A letter of guarantee is an agreement issued by a bank on behalf of a customer or company who proposes to acquire goods from a supplier. Don’t confuse this with Letter of Credit, though.
The letter assures the supplier of payment on behalf of the customer, even when the customer of the bank defaults.
It is applied for by a customer. After the bank evaluates the risk and they are comfortable, they will back the customer with a letter of guarantee.
Basics of a letter of guarantee
These letters are used when a party in a transaction is uncertain that the other party involved can meet a financial obligation. They are usually used in purchases of expensive equipment or other property.
They are used in a wide variety of business situations such as declarations during export and import processes, and sometimes in contracting and construction. The bank negotiates how much they will cover with their customer.
When is a letter of guarantee required?
- New Supplier
Suppliers change contracts often with several customers. Therefore, customers are likely to provide a supplier with a letter of guarantee since a new supplier won’t have a history of transactions with the new customer. The uncertainty that exists between the two parties will require a letter of guarantee.
- Trade outside usual Trading Area
For businesses that take place overseas, you may need a letter of guarantee to show commitment to pay for products. This often happens among import and export businesses, suppliers of goods outside a country may require assurance from a bank that they will receive the fees should clients cannot pay.
- Startup Company
Some start-up companies may not have the funds to finance the purchase of goods at the start. They may require a letter of guarantee when purchasing goods.
The Process for a Letter of Guarantee
The following process is followed:
- Examining and Issuing a letter of guarantee
When an application for a letter of guarantee is filed, a bank determines whether the customer qualifies for the transaction. This is done by reviewing the underlying deal, the customer’s credit score and other relevant material. Additional information or documentation from the customer may be required.
The fees for the transaction are determined by using the principles and rates as stated by the regulations of the bank.
- Amendment of letter
The letter may be amended by the involved parties to include the adequate requirements of parties. The subject of Amendments consists of the underlying asset, validity period and so on.
- Compensation against a letter of guarantee
When a supplier has supplied goods or rendered services to the customer and make claims for compensation from the assuring bank, the bank notifies the customer of the request. The bank then examines the claim and certifies that they meet the required claim clauses of the letter. If they are met, payment is made to the supplier for the stipulated amount agreed.
- Post-Guarantee Management
The bank updates its customer’s record to reflect changes when the bank has made payment to the supplier. The details of the letter are stored ad verified to ensure that it reflects the actual transactions.
A letter of guarantee is used when parties (buyers and sellers) or business, and customers do not want to make a trade credit agreement. A letter of guarantee is a promissory letter that protects and prevents the financial risk of a supplier or producer.