Strategic Management and Corporate Finance · Raising of Funds - Non Fund Based

Bank Guarantee: Types, Invocation and Difference from LC

Updated 11 October 2026 · Fact-checked

A bank guarantee is a written promise by a bank to pay a beneficiary if the bank's customer (the applicant) fails to meet a stated obligation. Main types are performance, financial and bid bond guarantees. To solve questions, identify the obligation, the guarantee type, the invocation conditions, and compare with a letter of credit.

Understand Bank Guarantee

A bank guarantee (BG) is a non-fund based facility. The bank does not lend money on day one. It gives its name and credit as support. If the customer defaults, the bank pays the beneficiary up to the guaranteed amount.

Three parties are involved. The applicant (also called the principal or customer) asks the bank to issue the guarantee. The bank is the guarantor or issuer. The beneficiary is the party who receives the promise and can claim under it. The bank usually charges a commission and takes margin money or security from the applicant. The applicant also gives a counter-indemnity to reimburse the bank if it pays.

The common types are:

Bid bond (tender guarantee): given with a tender. It assures the buyer that the bidder will sign the contract if it wins. If the bidder backs out, the buyer can claim.
Performance guarantee: given after a contract is won. It protects the buyer if the contractor fails to perform as agreed, for example delays or poor work.
Advance payment guarantee: given when the buyer pays an advance. It protects the buyer if the seller takes the advance but does not deliver.
Financial guarantee: it secures a payment obligation, such as repayment of a loan, payment of dues, or deposits to a government authority or a supplier.
Deferred payment guarantee: it supports payment of purchase price in instalments, for example for capital equipment.

Guarantees can be conditional or unconditional. In a conditional guarantee, the bank pays only if the beneficiary proves the stated default. In an unconditional (on-demand) guarantee, the bank pays on a written demand that complies with the terms, without examining the underlying dispute. Each guarantee has a validity period and a claim period. A claim must reach the bank within these periods. After expiry, the bank is released.

A letter of credit differs from a guarantee in its basic purpose. An LC is a payment mechanism. The bank pays the seller when compliant documents are presented, and the LC is the expected route of payment in the normal course of a trade. A BG is a safety net. The bank pays only if the applicant defaults. Because of this, the LC is a primary means of payment, while the BG is a contingent undertaking.

Key rules to remember

Parties to a guarantee: Applicant (principal) + Bank (issuer) + Beneficiary; Always name all three. The bank's liability is to the beneficiary, up to the guaranteed amount and within the validity period.
Bank's reimbursement right: Bank pays beneficiary → recovers from applicant under counter-indemnity, margin and security; Payment under the BG creates a debt of the applicant to the bank.
Bank's income and exposure: Guarantee commission = guaranteed amount × commission rate per annum × period in years; Use the rate given in the question. Pro-rate for months.
Margin money: Margin = guaranteed amount × margin %; The bank holds this from the applicant as cash cover. Exposure net of margin = amount − margin.
BG versus LC (core test): LC: bank pays against compliant documents in the ordinary course. BG: bank pays only on default of the applicant.; This single line answers most compare questions.

How to solve Bank Guarantee questions

Use this order for any descriptive or case question on bank guarantees. It keeps your answer structured: facts, concept, application, conclusion.

1Identify the applicant, the bank and the beneficiary from the facts.
2State the underlying obligation: tender, contract performance, advance, payment, or deferred payment.
3Name the right guarantee type: bid bond, performance, advance payment, financial or deferred payment guarantee.
4Note whether it is conditional or on demand, and read its validity and claim dates.
5For invocation questions, check that the demand is written, within the validity and claim period, and matches the terms of the guarantee.
6For comparison questions, use the basis of purpose, nature of liability, when the bank pays, documents needed, and the applicant's risk.
7For numerical parts, compute commission, margin and net exposure with the data given.
8Conclude clearly: whether the bank must pay, which instrument suits the need, or the figure asked.

Quickest way: Three-line answer for BG questions

When to use it: Use when you have limited time, such as a 5-mark short note or a quick compare question.

Line 1: define the BG as a bank's contingent promise to pay the beneficiary if the applicant defaults.
Line 2: name the type that matches the facts and what risk it covers.
Line 3: add either the invocation rule (written demand, within validity, as per terms) or one clear difference from an LC (LC is a payment tool, BG is a safety net).
For comparisons, write a five-point table-style list using bullets: purpose, bank pays when, nature, documents, risk.

