Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Module I: Basics of Credit and Credit Process

Chapter 7: Non Fund Based Facilities

Prof. Jayant Keskar

Objective
The objective of this chapter is to give an overview of non-fund working capital facilities
offered by banks, the process involved, and the regulatory guidelines for the same.

Structure
7.1 Introduction
7.2 Letter of Credit
7.2.1 Introduction to LC
7.2.2 Parties to Letter of Credit apart from Applicant and beneficiary
7.2.3 Type of Letter of Credits
7.2.4 RBI Guidelines
7.2.5 Document generally asked under LC
7.2.6 Incoterms 2010
7.2.7 Checklist for issuing LC
7.2.8 Charges
7.2.9 LC Mechanism
7.3 Standby Letter of Credit
7.3.1 Usage of Standby LC by Authorised Dealers
7.4 Bank Guarantee
7.4.1 Introduction to BG
7.4.2 Governing Rules/Guidelines
7.4.3 Types of Bank Guarantee
7.4.4 Check List for processing request
7.4.5 Guidelines for the Issuance of Guarantee
7.4.6 Invocation of Bank Guarantee

Page 1 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

7.4.7 Payment of Invoked Guarantees

7.4.8 Extension of BGs
7.4.9 Onerous clauses in BG
7.4.10 Auto Closure of BG
7.5 Trade Credit
7.5.1 Buyer’s Credit
7.5.2 Seller’s Credit
7.5.3 Coacceptance

7.1 Introduction
In assessment of the working capital of a borrower, banks shall consider the following
two types of facilities:
· Fund based facilities – These refer to the facilities for drawing cash and funds as
per requirement of the concerned borrower. Chapter 6 may be referred to for the
details on fund based working capital financing.
· Non-fund based facilities – The credit facilities given by the bank where actual
funds are not involved are termed as Non-fund based facilities. The banks are
facilitators in a trade transactions whereby there offer their
commitment/promise/undertaking to pay in case the buyer fails to pay the seller
and seller remains unpaid. So the financial guarantee/ assurance is offered by
banks to facilitate the trade transaction by offering suitable instrument to cater to
the needs of buyer and seller. Non-funded instruments are designed in such a way
whereby the seller of the goods or services gets financial commitment by a solvent
person like bank subject to the compliance of terms and conditions as mentioned
in the related trade instrument.
The non-funded facilities are divided in to three broad categories as under:
· Letter of Credit
· Guarantees
· Co-acceptance of Bills
· Depending upon the nature of the transactions some variant of the above products
are offered to suit the domestic and international trade. These are
· Trade Credit for import of goods
· Deferred payment guarantee for import of capital equipment and technical know-
how.

Page 2 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Now we shall discuss each product of non-funded facilities with reference to the
regulations, procedures, significance and usage.
7.2 Letters of Credit
7.2.1 Introduction
Letter of Credit (LC) is a payment mechanism wherein the credit issuing bank acts as
an intermediary between buyer and seller to address risk of both the parties and there
by facilitates the transaction.
The credit issuing bank undertakes irrevocably on behalf of its client
(Buyer/applicant) and in favour of the beneficiary (seller) to honour the payment
obligation against documents presented by the beneficiary in accordance with:
-The terms and conditions of the documentary credit
-Applicable provisions of UCPDC rules
-International Standard Banking Practice (ISBP)
7.2.2 Parties to LC:
The following are the parties involved in a LC:

a. Applicant : The buyer.

b. Beneficiary : The Seller
c. LC issuing Bank : The bank of the buyer which issues the LC favouring the
beneficiary (seller).
d. Advising Bank: Advising Bank advises the credit (LC) to the beneficiary, thereby
assuring the genuineness of the credit.
e. Confirming Bank: Generally a Bank in the country of seller. Confirming Bank on
adding its confirmation thereby undertakes the obligation of Issuing Bank.
f. Nominated Bank: The Bank with which credit is available or any Bank in the case
of a freely negotiable credit.
g. Reimbursing Bank: It is the Bank, authorised to honour the reimbursement
claim in settlement of negotiation acceptance / payment lodged with it by the
paying, negotiating or accepting Bank.
7.2.3 Type of Letter of Credits:
Ø Irrevocable - Can be cancelled or amended with consent of both the parties
(applicant & beneficiary) only.
Ø Revocable - Can be amended or cancelled by the applicant without notice to
beneficiary. Such LCs do not exists in practice now.
Ø Restricted Credit - Documents are restricted for negotiation under such credit to
a particular nominated Bank.

