What is Bank Guarantee? Various Types of Bank Guarantees and Payment of invoked Guarantees

 

 

Bank Guarantee

A bank guarantee refers to a promise provided by a bank or any other financial institution that if a certain borrower fails to pay a loan, then the bank or the financial institution will take care of the losses. The bank will assure the original creditor through this bank guarantee that if the borrower does not meet his or her liabilities, then the bank will take care of them.

An important criterion for judging the soundness of a banking institution is 

• the size and character, not only of its assets portfolio but also, of its contingent liability commitments such as guarantees, letters of credit, etc. 

 As a part of business, banks issue guarantees on behalf of their customers for various purposes. The guarantees executed by banks comprise both performance guarantees and financial guarantees. The guarantees are structured according to the terms of agreement, viz., security, maturity and purpose. With the introduction of risk weights for both on-Balance Sheet and off-Balance Sheet exposures, banks have become more risk sensitive, resulting in structuring of their business exposures in a more prudent manner. Banks should comply with the guidelines in the conduct of their guarantee business.

A bank guarantee is a contract between 3 different parties and they include:

• The applicant (the party that requests a bank guarantee from the bank and borrows from a creditor)
• The beneficiary (the party that receives a partial guarantee)
• The bank (the party that agrees to sign and assures payment in case the applicant fails to repay the loan)

Bank guarantees are very commonly utilised among business entities. With the help of a bank guarantee, the debtor or borrower or customer will be able to purchase equipment, machinery, raw materials, acquire additional funds, etc. for commercial purposes. Bank guarantees help businesses as creditors will get a proper reassurance that the loan amount will be repaid by the bank if the business is unable to repay the loan entirely on time.

When a bank signs a bank guarantee, it promises to pay any amount according to the request made by the borrower. Hence, signing a bank guarantee implies a high risk for banks.

Understand the Process of Bank Guarantee

• First, an applicant will ask for a loan from a beneficiary or creditor.
• While applying for the loan, these 2 parties will agree that a bank guarantee is necessary.
• Then, the applicant will request a bank to provide a bank guarantee for the loan taken from the creditor. The bank guarantee will be taken on behalf of the creditor.
• The bank will now offer the bank guarantee to the applicant and send a financial instruction to an advising bank.

Kinds of Bank Guarantee

• Deferred payment guarantee: This refers to a bank guarantee or a payment guarantee that is offered to the exporter for a deferred period or for a certain time period. When a buyer purchases capital goods or machinery, the seller will give credit to the buyer when the buyer’s bank gives a guarantee that it will pay the unsettled dues of the buyer to the seller. Under this type of guarantee, payment will be made in installments by the bank for failure in supplying raw materials, machinery or equipment.

 

• Financial guarantee: A financial bank guarantee assures that money will be repaid if the party does not complete a particular project or operation entirely. According to the financial guarantee agreement, when there is a delay in the completion of the project, the bank will make the payment.

• Advance payment guarantee: Under this kind of guarantee, an advance payment will be made to the seller. There will also be a guarantee that if the seller fails to deliver the service or product accurately or promptly, the buyer will receive a refund of the payment.

• Foreign bank guarantee: A foreign bank guarantee is provided by a bank on behalf of a borrower. This will be offered on behalf of the foreign beneficiary or creditor.

• Performance guarantee: Under a performance guarantee, compensation of money will be made by the bank when there is any delay in delivering the performance or operation. Payment will have to be made even if the service is delivered inadequately.

• Bid bond guarantee: Under this type of guarantee, there will be a supply bidding procedure. This will be conducted by the contractor for the owner of an infrastructure or industrial project or any kind of operation. The contractor of the project will guarantee that the best bidder or the highest bidder will have the capability and authority to implement a project as per his or her preferences. The bid bond will be given to the owner of the project as a proof of guarantee and the bond will imply that the project will have to be devised according to the bid contract.

Comparison between Bank Guarantee and Letter of Credit

Many times, people get confused between bank guarantee and a letter of credit. However, one should understand that both are pretty different.

A bank guarantee refers to a commercial or financial instrument that is provided by a bank, where the bank assures or guarantees a beneficiary that it will make the payment to the bank in case the actual customer fails to meet his or her obligations. The bank will pay on behalf of the customer who requests for a bank guarantee.

On the other hand, a letter of credit refers to a promise or commitment in writing made by a bank or any other financial institution or corporation to a particular seller that payment will be made to the seller if the seller completes performing whatever is mentioned in the letter of credit. For the bank to make the payment on behalf of the original buyer, there should be a documentary proof that the seller has completed the transaction accurately by delivering the right product or service on time. The seller will get a guarantee from the bank that the seller will definitely pay the amount on behalf of the original buyer once the obligations are fulfilled.

Under a bank guarantee, if the buyer is unable to make the payment to the seller or creditor, then the bank pays the fixed amount to the seller as the obligations of the contract are not met. On the other hand, under a letter of credit, the bank makes the payment to the seller once he or she delivers. This is because the seller has completed fulfilling the required obligations.

Bank guarantees are competitively priced in nature generally. They are usually valid for a long period. The tenure of a bank guarantee is usually high. Moreover, bank guarantees are commonly accepted in almost all countries. Bank guarantees are available in Indian Rupee as well as currencies of other nations. Hence, they are very helpful for global transactions with parties in different foreign countries.

