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What are the different types of Bank Guarantees?

What are the different types of Bank Guarantees?


Various types of guarantees are issued by the banks on behalf of their customers. Bank Guarantees (BG) is also known as Letter of Guarantees which can be broadly classified as (i) Financial Guarantees and (ii) Performance guarantees. Earnest money Deposit guarantee or Bid Bond Guarantee, Guarantee for Payment of Customs duty (specific or continuing), Advance Payment Guarantee (APG), Deferred Payment Guarantee (DPG), Shipping Guarantee, Performance guarantee, Retention Money guarantees etc are some of the prominent types of guarantees issued by the banks.

Bank Guarantee or letter of guarantee is a fee-based credit facility extended by the banks to their customers. The non-fund based facilities are the letter of guarantee or letter of credit by the banks wherein banks get fee income and Since there is no immediate outflow of funds from the banks they are also known as the non-fund based facility. However in the case of non-fund based credit facility, the bank has to discharge the financial liability of the contract agreed to the guarantee or documentary credit, if the contract is partly or fully not performed by the customer.

Financial guarantees
Financial guarantees are issued by the banks whenever a contract is awarded to their customer, who is generally a contractor of civil work or a supplier of goods, machinery, equipment by a Government Department or a large industrial undertakings, the customer is under obligation to deposit cash security or earnest money as a token of due compliance of the terms and conditions of the contract. This cash security provided by the contractor or supplier is forfeited by the Government Department or the company which awarded the contract, in the event the contractor or supplier fails to comply with the terms stipulated in sanction. The customer normally will have an option to furnish a bank guarantee in lieu of cash security, so that his working funds are not unnecessarily blocked. The guarantees issued by banks for above purpose is called financial guarantee wherein the banks undertake to pay the guaranteed amount during a specified period on demand from the beneficiary. The examples of Financial Guarantee are as under.
 Guarantee for Earnest money Deposit (Local Tender)/Bid Bond Guarantee (international tender):
[ A bid bond guarantee is a guarantee issued by the bank to the effect that bidder would not withdraw the bid before the expiry of bid/tender period or in case the contract is awarded to the bidder that he would comply with the terms of the tender and enter into the contract.].

Guarantee for Payment of Customs duty (specific or continuing):

a customer may require a guarantee favouring custom department for payment of customs duty covering import of raw materials. It means that the guarantee covers custom duty in arrears to the Customs Department by the customer up to a limit (stating maximum of amount) of guarantee undertaken by the bank.

Advance Payment Guarantee (APG)

Although Advance Payment guarantee is associated with the financial guarantee it has the inherent risk of performance guarantee Advance payment guarantees are issued on behalf of the (i) Supplier of raw materials/finished goods or (ii) on behalf of a contractor for an execution of contract when he receives the advance payment. Since supplier receives an advance from the purchaser for the supply of raw material or finished goods on a future date, it is a substitution of working capital funds. In the case of execution of the contract, if any one of the terms of the contract is not fulfilled, the guarantee is likely to be invoked. While accepting the request from the customer for APG limit the banker should thoroughly analyse all risk factors.

Although Advance Payment guarantee is associated with the guarantee it has the inherent risk of performance guarantee Advance payment guarantees are issued on behalf of the (i) Supplier of raw materials/finished goods or (ii) on behalf of a contractor for an execution of contract when he receives the advance payment. Since supplier receives an advance from the purchaser for the supply of raw material or finished goods on a future date, it is a substitution of working capital funds. In the case of execution of the contract, if any one of the terms of the contract is not fulfilled, the guarantee is likely to be invoked. While accepting the request from the customer for APG limit the banker should thoroughly analyse all risk factors.

Deferred Payment Guarantee (DPG)

In the cases of purchase of capital goods/machinery where the seller offers credit to the buyer and buyer’s bank guarantees the due payments to the seller. Here the seller draws drafts of different maturities on the buyer which are accepted by the buyer and co-accepted by the Buyer’s bank. Thereby the buyer’s bank guarantees due payment of those drafts drawn by the seller which represents the total consideration of the contract of sale/supply. The seller avail the refinance from his bank against co-accepted bills. DPG involves substitution of the term loan. Hence procedure applicable for assessment of term loan must be followed for DPG limit viz. projection under operating statement, Funds flow statement, DSCR, BEP etc.