Page 3 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Ø Freely Negotiable Credit (Unrestricted Credit) - Free from any restriction can
be negotiated with any Bank.
Ø Sight Credit- Payment on demand or on presentation/sight of documents.
Ø Usance Credit- Payment to be made after certain credit period as extended by the
seller.
Ø Deferred Payment Credit- It is a usance credit where payment will be made by
designated Bank, on respective due dates, determined in accordance with
stipulations of the credit, without the drawing of drafts.
Ø Revolving Letter of Credit – In Such LCs, the amount of credit is revived or
reinstated without requiring specific amendment to the credit. Revolving LCs with
automatic renewal clause is associated with risk and branches need to be careful
about the clauses. The reinstatement clause in the revolving LC assumes great
significance, hence the branches should put maximum liability clause in such LCs
and also maximum instances of reinstatement may be stated. Also branches
should not allow “waive – all – discrepancy” clause in such LCs.
Ø Transferable Letter of Credit- Such a credit states it is “transferable”. It can be
transferred in whole or in part to another beneficiary (“second beneficiary”) at the
request of the beneficiary (“first beneficiary”). However, it cannot be transferred
further.
Ø Back-to-back Credit or Countervailing Credit- When a second LC is issued on
the Backing of Principal LC, it is known back-to-back Credit or Countervailing
Credit.
Ø Anticipatory Credit: Anticipatory Credit Provides for payment to Beneficiary at
Pre-shipment stage also. Two types of Anticipatory Credit:
· Red clause Letter of Credit: A letter of credit which provides for an amount
in advance to Beneficiary for Purchasing raw material/Processing/Packing of
goods etc.
· Green Clause Letter of Credit: It is an Extended version of Red Clause Credit
and provides advance to Beneficiary for Warehousing, Insurance charges etc.
also.
7.2.4 RBI Guidelines
The following are the guidelines issued by the RBI relating to LCs:
· Bank should normally open letters of credit for their own customers who enjoy
credit facilities with them. Customers maintaining current account only and
not enjoying any credit limits should not be granted LC facilities except in cases
where customer is keeping 100 per cent cash collateral.
· The request of such customer for sanctioning and opening of letter of credit
should be properly scrutinised to establish the genuine need of the customer.

Page 4 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

The customer may be, required to submit a complete loan proposal including
financial statements to satisfy the bank about his, needs and also his financial
resources, to mire the bills drawn under.
· Where a customer enjoys credit facilities with some other bank, the reasons
for his approaching the bank for sanctioning LC limits have to be clearly stated.
The bank opening LC on behalf of such customer should invariably make a
reference to the existing banker of the customer
· In all cases of opening of letters of credit, the bank has to ensure that the
customer is able to retire the bills drawn under LC as per the financial
arrangement already finalised.
7.2.5 Document generally asked under LC
· Invoice
· Packing List/Weight list
· BL (Bill of Lading)/AWB (Air way Bill)/ Lorry receipt (These are Title to
goods)
· Insurance (only if Incoterm applied requires)
· Test /inspection certificate
· Certificate of origin (for import LCs)
· Bill of exchange.
7.2.6 Incoterms 2010:
International Commercial Terms, popularly known as INCOTERMS, were devised by
ICC which defines rights and obligation of the buyer and seller as regards delivery of
the goods and cost connected there to. We state below various INCOTERMS and their
significance.

Page 5 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

EXW FCA FAS FOB CFR CIF CPT CIP DAF DES DEQ DDU DDP

Free Free Cost Carriage Delivered Deliver Delivered Ex Delivered

Ex Free Cost & Carriage Delivered
SERVICES Alongside Onboard Insurance Insurance At ed Ex Quay Duty Duty
Works Carrier Freight Paid To Duty Paid
Ship Vessel & Freight Paid To Frontier Ship Unpaid Unpaid

Warehouse
Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Storage
Warehouse
Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Labor
Export
Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Packing
Loading
Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Charges

Inland Buyer/
Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Freight Seller*

Terminal
Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Charges
Forwarder's
Buyer Buyer Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller
Fees
Loading On
Buyer Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller Seller
Vessel
Ocean/Air
Buyer Buyer Buyer Buyer Seller Seller Seller Seller Seller Seller Seller Seller Seller
Freight
Charges On
Arrival At Buyer Buyer Buyer Buyer Buyer Buyer Seller Seller Buyer Buyer Seller Seller Seller
Destination
Duty, Taxes
& Customs Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Seller
Clearance
Delivery To
Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Buyer Seller Seller
Destination

