Pros and Cons of Bank Guarantees
In the previous article, we have already studied what bank guarantees are and how these bank guarantees are provided by a commercial bank as a value-added service to their corporate customers. We are also aware of the various types of bank guarantees as well as their purposes. In this article, we will understand some of the pros and cons which are associated with bank guarantees.
Pros of Bank Guarantees
Commercial banks provide bank guarantees to a large number of corporate clients. These bank guarantees provide significant revenue to commercial banks. These guarantees are available to corporate customers because of some benefits. An indicative list of some of these benefits has been mentioned below:
- Lower Costs: The main advantage of a bank guarantee is that it is a cost-effective way to improve the creditworthiness of a business. This is because the fees charged by the banks are generally not very high.
Banks generally charge anywhere between 0.5% to 1% of the amount that they guarantee. Thus, the transaction costs are low and not an impediment to the overall conduct of business. These lower costs enable companies to produce goods and services at a better price.
- Better Cash Flow Management: Another important factor to note is that bank guarantees eliminate the need for making any advance payments. Since the sellers are assured that they will be paid promptly once they deliver goods or services, they do not ask for advance payments. This helps the buying company to better manage its cash flow.
Since no advance payments are required, the working capital requirement is reduced and this positively impacts the overall cost of capital. Hence the cost of operations for the business is lowered because of better cash flow management which is made possible by bank guarantees.
- Increased Opportunities: There are a lot of opportunities that are not available to small and medium enterprises because of their lack of creditworthiness. The counterparty is not sure of the financial or operational capability of the corporations and hence is not willing to conduct business with them. Since bank guarantees replace the creditworthiness of the corporation with that of the bank, the concern of the counterparty does not remain valid. Small and medium businesses have witnessed a drastic increase in the opportunities available to them as a result of bank guarantees.
- Streamlined Process: Businesses that avail bank guarantees on a regular basis are aware of the fact that the process to obtain a bank guarantee is quite streamlined. Once the bank has conducted due diligence on the corporation, they are able to provide a bank guarantee within a couple of days. Hence, the process is not lengthy or complicated. It is, in fact, considered to be easier as compared to loans and overdrafts. This is one of the reasons why corporations prefer to obtain bank guarantees.
- Signaling Effect: The fact that commercial banks consider a corporation to be creditworthy speaks volumes about the way in which finances are managed in that corporation. Thus, the issuance of a bank guarantee by a reputed bank is often taken as a positive signal by all the prospective creditors in the market. The benefit of this signaling effect is that companies are able to obtain funds at lower costs because of the positive word of mouth in the market.
Cons of Bank Guarantees
There are certain disadvantages that are associated with bank guarantees as well. It is important for corporations as well as commercial banks to understand these cons before making any final decision.
- Difficult to Obtain: The process of obtaining bank guarantees is seamless only if a business has very strong financials, to begin with. However, if a business has unpredictable cash flow, then it can quite difficult to obtain a bank guarantee. Since unsecured bank guarantees are similar to bank loans, the due diligence is carried out at the same level. Hence, businesses whose financial position is less than ideal find it quite difficult to obtain these guarantees.
- Collateral Required: In many cases, banks ask for significant collateral which almost covers the cost of the bank guarantee. This makes it difficult for businesses to avail of such guarantees. The only benefit remains that businesses do not have to actually liquidate their investment in order to obtain funding. Instead, they can use them as collateral to obtain funding. However, if a business does not have the required collateral, then obtaining a bank guarantee becomes difficult.
- Regulatory Hassles: In many parts of the world, there have been frauds involving bank guarantees. In such countries, the regulators have come up with a very strict set of rules which need to be followed before a bank guarantee can be issued. This is because if bank guarantees are issued without due diligence by one bank, it can destabilize that bank which in turn can destabilize the entire banking system.
In such countries, there are too many regulatory hassles for obtaining bank guarantees. Hence, banks are not willing to offer their guarantees in such countries and even corporations refrain from availing of them.
After all the points are considered, one can say that bank guarantees provide more advantages than disadvantages. This is the reason why they are extremely popular amongst the business community in most parts of the world.
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