What Is a Bank Guarantee?
A bank guarantee is a promise from a bank or other lending institution that if a particular borrower defaults on a loan, the bank will cover the loss. note that a bank guarantee is not the same as a letter of credit (see the differences between those two below).
Bank Guarantee Example
Let's assume Company XYZ is a small, relatively unknown restaurant company that would like to purchase $3 million of kitchen equipment. The equipment vendor may require Company XYZ to provide a bank guarantee in order to feel more confident that it will receive payment for the equipment it ships to Company XYZ.
To obtain this bank guarantee, Company XYZ requests one from its preferred lender (usually the bank with which it keeps its cash accounts). The lender provides the guarantee in writing, which is then passed on to Company XYZ and its vendor. Company XYZ's lender essentially becomes a co-signer on the purchase contract with the vendor.
Why a Bank Guarantee Matters
A bank guarantee brings confidence to commerce. It enables companies to make purchases that they would otherwise not be able to make; these guarantees thus serve to heighten business activity and expand entrepreneurial activity.
Bank Guarantee vs. Letter of Credit
It is important to note that a bank guarantee is not the same as a letter of credit, although with both instruments the issuing bank accepts a customer's liability if the customer defaults.
With a guarantee, the seller's claim goes first to the buyer, and if the buyer defaults, then the claim goes to the bank. With letters of credit, the seller's claim goes first to the bank, not the buyer. Although the seller will likely get paid in both cases, letters of credit offer more assurance to sellers than guarantees generally do.