Page 6 of 21
 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Letter of Credit is popularly known as Documentary Credit in international parlance. It is

an undertaking of the issuing bank to pay on complying presentation as per UCPDC
(Uniform Customs and Practices for Documentary Credits ICC version 600). The Letter
of Credit is of two types:-
· Inland LC – These relate to the transactions done within India under LC.
· Foreign LC – These relate to import and export of goods and services done through
the LC route.
7.2.7 Checklist for issuing LC:
· Import LC shall be opened as per UCP-600 by a Forex B category branch only. Any
other originating branch will forward their application along with the documents
as listed above (section 7.2.5) to nearest Forex B category branch. Inland LC may
be issued by designated retail and corporate branches as per the policy of the
bank.
· Franked/Stamped LC Application to be attached
· Duly certified I E Code copy ( for Import LC)- For international trade transaction
the client needs to be issued importer-exporter code number by DGFT
(Directorate General of Foreign Trade) on an online application by the importer
or exporter.
· FEMA Declaration (For Import LC) to be attached
· Sanction Note/LOI to be checked for Customers having regular LC Limits
· Margin to be taken/confirmed as per Sanction in Consultation with original
branch.
· Board Resolution(for Limited Companies) or Consent Letter (for Partnership
Firms) to be attached
· Underlying Sales Contract / Performa Invoice/Indent/Purchase order etc. to be
attached.
· Insurance Policy if insurance is to be arranged by the importer as per Incoterms
(Except for CIF/CIP)
· In case of import LC, confidential opinion report (D&B, Experian etc.) for LC Value
USD 3 lakh to confirm the credentials of the overseas exporter and the exporter
are dealing in same line of business.
· Commission has to be charged as per Sanction/SOC (Schedule of Charges)
· Importability of goods/ services to be checked before LC opening as per extant
foreign trade policy.

Page 7 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

7.2.8 Charges :
Commission and other charges at sanctioned rate are to be applied upfront, while
issuing the LC. In case of LC against 100% cash collateral, charges as per card rate are
to be applied unless concessional rates are given by the sanctioning authority.
7.2.9 Letter of Credit (LC) Mechanism
Any business/industrial venture will involve purchase transactions relating to
machine/other capital goods and raw material etc., and also sale transactions relating
to its products. The customer may, therefore, find himself on either side of a LC
transaction at different times depending upon his position at that particular moment.
He may be an applicant for a letter of credit for his purchases while be the beneficiary
under other letter of credit for his sale transaction. It is, therefore, necessary that
complete LC mechanism covering the liabilities and rights and both the applicant and
the beneficiary are understood for maximum advantage.
The complete mechanism of a letter of credit may be divided in three parts as under:
1. Issuing of Credit – Letter of credit is always issued by the buyer’s bank (issuing
bank) at the request and on behalf and in accordance with the instructions of the
applicant. The LC may either be advised directly or through some other bank
(advising bank). The advising bank is responsible for transmission of credit and
verifying the authenticity of signature of issuing bank and is under no
commitment to pay the seller. The advising bank may also be required to add
confirmation and in that case will assume all the liabilities of issuing bank in
relation to the beneficiary as stated already. It will then be called as Confirming
Bank.
2. Negotiation of Documents by beneficiary – On receipt of letter of credit, the
beneficiary shall arrange to supply the goods as per the terms of LC and draw
necessary documents as required under LC. The documents will then be
presented to the negotiating bank for payment/acceptance as the case may be.
The negotiating bank will make the payment to the beneficiary and obtain
reimbursement from the opening bank in terms of credit.
3. Settlement of Bills Drawn under LC by the opener – The last step involved in letter
of credit mechanism is retirement of documents received under LC by the opener.
On receipt of documents drawn under LC, the opening bank is required to closely
examine the documents to ensure compliance of the terms and conditions of credit
and present the same to the opener for his scrutiny. The opener should then make
payment to the opening bank and take delivery of documents so that delivery of
goods can be obtained by him (where the credit is drawn under DP terms) and
should provide funds on due date in case of usance LC)