Shipping Guarantee

Shipping guarantee is issued to the shipping company to release the goods by the shipping companies on the basis of bank guarantee. Shipping guarantee is issued due to the arrival of the consignment (Ship carrying the goods already arrived) but non-receipt of relative documents of title to goods.

Performance Guarantee:

Performance guarantees are issued by the banks on behalf of a Service Contractor, who has to effectually perform all the conditions of the contract between him and the department/company that awarded the contract. The bank has to discharge the financial liability of the contract agreed in the guarantee, if the contract is partly or fully not performed by the customer. Such type of guarantees issued by the bank is called Performance Guarantee. Many a time the terms of the contract may be of highly technical in nature and bank is generally not expected to know the technical aspects of the contract. Therefore the bank assumes only the financial liability of the contract. Since the issuance of performance guarantee is more complicated and risky, before issuing performance guarantees, the bank has to ensure that the customer has sufficient experience in the line of business and he has capacity and means to carry out the obligation under the contract.

Retention Money guarantees

Retention money is a part of the amount payable to the contractor, is retained and payable at the end after successful completion of the contract. Retention Money guarantee is issued to ensure that retention money withheld by the beneficiary is released to the applicant (contractor) so that he gets sufficient working capital to complete the contract.

Related articles:

(i) Time limit for enforcement bank guarantees

(ii) Circumstances that may discharge guarantor from all liabilities

(iii) How to compute period of limitation for personal guarantees

 

(9) Comments

  1. Deepak Saini

    Is 100% FD backed Bank guarantee limits sanctioned to a customer is a credit facility? Is any credit risk involved in this? If yes, then do we have to classify the account into Multiple banking arrangement or sole?

    1. Surendra NaikSurendra Naik - Post author

      Bank guarantee is a non fund based credit facility. When the guarantee amount is fully covered by deposit of the customer, risk weight to the bank on such guarantee issued by it is zero. If the guarantee is invoked for partial/full amount the customer may lose his deposit in partial/full. If the guarantee is issued by a bank taking a separate security for the guarantee issued by it then it is sole arrangement between the bank and customer.

      1. priyesh kothari

        sir please provide your contact number . i need your guidance regarding performance gurantees. my id is given and mobile - 8920278607

    1. Surendra NaikSurendra Naik - Post author

      I have already explained the different kinds of financial guarantees.The performance guarantees are issued in respect of supply of equipment as well as contract.The supplier of equipment may require to submit performance guarantee from a bank with regard to turnkey requirements, project standard and specification, and on Operability test of equipment(i.e. the system operating at the capacity as defined in the contract for a continuous .....months/years etc.), preventive measure, warranty period etc.

  2. Kunal

    Sir, We are involved in Jobwork of steel. A steel mill is giving us contract for jobwork for which theyvare asking for high amountBG against their stock which will be kept with us. Please guide how we can manage such BG without block large sum of money Thanks

    1. Surendra NaikSurendra Naik - Post author

      The guarantee required by the Mill is a finacial guarantee similar to advance payment guarantee. Instead of money the Mills supplies materials to you. They may need guarantee for the value of the material. Ask them format of guarantee required by them and show it to your Banker. The bank may ask you to provide security for issuing guarantee either in the form of deposits or collateral.

  3. Saswat Ranjan Sahoo

    Nyc explanation Sir..TY..What is No lien account .? Can u plz explain..And what is Contingent liability..?

    1. Surendra NaikSurendra Naik - Post author

      1. No lien letter is an undertaking from the premises owners (in the case of rented premises) that he does not have a lien on goods hypothecated to the bank which is stored in his premises rented out to the borrower, towards his dues like rent receivable etc.click the following link to different kind of liens https://www.bankingschool.co.in/knowledge-capsule/important-banking-laws/what-is-the-meaning-of-lien/ 2.Arrears of cumulative dividends, Gratuity liability not- provided for, Disputed excise/customs /tax liabilities, Pending lawsuit (possibility of liability arises only on court judgment), and other liabilities not provided for are the examples of contingent liabilities.

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