Aditya, a 21-year-old Indian guy wants to pursue an MBA degree from the University of Chicago. He comes from a middle-class family. The income of his parents is not enough. They cannot start to reimburse Aditya’s academic and living expenses immediately. So, what option does Aditya have? He could go to a bank for a student loan. Banks usually give loans expecting that students, after getting a job, would pay off their education loans(Financial guarantee). But, here, banks also check the credibility of the student’s parents. Whether the parents will be able to clear their child’s loan in case, the child defaults.
Thus, the parents are acting as financial guarantors to the bank on behalf of their child.
In case, Aditya(borrower) defaults in paying the loan amount or interest or both to the bank(lender), his parents as financial guarantors have promised the bank that they would repay.
This is the concept of a financial guarantee. It is like an insurance for the lender.
Why is a financial guarantee required?
- The financial guarantee provides a safe space for investors.
- Investors are motivated by the idea of an individual or an entity making good their losses.
- Encouragement of investors means that there will be more investments, hence more production adding to the GDP (national income). Thus, a sound investor ecosystem is a catalyst in the growth of an economy.
- A financial guarantee increases the creditworthiness of a loan. A higher rating means a lower risk will be charged to the borrower.
- Financial guarantors exist to reduce the risk of the lenders(investors).
- A financial guarantee does not mean that all liability will be satisfied. The liability can only be disbursed in full when the guarantor is in a sound financial position.
Types of financial guarantee
Financial guarantee by Individual guarantor
A perfect example of this would be the Aditya case as discussed above. The parents(individuals) are acting as financial guarantors for their son.
The banks would also accept them as guarantors only when their income, bank statements, and other assets suffice for the repayment amount.
Parent companies as financial guarantors
Suppose Zeeshan Ltd. has a subsidiary company- DGM Ltd. Now, the subsidiary company goes to the bank for a loan for working capital requirements. Here the parent company, Zeeshan ltd can act as the financial guarantor on behalf of DGM Ltd. Before assigning Zeeshan Ltd. as the guarantor, the bank shall check its past performance. Whether it has been able to generate profits or not.
Bonds issued by the government or by private companies are guaranteed by financial institutions. Hence, they are highly rated assets due to the risk hedged by financial institutions. E.g: A single insurance company or a group of insurance companies can guarantee the bonds.
Banks as guarantors
Banks can act as guarantors on behalf of their customers after checking their credit- worthiness. This is reflected through their bank statements, repayment behavior history, and other assets owned by the customer(borrower).