What is a Guarantee?
A financial guarantee is a non-cancellable ‘promise’ backed by a bank or insurer to underwrite a contract and make payments to a recipient if its terms are not met.
Guarantees provide firms with security by ensuring that their capital will be repaid in the event of issues with the fulfilment of a contract they are engaged in. Given trade finance deals are often conducted between companies in jurisdictions which are remote from or unfamiliar to those involved, guarantees can provide both lenders and participants with the security required for them to engage in profitable international trade ventures.
Guarantee - Definition
Although the core concept of a guarantee remains the same however they are used, there are several types of guarantee which banks can provide to businesses to secure their financial operations in different contractual situations. In trade finance, guarantees have three common uses.
First, guarantees can provide security to importers providing part payment or deposits to international suppliers that the finance they provided is secure in the event of the supplier failing to fulfil that contract. This product, called an advance payment guarantee, is provided by a third party (such as a bank) to the party at risk (the importer). Second, guarantees can also protect importers against the risk that a supplier will not fully fulfil the terms of a contract because of errors, delays, or lack of quality. Instead, banks secure importers’ financial outlay against these risks using performance guarantees, which underwrite penalty fees or compensation payments made in contracts for failure to fulfil them.
Finally, in jurisdictions where financial institutions cannot directly assume guarantees (such as the United States), banks within those jurisdictions will typically offer guarantee obligations through other mechanisms, such as standby letters of credit (SLCs).
Guarantees vs. Insurance
Although they both provide levels of security to contracting parties in the event of non-fulfilment, there are three key differences between a financial guarantee and an insurance product.
Firstly, guarantees are underpinned by an indirect agreement between one of the two beneficiaries of a transaction (say, an importer of goods) and a third party (the bank guaranteeing the importer’s contract). This agreement sits alongside the primary agreement between the importer and the exporter. In contrast, insurance is a direct agreement between the insurance provider and the policy holder regarding the policy holder’s activities.
Secondly, guarantees are strictly focused on performance or non-performance within contracts, whereas insurance products underwrite contracts to protect against possible loss. Finally, whereas insurance can usually be cancelled by either the provider or the policy holder if enough notice is provided, guarantees cannot be cancelled. Instead, they expire once the contract they apply to is fulfilled.
- Iron Inc is an iron ore trader who imports iron ore into the UK from Australia, before selling it to large industrial smelters and manufacturers.
- A client approaches Iron Inc asking them to supply them with 10k tonnes of direct shipping ore – iron ore of sufficient quality to be fed directly into a blast furnace –in exchange for a fee of $1m.
- Iron Inc has never bought such a large volume of high-quality ore before, as its existing suppliers cannot produce that volume.
- Instead, it identifies a new supplier – Oz Pit – and negotiates a contract to have 10k tonnes of direct shipping ore extracted in Australia and delivered to the UK for $750k.
- As Oz Pit has never worked with Iron Inc before, they ask for 20% part payment of the contract up front before beginning extraction – $150k.
- Before making this payment, Iron Inc agrees an advanced payment guarantee with TFG, whereby if Oz Pit fails to fulfil this contract, TFG can guarantee that Iron Inc will have their $150k returned.
- Iron Inc pays Oz Pit the $150k and extraction begins.
- The ore is extracted and shipped to the UK.
Payments are exchanged, the contract is fulfilled and the guarantee expires.
- Provide reassurance to all parties in a commercial transaction that the terms of contracts regarding large financial investments will be met in full.
- Allow companies to give tendering parties assurances that they can fulfil contracts
- Offer financial credibility and creditworthiness to the firm through the backing of a bank
- Enable companies to bid for larger or more lucrative contracts in unfamiliar territories or industries because of the financial assurances underpinning their bids.
- Are designed and negotiated to have flexibility in their terms, to ensure they can be paid in different currencies.
- Can support ventures into unfamiliar political or legal jurisdictions where the risk of non-fulfilment of contracts is greater (for example, in a state which rules that an insolvent business in its territory must repay native citizens before it repays private investors).
Something to watch out for
Guarantees can sometimes be issued between parent companies and subsidiaries, in order to show would-be clients that the activities of the smaller company are underwritten by the larger, profitable conglomerate. These guarantees do not have to be recorded as liabilities on either firm’s balance sheet. However, firms using guarantees in this way must disclose the guarantee in a detailed financial statement explaining the terms of the guarantee, the maximum possible liability to the parent company, and the provisions made by the guarantor to recover funds in the event of it being activated.