Covering the risks associated with meeting third-party commitments through bank guarantees
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The bank can make funds available to a business in the form of short-term credit and medium and long-term loans and it can give its assistance in the form of an undertaking called a signed guarantee. In this case, the bank does not immediately provide a cash advance but provides its signature to the customer as a guarantee. It undertakes in writing to meet the obligations taken on by its customer with the beneficiary, in the event that its customer should fail to do so.
There are 4 main types of signed guarantee:
- the bank guarantee: the beneficiary can ask the issuing bank for payment without having to justify its request. A bank guarantee is therefore separate from the initial commercial agreement;
- the surety: the bank undertakes to make the payment instead of its customer if the latter does not respect its obligation. There is therefore a link between the bank’s obligation to pay and the obligation stated in the initial commercial agreement;
- the documentary credit: the beneficiary must provide documents in support of its request for payment, but the bank guarantee is still separate from the initial commercial agreement;
- the letter of credit: the bank provides a payment undertaking valid throughout the whole period of validity of the deed if the beneficiary submits supporting documents that comply with what is requested in the wording of the undertaking.
Who is concerned
Available to any business, whether a sole proprietorship or company, the covering of risks associated with meeting third-party commitments using bank guarantees applies in particular in the following cases:
- commitments made in the context of public tenders;
- counterparties that do not know each other (suppliers and buyers);
- lease contracts that require a bank guarantee;
- terms of payment requested from suppliers, etc.
Prerequisites
Documentation or description of the business
- copy of the company’s articles of association;
- group structure if the company is part of a more complex group;
- last 3 audited balance sheets of the borrower and, if applicable, the latest available trial balance;
- recent supporting documentation regarding VAT, tax and social security situations;
- order book (where applicable);
- list of customers and their relative contribution to turnover;
- list of suppliers.
Presentation of the application
- copy of the underlying initial agreement;
- copy of the bank guarantee wording agreed between the parties (exporter and importer);
- address and contact details of the beneficiary of the bank guarantee requested.
Guarantees
Even though a bank guarantee is a signed guarantee, it could become a payment guarantee in the event of incorrect execution or non-fulfilment by the debtor.
Credit risk is not negligible and guarantees may be requested depending on the business’ overall financial structure, its turnover, its professional reputation and the extent of the bank guarantees requested.
The most common guarantees requested for a bank guarantee are:
- the mortgage registration;
- the pledging of a cash deposit;
- the surety of the parent company or partners/shareholders;
- various moral guarantees.
When the partners/shareholders of a business have to stand surety for the company, the bank should be provided with the details of their financial situation.
How to proceed
Definition of a bank guarantee
Duration
A bank guarantee may be issued for a specified or open-ended period:
- specified period: the bank guarantee terminates on the maturity date mentioned in the document;
- open-ended period: the bank can terminate its undertaking by giving reasonable notice.
Amount
In principle, the amount of a bank guarantee depends on the initial agreement; it corresponds either to the amount of the initial agreement or a percentage thereof determined by the parties.
Remuneration/Cancellation
Since in principle there is no disbursement, unless the guarantee is called upon, a bank guarantee is not repaid but rather it is cancelled.
The bank guarantee can be cancelled:
- on the expiry of the undertaking issued by the bank;
- by the beneficiary returning the original version of the bank guarantee to the bank;
- by the issuing bank's receipt of a letter signed by the beneficiary stating that it expressly waives the bank guarantee in question;
- by the beneficiary calling on the bank guarantee, in which case the bank pays out the money to the beneficiary by debiting the business’ current account.
Types of bank guarantee
- the tender guarantee: the purpose of a tender guarantee is to ensure that bidders meet the undertakings made during tenders. The buyer thereby intends to avoid bids from unreliable or unqualified partners;
- the advance payment guarantee: the purpose of an advance payment guarantee is to ensure that the deposit paid by the buyer will be refunded if the merchandise is not supplied or if the work is not carried out;
- the performance guarantee;
- the payment guarantee;
- the rental deposit: the purpose of a rental deposit is to ensure payment of the rent to the owner.
Advantages, disadvantages and risks
Advantages
- ease of carrying out transactions between players that do not know each other well;
- more favourable commercial conditions while avoiding drawing too much on the business’s cash;
- reduction in cash flow shortages resulting from a gap between the payment of invoices received and the collection of invoices issued;
- enhancement of the business' brand image by the bank's acceptance of the undertaking.
Disadvantages
- often subject to fees even if not used or not executed;
- possible blocking of funds as a counter-guarantee of the bank guarantee.
Risks
Risk of the signed guarantee becoming a payment guarantee resulting in high costs for the bank’s customer (e.g. overdraft interest on the current account that does not have a credit line).
