A bank guarantee is a financial assurance issued by a bank to protect a seller against default by or insolvency of the buyer.
It provides a form of protection against credit risk by transferring the ultimate risk from the debtor company to the bank and is typically used to facilitate single, high-value transactions between counterparties that have no previous trading relationship, thus aiding the expansion of companies into new markets and geographies.
Who should use bank guarantees?
Bank guarantees are a sensible choice for suppliers who wish to secure large one-off transactions mainly in reasonably well-developed jurisdictions, and when there is some concern over a buyer’s creditworthiness. For buyers, bank guarantees act as an alternative to providing a deposit to a supplier, and provide a level of flexibility to both counterparties as they can be used for specific transactions or remain open-ended.
There are two distinct categories of bank guarantees. The first is an unconditional on-demand guarantee where the beneficiary may call on the bank to honour it simply by making an appropriate demand without being called upon to prove that the buyer is in default. The other type, which is more common, requires some notification to the bank of a contract breach as a precursor to demanding that the bank honour the guarantee.
Banks will typically only provide guarantees to companies with sufficient financial strength to repay the bank should the guarantee be called. Where this is not the case, banks will invariably require additional security either in the form of funds deposited with the bank - which will typically earn interest at current rates - or immovable assets like real estate.
While bank guarantees are available and used globally, they are frequently preferred by businesses in emerging markets like the United Arab Emirates and are particularly popular in Asia's textile industry, as well as in the real estate and infrastructure sectors. However, their use is not recommended for portfolios involving several buyers, buyers in multiple jurisdictions, or markets with high political risk.
What should counterparties be prepared for?
While bank guarantees are useful for companies looking to conduct business in new markets or with unfamiliar counterparties, they are not very straightforward to use. Firstly, the buyer must be willing to offer a bank guarantee, which is increasingly rare these days as most expect to trade on unsecured open account terms. Sellers insisting upon a bank guarantee in a competitive market could well see a buyer walk away from a deal.
Assuming a buyer is willing to offer a bank guarantee, they must then be able to persuade a bank to provide one. This will depend on various factors, such as the buyer’s financial health and their relationship with the bank. Bank guarantees can also prove expensive, depending on the amount being guaranteed and the reputation of the buyer, who may understandably be reluctant to incur such costs unless they have no alternative.
Then there is the well-worn adage that a badly drafted bank guarantee is not worth the paper it is written on. Any seller relying on bank guarantees should seek advice from legal experts - with the requisite knowledge of the local laws of both the buyer’s and bank’s jurisdictions - on drafting the guarantee and any potential barriers to enforcing it. Further, such advice will need to be regularly updated as laws can and do change over time.
Care should be taken to scrutinise expiry dates and the need to extend or seek new guarantees to cover the relevant period of trade. It is also vital to ensure that the liability under the guarantee is sufficient to cover the maximum outstanding from the buyer at any time. The bank’s creditworthiness and reputation also must be a consideration because there is a real, albeit rare, possibility of banks becoming insolvent.
Further, a bank guarantee does not offer absolute security as banks may contest payment in the event of a contract dispute despite the guarantee theoretically being unconditional and not linked to performance. This risk will vary depending upon the jurisdiction and the instrument’s wording but it is not unheard of to incur a loss despite the existence of a bank guarantee. Finally, a bank guarantee, which is ultimately enforced in the bank’s own jurisdiction in accordance with local laws, does not insure the seller against political risks, which can be significant in some markets and is on the rise around the world.
Conclusion
Bank guarantees, like any other risk management solution, have their advantages and drawbacks. And as open account terms become increasingly prevalent, especially where business relationships are well established, corporates are turning to more cost-effective alternatives such as trade credit insurance to protect themselves against credit risk. Given these considerations, corporates must carefully consider and compare the merits of the options available to them before choosing what best suits their needs, be it optimising short-term cashflows, securing one-off large contracts, or providing credit protection for the entire portfolio.
Read our blog series that will provide an in-depth look at each of these credit risk management tools and their strengths and weaknesses.
1 of 6: Credit risk management instruments driving trade around the world
2 of 6: Letters of Credit: The traditional solution to secure payment
3 of 6: Invoice financing: A cashflow management alternative
4 of 6: Bank guarantees: Facilitating and securing high-value transactions
5 of 6: Credit insurance: A holistic and cost-effective risk management solution
6 of 6: Credit risk management: Choosing the right solution can make all the difference
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