Bank Guarantee

A landlord will not sign a ten-year lease with a company that could be wound up next year without something to hold. A principal awarding a contract wants an assurance that the contractor will finish, or that someone will pay for the one who does. A government tender requires proof that the bidder is serious. In each case the counterparty is not asking for money; it is asking for the certainty that money would be there if things went wrong — and a business's own promise is worth exactly as much as the business, which is the problem.

A bank guarantee substitutes the bank's promise for the customer's. The landlord holds a document under which the bank will pay the bond on demand; the contractor's principal holds a performance bond it can call if the work stops. The business has borrowed the bank's credit standing without borrowing any money, and pays a fee for the difference. The bank has written a loan that will only ever be drawn on the worst day of the customer's year — and has agreed, in most cases, to pay first and argue later.

The parties — the customer who arranges it (the principal, in the document's own terms), the beneficiary who holds it and may call it, and the bank that pays. The amount — fixed, or reducing on a schedule as a contract is performed. The trigger — the load-bearing clause. An on-demand guarantee pays against a compliant written demand, with no proof of default required; a conditional guarantee pays only when the default is established. Beneficiaries insist on the first; almost every guarantee in this market is one. The expiry — a date, or an event such as practical completion, after which the beneficiary's right lapses and the bank's exposure ends; a guarantee with no expiry is a permanent loan-in-waiting.

The forms it takes — a rental bond in place of a cash deposit on a lease; a performance bond, often 5–10% of a contract sum, that a principal can call if the contractor fails; a tender or bid bond that costs the bidder its bond if it wins and walks away; a retention bond that lets a contractor be paid the money a principal would otherwise hold back until the defects period ends; an advance-payment bond that protects a buyer who has paid a deposit before delivery. Security — the bank's recourse against its customer for anything it pays: a general security agreement, directors' guarantees, a charge over a deposit, or cash cover. The limit — guarantees are issued under a guarantee facility with its own limit, or as a sub-limit of the customer's overall facility, and count against it whether or not they are ever called.

A guarantee is priced as a fee on the amount for as long as it is outstanding, not as interest on a drawing — which makes it look cheap next to a loan and makes its real cost easy to miss. A constructed illustration, every figure invented for teaching — a contractor whose bank issues a US$500,000 performance bond for an eighteen-month project at a 2.0% annual fee:

The fee is the small number. The large number is the limit the guarantee occupies: half a million dollars of the contractor's borrowing capacity that cannot fund the next job, for eighteen months, without a dollar being drawn. A business that runs several bonds at once can find its entire facility consumed by promises, and then asks its bank for more “because nothing is drawn” — which is where the cycle arithmetic and the bond book have to be read together. Cash cover removes the credit and the fee, at the cost of tying up the very cash the business borrowed to free.

As a drawn loan for the full amount. The bank has committed to pay on demand, so the credit assessment is the one it would make for a loan of that size to that customer — the same three questions, the same debt service cover on the assumption the guarantee is called, the same security. A guarantee sits inside the customer's total exposure, and a desk that leaves it out of the leverage arithmetic because “it is contingent” has understated the debt by the amount most likely to be owed on the worst day.

The contract behind it. A performance bond is called when the contractor cannot finish; a rental bond when the tenant cannot pay; a tender bond when the bidder wins something it should not have bid for. Each call arrives at the moment the customer is least able to reimburse the bank, which is the whole point of the beneficiary wanting it. So the desk reads the contract the bond protects — the margin in it, the customer's record of finishing, the terms under which a call can be made — because the probability of the guarantee becoming a loan is the probability of that contract going wrong. Wrongful calls. An on-demand bond can be called by a beneficiary who is itself in trouble; the bank pays anyway and the customer pursues the beneficiary afterwards. That is a credit risk on the customer, and a reason the desk cares who the beneficiary is.

The expiry and the count. Every outstanding guarantee is listed, with its expiry, and the list is reconciled to the limit at every review. A bond that should have lapsed at practical completion but was never returned is exposure the business has forgotten and the bank still carries.

“It's only contingent.” A guarantee book left out of the leverage calculation, a facility approved as if the bonds did not exist, and a call arriving in the same quarter the loan breaches its covenants. The two are not independent events; they are the same event seen from two sides.

The guarantee with no expiry. Issued for a lease, a contract or a deposit, never returned, never cancelled, and carried on the bank's books for years after the beneficiary forgot it existed — consuming limit, and callable by whoever finds it in a drawer.

Bonds as a way of winning work. A contractor who bids everything, bonds everything, and discovers that a facility full of performance bonds cannot fund the wages on the jobs it won. The guarantee did not cause the problem; it made the problem invisible for a year.

Reading the paper and not the counterparty. A beneficiary who calls a bond because its own cash has run out is a real risk on a real customer, and it is not visible anywhere in the customer's accounts. The question “who holds this, and how are they doing?” belongs on every guarantee review.

No published file yet turns on a guarantee — the product usually sits beside the decision rather than at its centre — but three pages on this site read the same promise from other angles. The guarantee the bank holds rather than issues is the subject of Personal Guarantees, written from the credit desk for the person signing it. The bank undertaking that a trade is built around, rather than protected by, is LC discounting, and the trade it finances is the trade loan. The building contract whose performance a bond protects — and the retention a bond can release — is read in Property Development Finance and the development loan. What a bank takes as recourse for issuing one is LVR, Security and Collateral.