How does a Bank Guarantee Work?

Once the bank issues a bank guarantee, it is forwarded to the seller after which he/she proceeds to complete the trade without any upfront payment. The guarantee also defines the time period within which the buyer has to pay the seller. Once that is done, the bank guarantee becomes null and void.
In the event of non-payment by the buyer within the stipulated time frame, the seller invokes the bank guarantee and the bank is liable to pay the seller.
We will explain this better with the help of an example.
Suppose ‘company X’ manufactures apparels and receives a huge order. However, they lack the adequate resources to purchase enough raw materials to fulfill this order due to the pending payments from the previous orders.
Now, there is a ‘company Y’ that sells the raw materials that ‘company X’ requires. But they are hesitant to do business without any upfront payment and cannot merely rely on ‘company X’s’ word. So, ‘company X’ decides to apply for a bank guarantee from a bank for the total amount of the trade. The bank, upon taking a look at ‘company X’s’ financials and collateral, approves the guarantee and provides it to ‘company Y.’
This bank guarantee issued to ‘company Y’ means that if the buyer, i.e. ‘company X’ is unable to complete the payment within the stipulated time frame as stated in the document, the bank that has issued the guarantee will pay the seller.
Once ‘company Y’ receives the guarantee, it will proceed to complete the trade and supply the raw materials to ‘company X’ who then begins manufacturing the goods for the order. At a later date, within the stipulated time frame, ‘company X’ makes the required payment directly to ‘company Y.’ The bank guarantee then becomes null and void.

FAQs on Bank Guarantee

What is a bank guarantee?
A bank guarantee is a contract wherein the bank pledges to make payment on behalf of the borrower in case the borrower fails to conclude the trade as agreed upon by both parties.

When is a bank guarantee required?
Bank guarantees are required when there is a shortage of funds or the lack of trust between the two parties.

Is a bank guarantee refundable?
As soon as the applicant pays his/her dues to the seller within the stipulated time frame, the bank guarantee becomes null and void.

Who is the beneficiary in a bank guarantee?
In most cases, the seller is the beneficiary of a bank guarantee.

What is the difference between the expiry date and the claim date in a bank guarantee?
The claim date is the date on which a beneficiary claims the benefits of the bank guarantee while the expiry date is the date by which the claim has to be made.

What is the claim period of a bank guarantee?
The claim period is a time period within which the beneficiary can claim the benefits of the bank guarantee.

Where does the bank guarantee appear on the balance sheet?
A bank guarantee is considered a contingent liability.

What is the limit of a bank guarantee?
If a company regularly requires bank guarantees, the bank often issues them the guarantees with a fixed upper amount known as the bank guarantee limit.

When is a bank guarantee invoked?
A bank guarantee is invoked by the beneficiary when the borrower fails to conclude the trade as per the terms agreed upon by both parties.

Can a bank guarantee be amended?
Yes, a bank guarantee can be amended. Both, the amount, as well as, the duration can be increased or decreased by sending a formal application of the same to the bank.

Can a bank guarantee be revoked?
A bank guarantee is automatically revoked once its tenure is completed or the applicant pays the beneficiary.

Can a bank guarantee be extended?
Yes, a bank guarantee can be extended by sending a formal application of the same to the bank.

What is a bank guarantee to customs?
To avail exemption from import duties, in many cases, the importer has to submit a bank guarantee to customs along with a bond.

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