A bank guarantee is a promise made by the bank to its customers to fulfil a contractual obligation.
It is a secured finance pledge made by a bank to a third party that it would assume payment risk on behalf of its clients. To safeguard the third party from financial losses, such guarantees are commonly employed in corporate transactions with businesses. This guarantee enables a company to purchase items that it otherwise would not be able to, thus assisting business growth and encouraging entrepreneurial activity.
For example, ABC Ltd. is a newly established textile mill looking to buy Rs.1 crore worth of fabric raw materials. The raw material vendor requires a bank guarantee to cover payments before delivering the raw material to ABC Ltd. company.
The lending institution holds ABC’s cash accounts requests and receives a business guarantee. The bank effectively cosigns the acquisition deal with the vendor. If ABC company fails to pay, the vendor may be entitled to recover funds from the bank.
For example, a large furniture maker might be interested in collaborating with a small woodshop vendor. The large producer will require a bank guarantee from the small seller before entering into a deal for Rs.50 lakh worth of wood material. In this situation, the beneficiary is a huge manufacturer who requires a guarantee before engaging into a contract. If the small vendor is unable to provide the wood material, the major furniture manufacturer may be entitled to claim losses from the bank.
As a means of secured finance, bank guarantee assists in establishing a person’s trustworthiness, which allows them to receive loans and participate in economic operations. When large firms give work orders to small businesses, they usually ask them to provide a bank guarantee before doing business with them.
In most cases, these assurances are given in place of security deposits. A financial commitment from the buyer, such as a security deposit, may be required in some contracts. Instead of depositing the money, the buyer can give the seller a financial bank guarantee, which will compensate the seller in the event of a loss.
These guarantees are given to ensure and operate as secured finance that a contract or duty is fulfilled. The bank will make good the beneficiary’s loss if there is a default in the performance, non-performance, or short performance of a contract.
For example, A and B enter into a contract for the execution of a project, which is backed by a bank guarantee. If A fails to complete the project on schedule and does not reimburse B for the loss, B can sue the bank for compensation using the bank guarantee.