arizona. In addition, in the event AWP fails to perform the contract, American Banking Corp. would reimburse the State of Arizona in the amount of USD:1 million in lieu of its client’s failure to perform said contract.
In the above example, ABC issued a Performance Security, on behalf of its client AWP, in favor of the State of Arizona. In this example, two scenarios can arise. One, the AWP performs the contract as per the terms, and gets paid by the State of Arizona, and all is well. All three parts of the Guarantee are happy. The Bank has collected its commission/fees from the client, the State of Arizona has its windmills installed, and the Bank client has received their payment from the State.
In the second scenario, however, the Bank’s customer, ie AWP, on whose behalf the Bank had issued the guarantee, may not perform the contracted work or may not perform it in accordance with the terms of the contract. In that case, the State of Arizona may invoke the guarantee and demand payment of the guaranteed amount of USD: 1 million. And ABC would be obliged to make the payment, without qualms.
Financial Guarantee: This type of guarantee relates to money, as against performance. Under this guarantee, the Bank agrees to make a payment, on behalf of its client, to a third party, in the event of its client’s default, to do so.
As an example, let’s say the World Bank submits an international bid or tender for the supply of 500 windmills to be installed in the African state of Mali. The value of the Offer is USD: 1 million. Under the terms of the offer, competing companies are expected to deposit a sum of USD:100,000.00 with the World Bank, as Earnest Money, to be eligible to participate in the offer. Millisecond. Wind Power (AWP), a competing company, approaches its Bankers to issue a guarantee in favor of the World Bank, on its behalf, for the indicated amount. The Bank undertakes to comply with the request of its client, subject to certain conditions, according to the Bank’s policies. This type of guarantee is called Financial Guarantee.
In the above case, the Bank has issued a guarantee in lieu of a cash deposit that your client should have held with the World Bank. This allows the company to participate in the offer without having to disburse the USD: 100,000.00, which could negatively affect its liquidity. This is just one example of a financial guarantee. If AWP wins the bid, but refuses to accept the contract, then the World Bank would invoke the guarantee and keep the guarantee deposit of USD: 100,000.00. Then the ABC would be left with the alternative of recovering the money from its client.
Both types of Warranties, discussed above, set forth the respective rights and responsibilities of the warranty parties. The amount of the guarantee is specified. The validity of the Guarantee is specific. So also the term to assert the guarantee. The grace period, if any, is also specified in the Warranty document. Limitations, if any, are also stated in precise terms to avoid confusion and conflict.
Conclusion: Guarantees are one of the main financing options available to Banks, to help their clients engaged in trade and commerce. Banks do not extend this facility to each and every one, but only to creditworthy customers. Although this facility is a contingent liability for the Bank, that is, it only materializes upon the occurrence of a certain event; In this case, customer default, a Prudent Bank assumes default by its customer, when considering the granting of this facility.