Page 8 of 21
 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

8 Operational Guidelines for Issuance of LC:

1. LCs are transmitted through SWIFT/SFMS but hard copy of LCs are issued in
security form only affixed with security holograms.
2. LCs are issued under two authorised signatures wherever they are not
transmitted by SFMS/SWIFT.
3. LC should be opened for the purchase of Goods / Services, which have relevance
to the line of activity of the applicant company.
4. Capital goods LC should be opened after ensuring tie- up of the funds on due date.
LC sanctioned for the purchase of raw material, should not be used for purchase
of capital goods.
5. For Import LC exceeding value USD 3,00,000/- opinion report on overseas
supplier from International Credit Agency be obtained.
6. Confirming to the sanction terms, LC may be amended at the request of applicant.
9 Examination of Documents:
Under Article 14, UCP 600, the documents under LC shall be closely scrutinised by the
Issuing Bank, to confirm that all the terms and conditions as mentioned in the Letter of
Credit are totally complied with. In case of noncompliance, such LCs will be refused for
payment, pointing out the discrepancy in the presentation and refusal notice be issued
to the negotiating Bank, stating not honouring of the LC claim and asking for further
disposal instruction.
10 Payment under Letter of Credit:
Once the documents are examined and found to be in order as per LC term, Bank
has a payment obligation towards the same. The document will be presented to the
customer and payment will be made to the negotiating Bank, either on sight basis or
on due date. If the customer does not have adequate funds, the payments will be done
by the Bank by opening a devolved account, as per Circular (IDBI Bank/ 2010-
11/261/CBG/TF/27 dated November 10, 2010 & IDBI BANK/2013-
14/383/CBG/TF/25 dated September 25, 2013).
11 Export LC Advising :
Any LC received on behalf of the constituent exporter shall be advised by the
branch to the said exporter promptly only after checking the apparent authenticity of
the credit established by the issuing Bank. Also, branch should go through the contents
of LC and shall advise the beneficiary in the matter. However, if the Branch is unable
to verify the authenticity and chose to advise the LC to the beneficiary, it may do so
clearly indicating in the advising memo that “LC Advised Unauthenticated”. Branch
also should charge one time advising commission for LC / Amendment as per SOC.

Page 9 of 21
 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

12 Adding Confirmation to Export LC

Adding confirmation on Export LC constitutes an additional undertaking on part
of the confirming bank to negotiate the LC on complying presentation. Therefore, the
branches need to pass on contingent exposure entries for non -funded exposure taken
by the bank after verifying the availability of bank line exposure sanctioned and also
recover the confirmation charges from beneficiary/LC opener as per terms of the LC.
13 Reversal /closure of expired LCs:
The bank needs to close all expired/un-availed LCs as it has an implication of risk
weighted assets and customers rotation of the limit for business purpose.
14. Assessment Of Letter Of Credit Limits

For assessing LC requirements of a borrower the followings points are to be considered:

(i) Purpose for opening L/C could be

· For import of raw material or a fixed asset or consumable stores and the
overseas seller is willing to sell only against L/C.
· In case of domestic purchase also the seller may be willing to sell the goods
against L/C only.

The document showing the terms of the seller will help establish the purpose of opening
a LC.

(ii) The quantity of goods to be purchased under L/C annually

(iii) Terms of L/C (Whether DP or DA)

(iv) Time taken by the seller to despatch the goods.

(v) Lead Time : The time taken to receive goods after opening an L/C.

(vi) Minimum level of stocks to be kept at all times/ Economic order quantity i.e.,
Minimum size of each consignment which will make economic sense.

(vii) Freight cost and insurance charges.

Assessment of DP LC limit

Assume a borrower purchases raw material worth Rs. 24 lacs in a year. Out of the above
50% of raw material are purchased through L/C. 50% of the purchase through LC is
imported. The indigenous raw material purchased through L/C takes 1 month to be
delivered after opening of L/C and in the case of imported ones it takes 4 months.

Page 10 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

In the above case the monthly consumption of indigenous raw material is Rs. 100,000 and
the monthly consumption of imported raw material is Rs. 12/12 = 100,000 lac. The
amount of the limit for indigenous raw material will be computed as under :

Assessment of DP LC Limits:

Annual purchase = Rs 24 lacs

Purchase through LC = Rs 12 lacs
Lead time = 1month
LC Limit required for Indigenous purchase =
Monthly consumption X (Lead Time + Usance period)
= 100,000 x 1 = Rs 100,000

The amount of LC limit for imported raw material will be

= Monthly consumption x (Lead time + Usance period)

= 50000 x 4 = Rs. 200,000
= The total L/C limit would then be Rs. 100,000 + 200,000 = Rs.300,000

Assessment of DA LC limits

Assume that a borrower purchases raw material worth Rs. 48 lacs in a year. Out of the
above 50% of raw material are purchased through L/C. 50% of the purchase through LC
is for imports. The indigenous raw material purchased through L/C takes about 2 months
to be delivered after opening of L/C and in the case of imported ones it takes about 4
months. Both the L/C's are to be on 2 months DA basis. Lead time for indigenous LC is 15
days and lead time for import LC is 2 months.

