Bank guarantees are usually on demand, whereas surety bonds may be conditional. With surety, there is a performance risk. This means the bank will face the financial risk on construction projects. In case of accounting, surety will considered as just a liability as any other insurance product. On the other hand, credit risks in a bank are considered as asset side.
It is true that in most countries, banks issue bonds. However, the security offered by an insurer is equally acceptable. The consideration has helped several enterprises to set up distinct lines of bonds and credit with insurance or surety companies. In this way, they are ensuring protection to their lines of credit with banks. Banks give preference to “on demand” bonds.
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Both bank guarantees and bank bonds serve as financial instruments that ensure protection to the parties engaging in an exchange of goods or services as documented in a contract. In some cases, a bank guarantee may also be referred to as a letter of credit. It is a technique followed for transferring payment. On the other hand, surety bonds or bank bonds ensure a kind of insurance against a party that breaks the contract. Here, the bank may play the role of an intermediary between two parties engaged in a contract.
A bank guarantee is a method through which parties can enter into a contract to ensure smooth transfer of money from the buyer to the seller. Here, the payment is not sent directly to the seller. In fact, the buyer has to invest in a letter of credit from a bank. Thereafter, it sends the same to the seller. Once the contract is complete, the seller will present the letter of credit to the bank. He will also receive payment. With a letter of credit, the buyer and seller can work through a bank that both trust. There is no need to rely on each other to preserve the contract.
A letter of credit makes sure that payment moves smoothly. On the other hand, a bank bond or surety bond can be defined as an instrument designed in a fashion to protect a party from the risk of a broken contract. For instance, if a gym owner wants an air conditioning company to install new air conditioners, but fears that the air conditioning company might not follow through, it may invest in a surety bond from any local bank. In the event, the air conditioning company fails to deliver the order; the bank will pay the gym owner a predefined amount of money in the form of compensation. Similarly, the air conditioning company might invest in a surety bond if it is worried that the gym owner will refuse to make payment once all air conditioners are installed.
Bank guarantees and surety bonds are known to ensure safer contracts for the parties involved. However, the roles played by the two are different. A bank guarantee is quite similar to an escrow account. Here, both seller and buyer agree to act and exchange funds through involvement of a bank. Any business looking forward to acquire a letter of credit must possess collateral to be able to satisfy the bank. On the other hand, surety bonds do not require any collateral as they simply need a bank to pay out in case; a different company emerges as untrustworthy.
Banks treat the two instruments differently. For instance, the bank considers a letter of credit as a liability as it is attached with an obligation to pay out cash. However, bank bond or BG bond is primarily an insurance product. Hence, it is considered as an asset. This means, when things go smoothly, the bank will keep its fee. It will not be under an obligation to pay the bondholder.