A bank guarantee is an undertaking issued by a bank at the request of customer (the applicant) to a third party (the beneficiary) to make a payment in the event of non-fulfilment of contractual obligations by the customer.
Bank guarantees are widely used for business and personal transactions to protect the third party from financial losses. Bank guarantees help businesses and companies to make high-ticket purchases to scale their businesses, which would otherwise not be possible, thus helping businesses grow and promoting entrepreneurial activity.
There are different types of bank guarantees that banks offer for SMEs. These guarantees include the following –
Financial guarantees: Bank guarantees issued in lieu or earnest money or security deposit are called financial guarantees. In the case of such guarantees, the bank undertakes to repay the seller if the buyer fails to do so. The bank charges a small fee from the buyer for issuing this guarantee.
For example, say an SME buys raw materials worth Rs.1 crore from a vendor for which payment is promised within 90 days. The SME takes out a financial guarantee from a bank and deposits the guarantee to the vendor for ensuring payment. Now, if the SME fails to pay Rs.1 crore to the vendor for the raw materials, the bank would make the payment on behalf of the SME.
Performance guarantees: If the contractor or buyer of the guarantee fails to perform its duties as specified in the contract, the bank guarantees to pay the third party the resultant losses from non-performance of the contractor.
For example, say an SME enters into a contract with a company for providing 1 lakh units of goods within 30 days. The SME takes out a performance guarantee from a bank and submits the guarantee to the company. The SME, then, manages to deliver only 90,000 units of goods within 30 days. In this case, the loss suffered by the company, due to a short supply of 10,000 units, would be compensated by the bank that issued the performance guarantee.
Bid bonds: In these types of bank guarantees, the bank guarantees that the bidder who wins the contract would fulfil the contract as per the terms at which they bid. This type of guarantee ensures that the bond owner would be compensated if the bidder fails to execute the contract as per the bid terms.
For example, say an SME contractor bid on a construction job and offered to complete the construction at Rs.1500 per square foot. The SME won the contract and took out a bid bond which was submitted to the company that offered the bid. Now, if the SME fails to complete the construction at the specified rate of Rs.1500 per square foot, the bank would compensate the company for the loss incurred.
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