Common mistakes in Bank Guarantee

Treating a bank guarantee as a loan that gives cash to the applicant.
Students link banks with lending and forget the non-fund based idea.
Fix: Say that no funds move at issue. The bank pays only if the guarantee is invoked, and then recovers from the applicant.
Confusing a performance guarantee with a financial guarantee.
Both protect a beneficiary and the names sound similar.
Fix: Performance guarantee covers failure to perform a contract. Financial guarantee covers failure to pay money.
Saying an LC and a BG both pay in the normal course.
Both are bank undertakings in trade.
Fix: State that LC is the payment route against documents, while BG is paid only on default.
Ignoring validity and claim period when asked about invocation.
Students focus on default and forget the guarantee's terms.
Fix: Always check that the demand reached the bank within the validity and claim periods and follows the terms.
Forgetting that the applicant must reimburse the bank.
The answer ends once the bank pays the beneficiary.
Fix: Add the counter-indemnity, margin and security that let the bank recover from the applicant.
Calculating commission on the full year when the guarantee runs for fewer months.
Rate is quoted per annum and students skip the time factor.
Fix: Multiply by months ÷ 12.

Worked examples

Example 1

Sundaram Infra Ltd has won a road contract worth ₹20,00,000 from a State agency. The agency asks for a performance guarantee of 10% of the contract value, valid for 18 months. The bank charges commission at 2% per annum and takes 25% margin money. Compute the guarantee amount, the commission for the full period and the margin money, and state the type of guarantee.

Show the solution

Guarantee amount = 10% × ₹20,00,000 = ₹2,00,000.
Commission for one year = 2% × ₹2,00,000 = ₹4,000.
Period = 18 months = 1.5 years, so commission = ₹4,000 × 1.5 = ₹6,000.
Margin money = 25% × ₹2,00,000 = ₹50,000.
Type: it secures performance of a contract, so it is a performance guarantee.

Answer: Guarantee amount ₹2,00,000; commission for 18 months ₹6,000; margin money ₹50,000; it is a performance guarantee.

Example 2

Mehra Traders gave a bank guarantee to a supplier, Kapoor Steels, as security for payment of dues. Mehra Traders failed to pay on the due date. Kapoor Steels sent a written demand to the bank within the validity and claim period, complying with the guarantee terms. Explain whether the bank must pay and what happens next. Also state how this differs from an LC.

Show the solution

Identify the parties: applicant Mehra Traders, beneficiary Kapoor Steels, and the issuing bank.
The guarantee secures payment of money, so it is a financial guarantee.
Invocation conditions are met: default has occurred, the demand is in writing, it is within the validity and claim period, and it follows the terms.
The bank must therefore pay the beneficiary up to the guaranteed amount. If it is an on-demand guarantee, it pays without going into the dispute between the parties.
The bank then recovers the amount from Mehra Traders under the counter-indemnity, using margin money and other security.
Difference from an LC: under an LC the bank pays against compliant documents as the normal payment route. Under this BG the bank paid only because the applicant defaulted.

Answer: Yes, the bank must pay Kapoor Steels up to the guaranteed amount, and then recovers it from Mehra Traders. A BG pays on default, whereas an LC pays against documents in the ordinary course of the trade.

Exam tips

Start every answer with a one-line definition and the three parties. It earns marks quickly.
For a compare question, give at least five points: purpose, nature, when the bank pays, documents, and risk to the applicant.
In case facts, read the dates. Validity and claim period often decide whether a claim succeeds.
Match the guarantee type to the facts by asking: is it a bid, a delivery, an advance, or a payment?
Show every step in numerical parts: amount, rate, period and margin. Method marks are given even if you slip on a figure.

Practice questions from Raising of Funds - Non Fund Based

Bank Guarantee: frequently asked questions

What are the main types of bank guarantee?

The common types are bid bond, performance guarantee, advance payment guarantee, financial guarantee and deferred payment guarantee. Each covers a different risk of the beneficiary. Choose the type from the obligation being secured.

What is the difference between a letter of credit and a bank guarantee?

An LC is a payment tool. The bank pays the seller against compliant documents in the ordinary course. A BG is a safety net where the bank pays only if the applicant fails to meet an obligation.

How is a bank guarantee invoked in India?

The beneficiary sends a written demand to the issuing bank within the validity and claim period, following the terms of the guarantee. The bank checks the demand against those terms and pays up to the guaranteed amount. It then recovers the sum from the applicant.

Is a bank guarantee a fund based facility?

No. It is a non-fund based facility because the bank lends no money at issue. The bank takes on a contingent liability that turns into payment only if the guarantee is invoked.