Net Worth & Solvency Glossary · Lending
A bank guarantee (BG) is a bank's written promise to pay a stated sum to a third party (the beneficiary) if the bank's customer fails to perform an obligation.
It works as a contract of guarantee. In the terms section 126 of the Indian Contract Act, 1872 uses, the bank is generally treated as the surety, its customer as the principal debtor and the beneficiary as the creditor.
Who gives what to whom, with the applicant's side of the bargain shown under its name. Labels only.
Pays on a valid invocation, then recovers what it paid from its customer.
A government department, a buyer or a landlord, for example.
Meaning
In banking, "BG" is shorthand for this instrument. The customer (the applicant) asks its bank to issue a guarantee in favour of a beneficiary, such as a government department, a buyer or a landlord.
Inside the guarantee's validity, stating that the customer has defaulted in the terms the guarantee describes.
As a rule of practice it does not usually investigate the dispute behind the claim, and that independence is a large part of why a beneficiary accepts a guarantee at all.
If the invocation was wrong, the customer pursues the beneficiary afterwards, not the bank.
The bank then recovers what it paid from its customer, which is where the net worth test of section 02 begins.
Tenor matters as much as the amount, because a guarantee lapses on its expiry date unless it has been invoked or extended. Many guarantees also carry a claim period after expiry, during which a claim for a default inside the validity can still be made.
The limit
A BG limit is the total amount of guarantees a bank has agreed to issue for a customer. It is a non-fund limit.
This is why a guarantee limit can be harder to obtain than a funded loan of the same amount, and why an applicant with strong turnover but thin net worth may be declined. A certified net worth figure tells the credit team what could be recovered, and it is read alongside the charges over the assets it names. A CA prepares a net worth certificate for a bank loan for this kind of file.
Three levers
Banks use three levers on a guarantee limit. Each bank sets them by its own credit policy.
Cash or a deposit the customer keeps with the bank against the guarantee. The bank marks a lien on it, so the customer cannot withdraw it while the guarantee is live.
How much margin a bank asks for depends on its policy and on the customer's standing.
The customer's own written undertaking to reimburse the bank if the guarantee is invoked. It is signed before the guarantee is issued.
A "counter BG" can also mean a guarantee issued by one bank to another, which then issues the final guarantee to the beneficiary.
The bank's charge for issuing the guarantee, usually based on the amount and the tenor together.
All three appear in the sanction letter.
If it is invoked, it becomes a real obligation.
Sources: Indian Contract Act, 1872, section 126 (India Code). This entry describes Indian banking practice in general terms. The guarantee wording and the bank's sanction letter govern each case.
Need help with a certificate for a bank guarantee file? See our Net Worth Certificate for Bank Loan.A certified net worth figure, read alongside the charges over the assets it names.