Written byA bank guarantee is a written promise from a bank to pay a set amount to a third party if its customer does not meet an obligation.
Also known as: banker's guarantee, letter of guarantee, guarantee facility
Key points
- It is most often used in place of a cash bond on a commercial lease, so a tenant keeps its working capital.
- No money changes hands upfront: the bank pays only if the party holding the document calls on it.
- Banks normally take security for the full amount, usually cash on deposit or a charge over property.
- Fees run for as long as the document stays on foot, and many have no expiry until the original is returned.
- The facility is a contingent liability: it ties up security, uses part of your bank limit and counts when other lenders assess you.
How a bank guarantee works
You apply to your bank, which assesses you much as it would a commercial loan and then issues a signed document naming the beneficiary, the amount and what it relates to. The beneficiary, often a landlord, holds the original. Nothing is drawn while the arrangement runs normally.
If you breach the contract, the beneficiary presents the document and the bank pays, without arguing the merits of the dispute. The bank then recovers the money from you or from the security it holds. Releasing the facility means the beneficiary returning the original so the bank can cancel it.
Where bank guarantees are used
Commercial property is the common one. Landlords want cover for unpaid rent and make good costs, and a bank promise is stronger than a bond sitting in a tenant's account. Builders use them for retention on a contract, and importers, councils and government agencies often ask for one before awarding work.
They are also a cashflow tool. Handing over a large cash bond ties up money a business could put into stock or equipment, so some operators prefer to pay a fee and keep the cash working. The trade off is that the bank still wants cover, so the cash is often held on deposit anyway.
Example
A cafe owner signs a five year lease on a shopfront in Newcastle. The landlord asks for a bond worth six months of rent. Rather than hand over the cash, the owner asks her bank for a guarantee for the same amount. The bank issues the document to the landlord and holds a term deposit as security, charging an ongoing fee. Three years in, the cafe is trading well and the owner asks the landlord for the original back so the facility can be cancelled and the deposit released.
Not to be confused with
- Personal guarantee
- a personal guarantee is an individual promising to cover a business debt, not a bank promising to pay
- Security deposit
- a security deposit is cash handed over upfront; this is a promise to pay if called on
Frequently asked questions
How does a bank guarantee work?
Your bank issues a signed document to a third party, promising to pay a stated amount if you fail to meet an obligation such as rent. The bank usually holds security for that amount. If nothing goes wrong, no money is ever paid and the document is returned for cancellation.
How much does a bank guarantee cost?
Banks charge an establishment fee and an ongoing fee, generally worked out as a percentage of the amount covered and charged for as long as the facility stays open. The bigger cost is often the cash you have to leave on deposit as security. Ask the bank for the full fee schedule.
Is a bank guarantee the same as a letter of credit?
They are close cousins. A letter of credit is designed to be drawn on as part of normal trade, usually to pay an exporter once documents are presented. A bank guarantee is meant to sit unused and only pays if something goes wrong, which makes it a backstop rather than a payment method.
How do I cancel a bank guarantee?
Most have no expiry date, so the bank will only cancel once the beneficiary returns the original document or provides a written release. That means asking the landlord or contract holder directly. Until it comes back, the fees keep running and your security stays tied up.
Do I need security for a bank guarantee?
Almost always. Banks commonly require cash held on term deposit for the full amount, or a charge over property. Some established businesses can arrange one against an existing facility limit instead. Either way the bank assesses your position first, because it is taking on real credit risk.
Related terms
Broader term: Guarantee
Guarantee
A guarantee is a contract in which a guarantor promises a creditor to pay or perform if the principal debtor defaults, supporting the debt rather than replacing it.
Read definitionPersonal guarantee
A personal guarantee is a legally binding promise by an individual, usually a director or business owner, to pay a creditor if the borrowing business or person defaults.
Read definitionSecurity (collateral)
Security (collateral) is an asset or legal interest a borrower grants a lender, which the lender can take and sell to recover the debt if the borrower defaults.
Read definitionSecurity deposit
A security deposit is an upfront cash contribution a borrower pays towards the purchase price of a financed asset, reducing the amount the lender funds.
Read definitionLiability
A liability is a legal responsibility to pay money or answer for a loss; in accounting, a present obligation to transfer an economic resource, shown on the balance sheet.
Read definitionCommercial loan
A commercial loan is credit provided to a company, trust or other business structure to fund business activities such as property, equipment or working capital, not personal spending.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.