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How Does a Bank Guarantee Work? A Step-by-Step Guide

  • 08-Aug-2023

A Bank Guarantee (BG) is a promise from a bank or other financial institution that if a particular debtor defaults on a loan, the bank will cover the loss. It is a tool to mitigate risk in financial transactions, ensuring that a debt will be paid, either by the original party or the bank.

1. Recognizing the Need

  • When Required? Typically during large transactions, international deals, or when the business's credibility is uncertain.

2. Approaching a Bank

  • The party needing the assurance (known as the "applicant") approaches a bank or a financial institution.
  • They present the purpose, details of the transaction, and the beneficiary (the party that would receive compensation if the applicant defaults).

3. Submitting the Application

  • A formal application, often with detailed information about the transaction, contract, or deal, is given to the bank.
  • The bank might require financial statements, details of the deal, or other relevant documentation.

4. Evaluating Creditworthiness

  • Before issuing a bank guarantee, the bank examines the applicant's credit history and financial stability.
  • They assess the risk of default and the applicant's ability to fulfill the contract.

5. Determining Collateral

  • Due to the risks involved, the bank might request collateral or other forms of security.
  • This could be in the form of cash, real estate, or other assets.

6. Issuance of the Bank Guarantee

  • If satisfied, the bank issues the bank guarantee, specifying the exact conditions under which it would pay the beneficiary.
  • The validity period, amount, and other terms are clearly stated.

7. Transaction Execution

  • With the bank guarantee as a safety net, the applicant and beneficiary can proceed with their transaction or agreement.
  • It ensures trust, especially if the two parties haven't had previous dealings.

8. Invoking the Guarantee (If Required)

  • If the applicant doesn't meet the contractual obligations, the beneficiary can invoke the bank guarantee.
  • By presenting it to the issuing bank, the beneficiary can claim the specified amount.

9. Bank's Recourse

  • After paying the beneficiary, the bank will seek to recover its funds from the applicant.
  • If collateral was provided, the bank has the right to seize it. Otherwise, the bank might resort to legal avenues.

10. Expiry or Release of the Guarantee

  • If the transaction proceeds without any hitches and obligations are met, the bank guarantee expires or is released.
  • Any collateral or security deposit is returned to the applicant.

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