FAQs 

1.     Is it possible to apply for Bank Guarantee online? 

Yes, you can apply for Bank Guarantee online.

2.     Can I opt for Bank Guarantee in case I have a savings account? 

Yes, you can opt for Bank Guarantee if you hold a savings account with the bank. 

3.     How long does it take for the Bank Guarantee to be issued?

Depending on the bank, the time for the Bank Guarantee to be issued will vary.  

4.     What are the documents that must be submitted for Bank Guarantee in case I have a current account?

In case you are a current account holder, the list of documents that must be submitted are mentioned below: 

·        Application form 

·        Bank Guarantee text (Word Format) 

·        Stamp paper (According to State Stamp Act) 

·        In the case of a Private/Public Limited Company, the Board Resolution must be provided 

5.     What security must be provided to avail Bank Guarantee?

Bank Guarantee is provided against the collateral or 100% of the Fixed Deposit that is available. However, the previous year’s performance is considered when the bank provides a Bank Guarantee. 

Payment of invoked guarantees

Where guarantees are invoked, payment should be made to the beneficiaries without delay and demur. An appropriate procedure for ensuring such immediate honouring of guarantees should be laid down so that there is no delay on the pretext that legal advice or approval of higher authorities is being obtained.

 

Delays on the part of banks in honouring the guarantees when invoked tend to erode the value of the bank guarantees, the sanctity of the scheme of guarantees and image of banks. It also provides an opportunity to the parties to take recourse to courts and obtain injunction orders. In the case of guarantees in favour of Government departments, this not only delays the revenue collection efforts but also gives an erroneous impression that banks are actively in collusion with the parties, which tarnish the image of the banking system.

 

There should be an effective system to process the guarantee business to ensure that the persons on whose behalf the guarantees are issued will be in a position to perform their obligations in the case of performance guarantees and honour their commitments out of their own resources, as and when needed, in the case of financial guarantees.

The top management of the banks should bestow their personal attention to the need to put in place a proper mechanism for making payments in respect of invoked guarantees promptly, so that no room is given for such complaints. When complaints are made, particularly by the Government departments for not honouring the guarantees issued, the top management of the bank, including its Chief Executive Officer, should personally look into such complaints.

 

In this regard, the Delhi High Court has made adverse remarks against certain banks in not promptly honouring the commitment of guarantees when invoked. It has been observed that a bank guarantee is a contract between the beneficiary and the bank. When the beneficiary invokes the bank guarantee and a letter invoking the same is sent in terms of the bank guarantee, it is obligatory on the bank to make payment to the beneficiary.

 

The Supreme Court had observed [U.P. Co-operative Federation Private Ltd. versus Singh Consultants and Engineers Private Ltd. (1988 IC SSC 174)] that the commitments of the banks must be honoured, free from interference by the courts. The relevant extract from the judgement of the Supreme Court in a case is as under:

            'We are, therefore, of the opinion that the correct position of law is that commitment of banks must be honoured free from interference by the courts and it is only in exceptional cases, that is, to say, in case of fraud or any case where irretrievable injustice would be done if bank guarantee is allowed to be encashed, the court should interfere'.

 

In order to avoid such situations, it is absolutely essential for banks to appraise the proposals for guarantees also with the same diligence, as in the case of fund based limits, and obtain adequate cover by way of margin so as to prevent the constituents to develop a tendency of defaulting in payments when invoked guarantees are honoured by the banks.

1. In the interest of the smooth working of the Bank Guarantee Scheme, it is essential to ensure that there is no discontentment on the part of the Government departments regarding its working. Banks are required to ensure that the guarantees issued by them are honoured without delay and hesitation when they are invoked by the Government departments in accordance with the terms and conditions of the guarantee deed, unless there is a Court order restraining the banks.
2. Any decision not to honour the obligation under the guarantee invoked may be taken after careful consideration, at a fairly senior level, and only in the circumstances where the bank is satisfied that any such payment to the beneficiary would not be deemed a rightful payment in accordance with the terms and conditions of the guarantee under the Indian Contract Act.
3. The Chief Executive Officers of banks should assume personal responsibility for such complaints received from Government departments. Sufficient powers should be delegated to the line functionaries so that delay on account of reference to higher authorities for payment under the guarantee does not occur.
4. Banks should also introduce an appropriate procedure for ensuring immediate honouring of guarantees, so that there is no delay on the pretext that legal advice or approval of higher authorities is being obtained.
5. For any non-payment of guarantee in time, staff accountability should be fixed and stern disciplinary action including award of major penalty such as dismissal, should be taken against the delinquent officials at all levels.
6. Where banks have executed bank guarantees in favour of Customs and Central Excise authorities to cover differential duty amounts in connection with interim orders issued by High Courts, the guarantee amount should be released immediately when they are invoked on vacation of the stay orders by Courts. 

Banks should not hold back the amount on the pretext that it would affect their liquidity position.

Banks should honour the guarantees issued by them as and when they are invoked in accordance with the terms and conditions of the guarantee deeds. In case of any disputes, such honouring can be done under protest, if necessary, and the matters of dispute pursued separately.

 

Non-compliance of the instructions in regard to honouring commitments under invoked guarantees will be viewed by Reserve Bank very seriously and Reserve Bank will be constrained to take deterrent action against the banks.