The assessment is as follows :

Then 2 months should be added to the Lead Time subject to adjustment of transit period
already covered under the Lead Time. Assuming such transit period is 15 days (0.5
month) then the requirement will be

Annual purchase = Rs 48 lacs

Purchase through LC = Rs 12 lacs
Purchase through inland LC = Rs 6 lacs
Purchase through import LC = Rs 6 lacs

LC indigenous Limit = Monthly consumption x (Lead Time + Usance period)

= 0.5 x (0.5 + 2) = Rs 1.25 lacs

LC for import = 0.5 x (2+2)

= Rs 2 lacs

Page 11 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

7.3 Standby Letter of Credit

Standby Letter of Credit (SBLC) is a financial support instrument and have similarities
with Commercial Letter of Credit (LC) and Bank Guarantee (BG). This is in substitution of
Demand Guarantees and supports payment when due or after default. Documents
generally called for under SBLC are a simple statement of claim and / or proof of delivery
of goods and / or certificate of non-performance. This type of Letter of Credit is opened
mostly by banks in countries where, by law they are precluded from issuing guarantees
and in such cases this type of Credit is issued as substitutes for performance or other
financial guarantees. Even though Standby Credit is a mere substitute for Guarantee it
has developed as an all-purpose financial support instrument embracing wider range of
uses than the normal Demand Guarantee and is issued to cover situations of non-
performance. No Transport Document is called for under this Credit.
In a SBLC:
· The Issuer, usually a Bank
· At the request of its customer, Applicant
· Agrees that the Beneficiary will be paid
· Before the credit’s expiry
· Upon the beneficiary’s presentment of:
i. Its demand for payment and
ii. Any documents evidencing the Applicant’s Non-performance.
There are following type of SBLCs:
1) Commercial SBLC
2) Financial SBLC
3) Performance SBLC
4) Advance payment SBLC
5) Bid Bond SBLC
7.3.1 Usage of SBLC by Authorised Dealers:
SBLC may be undertaken for the following transactions:
i. As a document of promise in respect of “non-performance’ situation especially
as a substitution to the guarantees which ADs are permitted to issue under
FEMA, such as issuing a guarantee in respect of any debt, obligation or other
liability incurred by:
a) An exporter on account of exports from India.

Page 12 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

b) Owed to a person resident in India by a person resident outside India for a

bonafide trade transaction, duly covered by a counter guarantee of a bank
of international repute resident abroad.
ii. Exporters may opt to receive SBLC in respect of exports from India.
Appropriate safeguards and precautions some of which are illustrated below shall be
observed by Authorised Dealers where such SBLCs are issued.
a) The facility of issuing Commercial SBLCs shall be extended on a selective basis
and to the following categories of Importers only:
i. Where such Standbys are required by Applicants who are independent
power producers/importers of crude oil and petroleum products.
ii. Special category of importers viz. Export Houses/Trading Houses/Star
Trading Houses/Superstar Trading Houses/ 100% EOUs.
iii. Public Sector Units/Public Limited Companies with good track record.
b) Satisfactory credit report on the overseas supplier should be obtained by the
Issuing Bank before issuing Standbys.
c) Invocation of the Commercial SBLC by the Beneficiary is to be supported by
proper evidence. The beneficiary of the credit should furnish a declaration to the
effect that the claim is made on account of failure of the importer to abide by his
contractual obligations, along with the following documents:
i. A Copy of Invoice
ii. Non-negotiable set of documents including a copy of Non-negotiable Bill
of Lading/Transport Document.
iii. A Copy of Lloyds /SGS Inspection Certificate wherever provided for as per
the underlying contract
d) Incorporation of suitable clause to the effect that in the event of such
Invoice/Shipping Document has been paid by the Authorised Dealer earlier,
provisions to dishonour the claims quoting the date/manner of earlier payment
of such documents may be considered.
e) The Applicant of a Commercial SBLC (Indian importer) shall undertake to
provide evidence of imports in respect of all payments made under SBLC (Bill of
Entry).
Authorised Dealers shall follow up evidence of imports as provided for under FEMA in
all cases of payments made.
SBLC are governed by UCP 600, URDG 758 and ISP 98 depending upon the choice and
agreement between applicant and beneficiaries.

