Bank Guarantees — Types & Assessment
Relevent for JAIIB PPB | CAIIB ABM | CCP Module C
Why It Matters in Branch:
Bank Guarantees are frequently invoked; therefore, understanding their types, contingent liability calculation, and the invocation process is essential for credit and operations staff.
SHORT NOTES
DEFINITION OF BANK GUARANTEE:
A Bank Guarantee (BG) is an unconditional undertaking given by a bank as a guarantor. Under this arrangement, the bank promises to pay the beneficiary (creditor) a fixed amount if the customer (principal debtor) fails to meet contractual obligations.
KEY CHARACTERISTIC: Bank Guarantee is unconditional and irrevocable. Bank must pay on valid invocation — it cannot refuse payment citing disputes between customer and beneficiary.
TYPES OF BANK GUARANTEES:
PERFORMANCE GUARANTEES (Non-financial guarantee):
1. Bid Bond / Tender Guarantee: Ensures bidder does not withdraw after winning tender. Usually 1-5% of tender value.
2. Performance Guarantee: Ensures contractor completes the work as per contract.
3. Advance Payment Guarantee: Ensures buyer that advance paid to seller will be refunded if work not completed.
4. Retention Money Guarantee: Released in lieu of retention money withheld by buyer.
FINANCIAL GUARANTEES:
1. Deferred Payment Guarantee (DPG): Guarantees payment of instalments for machinery purchased on credit.
2. Financial Guarantee: Guarantees payment of duties, taxes, rent, etc.
3. Statutory Guarantee: Issued to government/statutory bodies for compliance purposes.
ASSESSMENT OF BG LIMITS:
Unlike CC, BG does not involve immediate fund flow. But banks must assess:
- Probability of invocation (performance risk vs financial guarantee)
- Financial strength of customer to reimburse bank
- Period of guarantee — BG limits are non-fund based but block customer’s borrowing capacity
MARGIN REQUIREMENTS:
Banks typically stipulate cash margin of 10-25% (or higher) for performance guarantees.
For financial guarantees involving certain payment, margin may be 100%.
INVOCATION PROCESS:
Valid claim must be received before guarantee expiry.
Bank should honour valid claim even if customer disputes it — it is a dispute between customer and beneficiary, not involving bank.
After paying, bank has right of recovery from its customer.
LIMITATION:
BG must be invoked before expiry date. Claims received after expiry are not payable.
BRANCH CONTEXT
✦ The trickiest situation is when a customer calls at the last minute asking us to stop payment on a BG that is being invoked, claiming the beneficiary’s claim is fraudulent. Unless there is a court order restraining payment, the bank is legally obliged to honour the guarantee. This is the unconditional nature of bank guarantees.
