What is a Bank Guarantee?
A Bank Guarantee also known as a Letter of Guarantee is utilised to guarantee payment on a loan in the event the beneficiary of the Bank Guarantee defaults on that loan. A Bank Guarantee takes many different forms including direct and indirect guarantees as explained below. The mechanics of the transaction are straightforward where one bank receives the Bank Guarantee (The Receiving Bank) on behalf their client (The Beneficiary) from another bank (The Issuing Bank) on instructions received from their client (The Applicant or Provider).
A simple misconception exists where a Bank Guarantee (BG) is compared to a Standby Letter of Credit (SBLC) and a Documentary Letter of Credit (DLC) as similar means of payment. This is an incorrect assumption as a Bank Guarantee is utilised as SECURITY for payment, and Standby and Documentary Letters of Credit are a MEANS of payment.
The laws of the country in which the Issuing bank is domiciled govern all aspects of the law in relation to Bank Guarantees, not as sometimes mistakenly assumed the laws of the country where the beneficiary bank is domiciled. It is therefore most important that all legal aspects regarding each BG be studied on a separate basis.
As already indicated a BG can be structured under many different formats. A Direct Bank Guarantee is where one bank issues a BG direct to another bank. An Indirect BG is where the issuing bank instructs their correspondent bank to issue the Bank Guarantee on their behalf. In such cases it is usual for the correspondent bank to request a counter Guarantee or block the equivalent value on the issuing bank’s account. Another popular type of guarantee is the Performance Guarantee or Surety Bond, and it is important to differentiate between these two types of guarantees and a Bank Guarantee. In the event of a default a Bank Guarantee is payable on DEMAND, whilst a Performance Guarantee or Surety Bond is more like a type of insurance which will only pay once certain criteria have been met.
Collateral Transfer is a very popular facility for raising loans or credits lines referred to as Credit Facility Guarantees and utilises Demand Bank Guarantees. The Demand Bank Guarantees uses exact and unique wording and are governed by ICC Uniform Rules for Demand Guarantees (URDG 760) and are payable on First Demand.
A Bank Guarantee that is used in this manner is often incorrectly referred to as Leased Bank Guarantees, as they closely resemble a commercial leasing transaction. The term lease(d), is a loose definition, and has been used for many years, whereas the technical term is the Collateral Transfer Facility, also referred to as C/T Facility. The C/T Facility, is a financial model, where the client requesting The Bank Guarantee, (The Beneficiary) requests an asset owner, (The Provider), to instruct their bankers, (The Issuing Bank), to transfer a Bank Guarantee to the beneficiary’s banker, (The Receiving Bank).
The C/T Facility allows the beneficiary to take temporary ownership (usually for a term of one year), of the Bank Guaranty, and as such the provider will charge a fee. At the end of the term, or expiry date, the BG will revert to the ownership of the provider. Essentially, the provider is placing the Bank Guarantee at the disposal of the Beneficiary in order to boost the size of the balance sheet. If a loan or line of credit, referred to as Credit Guarantee Facilities, is required using the asset as security, the beneficiary will request the Provider to supply a Demand Bank Guarantee.
Leased Bank Guarantees may be received from a varying range of providers. These providers are situated in different parts of the world and range from, Family Offices, Equity and Hedge Funds, companies enjoying an excess of assets and Sovereign Wealth Funds. Utilising their balance sheets, providers can arrange to issue Bank Guarantees against such assets as gold, silver and similar commodities of value, unencumbered share, bond and property portfolios and of course, cash.
Leased Bank Guarantees are applied to the beneficiary’s account for “Value Received”, as Bank Guarantees cannot be traded and therefore do not carry a credit rating. It is often the case, that banks and their credit committees, will assign the Issuing Banks rating to the Bank Guarantee, and if that rating is non-investment grade, they will decline the beneficiary’s application for a loan or a line of credit. However, there are many bankers who will judge a Bank Guarantee’s value by looking at the Issuing Banks history in honouring calls on their Bank Guarantees, and if that history has a good track record, the bank will approve the beneficiary’s application for a loan or a line of credit.
More and more companies are using the Collateral Transfer Facility to raise a loan or line of credit, and both the providers and beneficiary’s bankers through their own due diligence on the lenders and providers contracts, will ensure the smooth running of the transaction which ultimately provides a line of credit for the beneficiary.