Page 13 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

7.4 Bank Guarantee

7.4.1 Introduction
Bank Guarantee (BG) is an instrument issued by the Bank in which the Bank agrees to
stand guarantee against the non-performance of some action of a party. The
quantum of guarantee is called the guarantee amount. The guarantee is issued upon
receipt of a request from applicant for some purpose/transaction in favour of a
Beneficiary. The issuing bank will pay the guarantee amount to the beneficiary of the
guarantee upon receipt of the claim from the beneficiary. This results in invocation
of the Guarantee.
Bank guarantees can be Inland (which are issued in favour of Beneficiary within the
country) as well as Foreign (which are issued in favour of Beneficiary outside the
country)
7.4.2 Governing Rules/Guidelines :
A. Indian Contract Act;
B. Reserve Bank of India;
C. FEMA (Foreign Exchange Management Act)*;
D. URDG758 (Uniform Rules for Demand Guarantees)*;
(*Applicable for Foreign Bank Guarantee)
7.4.3 Types of Bank Guarantee :
7.4.3.1 Financial BG:
Financial guarantees are direct credit substitutes wherein a bank irrevocably
undertakes to guarantee the repayment of a contractual financial obligation.
Examples:-
Ø Guarantees for credit facilities;
Ø Guarantees in lieu of repayment of financial securities;
Ø Guarantees in lieu of margin requirements of exchanges;
Ø Guarantees for mobilisation advance, advance money before the
commencement of a project and for money to be received in various stages of
project implementation; such guarantees are also known as Advance Payment
Guarantee.
Ø Guarantees towards revenue dues, taxes, duties, levies etc. in favour of Tax/
Customs / Port / Excise Authorities and for disputed liabilities for litigation
pending at courts;
Ø Deferred payment guarantees.

Page 14 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

(As per RBI circular RBI/2012-13/467 dated April 02, 2013 on New Capital Adequacy
Framework, Financial guarantees attract credit conversion factor (CCF) of 100%).
7.4.3.2 Performance BG :
Performance guarantees are essentially transaction-related contingencies that
involve an irrevocable undertaking to pay a third party in the event the
counterparty fails to fulfil or perform a contractual non-financial obligation. In
such transactions, the risk of loss depends on the event which need not
necessarily be related to the creditworthiness of the counterparty involved.
Examples:-
Ø Guarantees in lieu of security deposits / earnest money deposits (EMD) for
participating in tenders, such guarantees are also known as Bid Bond
Guarantee.
Ø Performance bonds and export performance guarantees;
Ø Retention money guarantees;
Ø Warranties, indemnities and standby letters of credit related to particular
transaction.
7.4.4 Check List for Processing request
Ø Request Letter by the client – BG applicant
Ø Board Resolution(for Company) | Consent Letter (for Partnership Firm) ; For non-
limit clients
Ø Duly attested Copy of Underlying such as Contract/Agreement etc.
Ø Counter Guarantee duly franked or on stamp paper; (For non-limit clients);
Ø F.D.R (valid till BG expiry) duly discharge- 100% Margin for Inland Bank
guarantee/110% Margin for Foreign Bank guarantee if BG is against .cash margin
Non Limit Clients. Margin in form of FD as per sanction for Regular Limit Clients.
Ø Duly vetted hard copy of BG format accepted by customer (soft copy to be
obtained for issuance )
Ø Scrutiny of the BG text and approval by competent authority for onerous
clause/Deletion of Notwithstanding, Clause/BG Cashable at other location/BG
issuance against counter guarantee (approved format) of other bank. (Availability
of credit line and tenor as well as acceptability of counter guarantee format to be
checked for issuance of Foreign BG;
Ø BG should be printed on the stamp paper as per the stamp duty applicable in the
state.

Page 15 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

7.4.5 Guidelines for the Issuance of BG:

Ø The text of the BG should be carefully scrutinized so as to confirm that the BG will
not have any onerous clause or any other clause affecting the interest of the Bank.
Vetting of the BG should be done prior to the stage of issuance.
Ø All BG shall be signed by two officials jointly.
Ø Bank should issue Guarantees in terms of sanction for maturity period upto 10
years. For maturity period above 10 years, appropriate assessment and approval.
Ø BG should not be issued with onerous clauses, such as Auto Renewal, Open ended,
etc.,
Ø No BG should be issued without notwithstanding clause.
Normally a BG is payable on invocation at the counter of the Issuing Branch, however
sometimes branches may get a request for the issuance of guarantees which are en-
cashable at a branch other than the issuing branch,
7.4.6 Invocation of Bank Guarantee:
Ø Any claim for invocation of the guarantee should be thoroughly checked, as
regards in terms of the guarantee and the same should be processed.
7.4.7 Payment of Invoked Guarantees :
Ø Where BG are invoked payment should be made to the beneficiaries, without delay
and demur.
Ø It is to be noted that a BG is a contract between the beneficiary and bank. When
the beneficiary invokes the BG and a letter invoking the same is in conformity with
the terms of the BG, it is obligatory on the part of the Bank to make payment to the
beneficiary.
7.4.8 Extension of BGs:
Ø Request letter from customer for extension should be obtained.
Ø Availability of credit line and tenor as per sanctioned terms (in sanctioned cases)
or approval for extension.
Ø Availability of Margin (FDR) for extended period.
Ø Notwithstanding clause should be incorporated in BG extension invariably.
7.4.9 Onerous clauses in BG:
Ø Normally no BG should be issued without the notwithstanding clause at the end of
the guarantee, as mentioned below :
· Notwithstanding anything contained herein–above our liability shall not
exceed Rs._ _ _ _ /- (Rupees in words), and the guarantee will be valid till
(Date:_ _ / _ _ /_ _ _ _). Unless a demand is made in writing on the bank at
(Address of the Branch:_ _ _ _) on or before (Date:_ _ / _ _ /_ _ _ _), all your

