Bank Guarantee : Uses, Eligibility & Process, Advantages

A bank guarantee is a financial assurance provided by a bank on behalf of its customer. It serves as a guarantee that the bank will fulfil the financial or contractual obligations if the customer fails to do so. In simple terms, if you're wondering what is bank guarantee or looking for the bank guarantee meaning, it is a promise by the bank to cover losses incurred by a third party due to the non-performance or default of its customer. 

Meaning of Bank Guarantee

A bank guarantee is a formal assurance given by a bank on behalf of its customer, committing to cover the financial loss if the customer fails to meet specified contractual obligations. It acts as a safety net for the beneficiary, typically used in high-value or high-risk transactions where trust needs to be reinforced.

In simpler terms, bank guarantee refers to a bank's promise to step in and pay the beneficiary if the customer defaults. This provides financial security to the third party (beneficiary) and allows businesses or individuals to enter agreements with greater confidence.

Bank guarantees are widely used in business and trade to:

• Secure credit-based purchases,
• Fulfil tender conditions,
• Back up performance in contracts, and
• Enhance credibility during negotiations.

Example of Bank Guarantee

Let’s say XYZ Ltd., a newly launched textile company, wants to purchase raw fabric worth ₹1 crore. The supplier, to safeguard payment risk, asks XYZ Ltd. to provide a bank guarantee before dispatching the goods. XYZ approaches its bank and obtains the guarantee. The bank essentially assures the supplier that if XYZ Ltd. fails to make the payment, the bank will cover the loss. This assurance enables the supplier to confidently proceed with the order.

In another case, a leading furniture manufacturer plans to contract a small woodshop vendor for ₹50 lakh worth of materials. The manufacturer requires a bank guarantee from the vendor to ensure timely and complete delivery. Here, the manufacturer is the beneficiary. If the woodshop fails to deliver as agreed, the manufacturer can claim compensation directly from the bank under the guarantee.

Bank Guarantee Sample

A sample format of a bank guarantee can be accessed from the official NLC India website here.

Uses of Bank Guarantee

• When large companies purchases from small vendors, they generally require the vendors to provide guarantee certificate from banks before providing such business opportunities.
• Predominantly used in the purchase and sale of goods on credit basis, where the seller is assured of payment from the bank in case of default by the buyer.
• Helps in certifying the credibility of individuals, which in turn, enables them in obtaining loans and also assists in business activities.

Though there are lots of uses from a bank guarantee for the applicant, the bank should process the same only after ensuring the financial stability of the applicant/business. The risk involved in providing such a guarantee must be analysed thoroughly by the bank.

Advantages and Disadvantages of Bank Guarantees

Bank guarantee has its own advantages and disadvantages. The advantages are:

• Bank guarantee reduces the financial risk involved in the business transaction.
• Due to low risk, it encourages the seller/beneficiaries to expand their business on a credit basis.
• Banks generally charge low fees for guarantees, which is beneficial to even small-scale business.
• When banks analyse and certify the financial stability of the business, its credibility increases and this, in turn, increase business opportunities.
• Mostly, the guarantee requires fewer documents and is processed quickly by the banks (if all the documents are submitted).

On the flip side, there are some disadvantages such as:

• Sometimes, the banks are so rigid in assessing the financial position of the business. This makes the process complicated and time-consuming.
• With the strict assessment of banks, it is very difficult to obtain a bank guarantee by loss-making entities.
• For certain guarantees involving high-value or high-risk transactions, banks will require collateral security to process the guarantee.

Types of Bank Guarantee

The major types of bank guarantee used in businesses are given below:

Bank Guarantee (BG) Eligibility and Process

Any person who has a good financial record is eligible to apply for BG. BG can be applied by a business in his bank or any other bank offering such services. Before approving the BG, the bank will analyse the previous banking history, creditworthiness, liquidity, CRISIL, and CIBIL rating of the applicant.

The bank would also examine the BG period, value, beneficiary details, and currency as required for the approval. In certain cases, banks will require security to be provided by the applicant to cover the BG value. Once the banking officials are satisfied with all the criteria, they will provide the necessary approvals required for the BG processing.

Bank Guarantee Charges

Generally, BG charges are based on the risk assumed by the bank in each transaction. For example, a financial BG is considered to assume more risk than a performance BG. Hence, the fee for financial BG will be higher than the fee charged for performance BG. Based on the type of the BG, fees are generally charged on a quarterly basis on the BG value of 0.75% or 0.50% during the BG validity period.

Apart from this, the bank may also charge the application processing fee, documentation fee, and handling fee. In some cases, security is required by the bank from its applicant, which is generally 100% of the BG value. In certain cases, collateral security or cash margin may also be accepted by the issuing bank.

Difference between BG & Letter of Credit (LOC)

LOC is a financial document which imposes an obligation on the bank to make payment to the beneficiary on completion of certain services as required by the applicant. LOC is issued by the bank when the buyer requests his bank to make payment to the seller on the receipt of certain goods or services. That is, when the buyer runs into cash flow difficulties or similar situations and thus cannot make immediate payment to the seller, he will approach his bank to make the payment to the seller on submission of certain documents.

The bank will later recover the amount paid from the buyer along with the required charges. On the other hand, under BG, the bank is required to make payment to the third-party only if the applicant fails to make the payment to the third-party or does not fulfil the required obligations under the contract.

A BG is essentially used to ensure a seller from loss or damage due to the non-performance by the other party in a contract. LOC is generally misunderstood as BG since they share some common characteristics. They both play a significant role in trade financing when the parties to the transactions don’t have established the business relationships. However, there are a lot of differences between LOC and BG.

Major differences between Letter of Credit (LOC) and Bank Guarantee (BG) are as follows:

In conclusion, a bank guarantee is a critical financial tool that supports trust in commercial transactions. Whether you’re a buyer, seller, or service provider, understanding what is bank guarantee helps reduce financial risk and secure business deals.