A bank guarantee is a guarantee from a lending institution ensuring the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank covers it. A bank guarantee enables the customer, or debtor, to acquire goods, buy equipment or draw down loans, and thereby expand business activity.
BREAKING DOWN 'Bank Guarantee'
A bank guarantee is a lending institution's promise to cover a loss if a borrower defaults on a loan. The guarantee lets a company buy what it otherwise could not, helping business growth and promoting entrepreneurial activity. For example, Company A is a new restaurant wanting to buy $3 million in kitchen equipment. The equipment vendor requires Company A to provide a bank guarantee to cover payments before shipping the equipment. Company A requests a guarantee from the lending institution keeping its cash accounts. The bank essentially cosigns the purchase contract with the vendor.
Types of Bank Guarantees
A direct guarantee is typically used in foreign or domestic business and issued directly to the beneficiary. The guarantee applies when the bank's providing security is not reliant on the existence, validity and enforceability of the main obligation. Guarantees are often chosen for cross-border transactions since the beneficiary asserts claims rapidly due to the general nature of the guarantee. A direct guarantee is easier to adapt to foreign legal systems and practices due to not having form requirements.
An indirect guarantee is often issued for export business, especially when government agencies or public entities are beneficiaries. Many countries do not accept foreign banks and guarantors because of legal issues or other form requirements. With an indirect guarantee, a second bank, typically a foreign bank with a head office in the beneficiary's country of domicile, is utilized.
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