Page 16 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

rights under this guarantee will be forfeited and we shall be relived and
discharged from all liabilities thereunder.
Ø The BGs in which there is inbuilt and auto renewal clause, such BGs are called open
ended and the liability of the bank for such BGs is perpetual in nature. A guarantee
should be definite in terms of liability for the amount and period.
7.4.10 Auto closure of the BG:
Ø In case of BGs issued favoring government authorities/ departments, Courts an
additional precautionary measure
All the proofs of dispatch of the notice/reminders to the beneficiary are to be kept on
record and preserved as per extant “Preservation of documents” policy.
7.4.11 Closure / reversal of expired Bank Guarantee :
Ø As Bank’s precious capital is engaged in outstanding BG balance.
Ø The BG liability should be reversed after Bank receives either the original BG duly
discharged by the beneficiary or a Letter of Discharge in lieu of the original BG.
7.5 Trade Credit
Reserve Bank of India (RBI) has allowed a special facility to finance the imported goods
by raising foreign currency loan from the overseas lender. Depending upon the source of
finance such credits are known as byer’s credit or supplier’s credit.
7.5.1 Buyer’s Credit – If the credit is arranged by the buyer (importer) for a payment of
imports into India such credits are known as buyer’s credit. Subject to the rules stated
here under, the trade credit will facilitate the payment of imported goods by raising
foreign currency loan under the guarantee of the importer’s bank.
7.5.2 Supplier’s Credit – Supplier’s credit relates to credit for imports into India
extended by the overseas supplier or overseas bank or any other financial intermediary
in the world.
The rules governing trade credit are mentioned below:
a) Amount – USD 20 million or equivalent in any other foreign currency per instance
of shipment. For amount exceeding USD 20 million prior approval from RBI may
be sought.
b) Period - For raw materials upto 1 year from the date of shipment.
i. For capital goods – 5 years from the date of shipment (capital goods
as defined by DGFT)
ii. However, the period shall be subject to the operating cycle of the
customer and the above will be the outer limits only.
c) Pricing - All in cost ceiling – six months LIBOR plus 350 basis point per cent per
annum.

Page 17 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

d) Guarantee – AD banks are allowed to issue Letters of Credit / Guarantee / Letter

of Undertaking / Letter of Comfort in favour of overseas supplier, bank and
financial Institutions as under:
i. Raw material - guarantee upto one year
ii. Capital goods – guarantee upto first three years of trade credit.
iii. Gold, Platinum, Silver, polished diamonds shall have total credit period
including LC and DA documents should not exceed 90 days.
e) Trade credit cannot be offered for import of services and units located in SEZ.
However, trade credit can be offered for Merchant Trade imports to the extent
advance remittance against exports are not received.
f) Interest payment of trade credit to the overseas lender shall be subject to
provisions withholding tax.
g) AD banks needs to correctly report to RBI through their nodal office monthly
statement punishing details of fresh disbursement under trade credit, repayment,
roll over etc. and cumulative position.
So the trade credit is an extension of the product bank guarantee whereby foreign
currency loans are raised at internationally competitive rate of interest to facilitate
import payments.
7.5.3 Co-acceptance
Facilities of co-acceptance bill deferred payment guarantees are generally required for
acquiring plant and machinery technically be taken as a substitute of term loan which
requires detailed appraisal of the borrower’s needs and financial position as required in
a sanction of term loan proposal. RBI terms this facilities as BAF (Banker’s Acceptance
Facility). The effect of such facility is that once the bank co-accepts the bill it becomes
commitment of the bank guaranteeing payment to beneficiaries. So the banker needs to
be very careful in granting such facilities as banks undertake to pay on co-accepted bills
despite funds position of the clients. RBI guidelines being as under:
1) Detailed appraisal of the customer’s requirement be completed and the bank
needs to fully satisfy about genuine ness of the need of the customer.
2) Genuine trade bill of bonafide transaction only should be co-accepted. House
bill/accommodation bill drawn on good concerns needs to be abided.
3) Co-acceptance facilities will normally not be sanctioned to the customers enjoying
credit limit with other banks.
4) Once the bill is co-accepted a non-fund liability entry needs to be recorded in the
books of the bank engaging the customers’ liability for the transaction

Page 18 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

7.6 Illustrations and Case lets

Illustration 1

Assume a borrower purchases raw material worth Rs. 48/- lacs in a year. Out of the above
Rs. 24/- lacs worth of raw material are purchased through L/c. Further out of this Rs.
24/- lacs worth of raw material purchased through L/C, Rs. 12/- lacs worth of raw
materials are imported. The indigenous raw material purchased through L/C takes about
2 months to be delivered after opening of L/C and in the case of imported ones it takes
about 4 months and the minimum import consignment is Rs. 3/- lacs.

