Financial Guarantee

What Is a Financial Guarantee?

A financial guarantee is an agreement that guarantees a debt will be repaid to a lender by another party if the borrower defaults. Essentially, a third party acting as a guarantor promises to assume responsibility for a debt should the borrower be unable to keep up on its payments to the creditor.

Guarantees can also come in the form of a security deposit or collateral. The types vary, ranging from corporate guarantees to personal ones.

Understanding Financial Guarantees

Some financial agreements may require the use of a financial guarantee before they can be executed. In many cases, a guarantee is a legal contract that promises repayment of a debt to a lender. This agreement takes place when a guarantor agrees to take on the financial responsibility if the original debtor defaults on their financial obligation or goes insolvent. All three parties must sign the agreement in order for it to go into effect.

Guarantees may take on the form of a security deposit. Common in the banking and lending industries, this is a form of collateral provided by the debtor that can be liquidated if the debtor defaults. For instance, a secured credit card requires the borrower — usually someone with no credit history — to put down a cash deposit for the amount of the credit line.

Financial guarantees act just like insurance and are very important in the financial industry. They allow certain financial transactions, especially those that wouldn't normally take place, to go through, permitting, for instance, high-risk borrowers to take out loans and other forms of credit. In short, they mitigate the risk associated with lending to high-risk borrowers and extending credit during times of financial uncertainty.

Guarantees are important because they make lending more affordable. Lenders can offer their borrowers better interest rates and can get a better credit rating in the market. They also put investors at ease, making them feel more comfortable because they know their investments and returns are safe.

Special Considerations

A financial guarantee doesn't always cover the entire liability. For instance, a guarantor may only guarantee the repayment of interest or principal, but not both.

Sometimes, multiple companies sign on as a party to a financial guarantee. In these cases, each guarantor is usually responsible for only a pro-rata portion of the issue. In other cases, however, guarantors may be responsible for the other guarantors' portions if they default on their responsibilities.

Financial guarantees may cut down the risk of default in most cases but that doesn't mean they're fool-proof. We saw this during the fallout after the financial crisis of 2007-2008.

Most bonds are backed by a financial guarantee firm, also referred to as a monoline insurer, against default. The global financial crisis hit financial guarantee firms particularly hard. It left numerous financial guarantors with billions of dollars of obligations to repay on mortgage-backed securities (MBSs) that defaulted, causing financial guarantee firms to have their credit ratings slashed.

Types of Financial Guarantees

As noted above, guarantees may come in the form of a contract or may require the debtor to put up some form of collateral in order to access credit. This acts as an insurance policy, which guarantees payment for both corporations and personal lending. Here are some of the most common types of both.

Corporate Financial Guarantees

A financial guarantee in the corporate world is a non-cancellable indemnity. This is a bond backed by an insurer or other secure financial institution. It gives investors a guarantee that principal and interest payments will be made. 

Many insurance companies specialize in financial guarantees and similar products used by debt issuers as a way of attracting investors. As noted above, the guarantee gives investors comfort that the investment will be repaid if the securities issuer can't fulfill the contractual obligation to make timely payments. It also can result in a better credit rating, due to the outside insurance, which lowers the cost of financing for issuers.

A letter of intent (LOI) is also a financial guarantee. This is a commitment that states that one party will do business with another. It clearly lays out the financial obligations of each party but may not necessarily be a binding agreement.

LOIs are commonly used in the shipping industry, where the recipient's bank provides a guarantee that it will pay the shipping company once the goods are received.

Personal Financial Guarantees

Lenders may require financial guarantees from certain borrowers before they can access credit. For example, lenders may require college students to get a guarantee from their parents or another party before they issue student loans. Other banks require a cash security deposit or form of collateral before they give out any credit.

Don't confuse a guarantor with a cosigner. A cosigner's responsibility for a debt occurs at the same time as the original borrower, while the guarantor's obligation only kicks in when the borrower defaults.

Example of a Financial Guarantee

Here's a hypothetical example to show how financial guarantees work. Let's assume that XYZ Company has a subsidiary named ABC Company. ABC Company wants to build a new manufacturing facility and needs to borrow $20 million to proceed.

If banks determine that company ABC has potential credit deficiencies, they may ask XYZ Company to become a guarantor for the loan. That means that if ABC defaults, XYZ Company must repay the loan using funds from other lines of business.