In the above case the monthly consumption of indigenous raw material is Rs. 12/12 - Rs.
1/- lac and the monthly consumption of imported raw material is Rs. 12/12 = 1/- lac. The
amount of the limit for indigenous raw material will be computed as under :

Monthly consumption X (Lead Time + A weeks cushion)

= 1 X (2 + 0.25 months)
= Rs. 2.25 lacs

The amount of LC limit for imported raw material will be

Monthly consumption X (Lead time + A month's cushion)
= 1 X (4 + 1) = Rs. 5/- lacs.

The total L/C limit would then be Rs. 2.25 + 5.00 = Rs. 7.25 lacs say Rs. 8/- lacs.

Assessment of DA-LC limits:

If in the above example both the L/C's are to be on 2 months DA basisthen 2 months
should be added to the Lead Time subject to adjustmentof transit period already covered
under the Lead Time. Assuming suchtransit period is 15 days or 1/2 month then the
requirement will be

Indigenous = 1 x (2 + 0.25 + 1.5) = 3.75 lacs

Imported = 1 X (4 + 1 + 1.5) = 6.50 lacs
---------
9.25 lacs
Example 2:
ABC Co. P Ltd., has approached us for credit limit which includes Term Loan, Cash Credit,
BG and LC.
The LC limit is for purchase of raw material both from the domestic market and also from
abroad. The details of the procurement of raw material under LC and various terms
under which the purchase is made is as under:
Total Sales is projected at Rs.1200 crores.
RM Purchase is projected at 80% of the total sales.

Page 19 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Under the RM purchases, 30% is by way of CC and 70% is by way of LC. Of the 70%
purchased of RM under LC, 30% of such purchases is from the domestic market and 70%
is from international market.
Other details of terms of LC is as under:
Domestic puchases Purhases from abroad
Customs duty 0 2%
Lead Period 40% in 20 days 30% in 30 days
Including transit period 60% in 15 days 70% in 20 days
Usance period 80% - 0 days 10% - 90 days
20% - 90 days 80% - 80 days
10% - 60 days
Cushion period 2 days 7 days

Total Sales : Rs.1200 crores

Of which Raw material Rs.960.00 crores
Total Purchase under LC Rs.672.00 crores
Domestic Foreign
Purchase under LC Rs.202.00 crores Rs.470.00 crores
Less : Customs duty Rs.0.00 crores Rs. 10.00 crores
Net purchase under LC Rs.202.00 crores Rs.460.00 crores
Lead Period 40% - 20 days=8 days 30% - 30 days=9
60% - 15 days=9 days days
70% - 20 days=14
days
Usance 80% - 0 days = 0 days 10% - 90 days=9
20% -90 days=18 days days
80%-80 days=64
days
10%- 60 days=6 days
No of days 37 days 109 days
Limit 37/360*202=21 crores 109/360*460=139
Limit Rs.21 crores Rs.139 crores

Page 20 of 21
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Caselets

• Total expected value of tenders in a year -Rs.60.00 Crores

• Success/Strike rate- 20%
• Average earnest money required-3%(get released/adjusted
with a quarter)
• Performance deposit ranges between-10%( Contract period
maximum 12 Months)
• Mobilization of advance-10% of advance there are 4 stages
• Retention Money -10% for 2 years(50% get released after
ayear)
• Existing outstanding Guarantee-0.80 Crores
• Guarantee expired in current year-060 Crores
• What would be eligible limit for BG?

Caselets

parameters calculation
Successful bid monthly 60cr=60Cr/12=5 crores
Earnest money BG 50000000X3%=1500000X3=45 Lacs
Performance BG 60crX20%=12Cr/12=1crX10%=10 lacsX12=120
lacs
Mobilisation of advance 10 lacsX3=30 lacs
Retention money 10lacsX24=240 lacs less 50%=120 lacs
Total 45+120+30+120=315 lacs
Add Opening balance of BG 80 lacs

less BG retired 50 lacs

Bg Required 315+80-50=345 lacs

Page 21 of 21