[PROJECT REPORT ON

BANK OF BARODA

ANUJ KALYANKAR

STRATEGIES FOR
IMPROVING NBF IN
CORPORATE SECTOR]
INTRODUCTION
 NON-FUND BASED FACILITIES
 
The credit facilities given by the banks where actual bank funds are not
involved are termed as 'non-fund based facilities'. These facilities are
divided in three broad categories as under:
 
 Letters of credit
 Guarantees
 Co acceptance of-bills/deferred payment guarantees.
 
Units for the above facilities are also simultaneously sanctioned by
banks while sanctioning other fund based credit limits.
 
Facilities for co-acceptance of bills/deferred payment guarantees are
generally required for acquiring plant and machinery and may,
technically be taken as a substitute for term loan which would require
detailed appraisal of the borrower's needs and financial position in the
same manner as in case of any other term loan proposal.

RBI GUIDEUNES ON NON-FUND BASED

FACILITIES
 
Reserve Bank of India has also issued detailed guidelines to commercial
banks in respect of non-fund based credit facilities. Some of the
important points to be kept in view in this regard are discussed below:
 

1. Letters of Credit

 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
L/C facilities except in cases where no other credit facility is needed by
the customer.

 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. 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 L/C limits have to
be clearly stated. The bank opening L/C 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 L/C as per the
financial arrangement already finalised.
 
2. Guarantees
 The conditions relating to obligated being a customer of the bank
enjoying credit facilities as discussed in case of letters of credit are
equally applicable for guarantees also. In fact, guarantee facilities also
cannot be sanctioned in isolation.

 Financial guarantees will be issued by the banks only if they are

satisfied that the customer will be in a position to reimburse the bank in
case the guarantee is invoked and the bank is required to make the
payment in terms of guarantee.

 Performance guarantee will be issued by the banks only on behalf of

those customers with whom the bank has sufficient experience and is
satisfied that the customer has the necessary experience and means to
perform the obligations under the contract and is not likely to commit
any default.

 As a rule, banks will guarantee shorter maturities and leave longer

maturities to be guaranteed by other institutions. Accordingly, no bank
guarantee will normally have a maturity of more than 10 years.

 Banks should not normally issue guarantees on behalf of those

customer's who enjoy credit facilities with other banks.
 
3. Co-acceptance of Bills

 Limits for co-acceptance of bills will be sanctioned by the banks after

detailed appraisal of customer's requirement is completed and the
bank is fully satisfied about the genuineness of the need of the
customer. Further customers who enjoy other limits with the bank
should be extended such limits.

 Only genuine trade bills shall be co-accepted and the banks should
ensure that the goods covered by bills co-accepted are actually
received in the stock accounts of the borrowers. The valuation of
goods as mentioned in the accompanying invoice should be verified to
see that there is no overvaluation of stocks.
 The banks shall not extend their co-acceptance to house bills/
accommodation bills drawn by group concerns on one another.

 Before discounting/purchasing bills co-accepted by other banks for

Rs.2 lakh and above from a single party, the bank should obtain written
confirmation of the concerned controlling office of the accepting bank.

 When the value of total bills discounted/purchased (which have been

co-accpeted by other banks) exceed Rs.20 lakh for a single borrower/
group of borrowers prior approval of the Head Office of the
co-accepting bank shall be obtained by the discounting bank in writing.

 Where banks open L/C and also co-accept bills drawn under such L/C,
the discounting banks, before discounting such co-accepted bills, must
ascertain the reason for co-acceptance of bills and satisfy themselves
about the genuineness of the transaction.

 Co-acceptance facilities will normally not be sanctioned to customers

enjoying credit limit with other banks.

LETTER OF CREDIT

 
Letter of credit is, a method of settlement of payment of a trade
transaction and is widely used to finance purchase of machinery and raw
material etc. It contains a written undertaking given by the bank on
behalf of the purchaser to the seller to make payment of a stated amount
on presentation of stipulated documents and fulfilment of all the terms
and conditions incorporated therein. All letters of credit in India relating
to the foreign trade i.e., export and import letters of credit are subject to
provisions of 'Uniform Customs & Practice for Documentary Credits'
(UCPDC). The latest revision of these provisions effective from 1st
January, 1994 has been issued by International Chamber of Commerce
as its publication No. 500 of 1994. These provisions neither have the
status of law or automatic application but parties to a letter of credit bind
themselves to these provisions by specifically agreeing to do so. These
provisions have almost universal application and help to arrive at
unambiguous interpretation of various terms used in letters of credit and
also set the obligations, responsibilities and rights of various parties to a
letter of credit.
Inland letters of credit may also be issued subject to the provisions of
UCPDC and it is, therefore, important that customers should be fully
aware of these provisions and shall also understand complete L/C
mechanism as these transactions will find increasing use in the coming
 days. Complete text of UCPDC is not being reproduced. However,
important articles have been given as extracts wherever necessary. An
attempt has been made to explain the L/C mechanism in full as there are
some inherent risks and wrong notions while dealing with these
transactions.
 

Definition of a Letter of Credit

 

Article 2 of UCPDC defines a letter of credit as under:

The expressions "documentary credit(s) and standby letter(s) of credit
used herein (hereinafter referred to as "credit(s)" means any
arrangement, however, named or described whereby a bank (the issuing
bank), acting at the request and on the instructions of a customer (the
applicant of the credit) or on its own behalf.

(i) is to make a payment to or to the order of a third party (the

"beneficiary"), or is to accept and pay bills of exchange (Draft(s))
drawn by the beneficiary,
or
(ii) authorises another bank to effect such payment, or to accept and
pay such bills of exchange (Draft(s)),
or
(iii) authorises another bank to negotiate against stipulated
document(s), provided that the terms and conditions of the credit
are complied with. 
For the above purpose the branches of a bank in different countries are
considered another bank.

Letter of credit is a written undertaking by a bank (issuing bank) given to

the seller (beneficiary) at the request and in accordance with the
instructions of buyer (applicant) to effect payment of a stated amount
within a prescribed time limit and against stipulated documents provided
all the terms and conditions of the credit are complied with".

Letters of credit thus offers both parties to a trade transaction a degree

of security. The seller can look forward to the issuing bank for payment
instead of relying on the ability and willingness of the buyer to pay. He is
further assured of payment being received on due date enabling him to
have proper financial planning. The only condition being attached is
submission of stipulated documents and compliance with the terms and
conditions of credit. The buyer on the other hand will be obliged to pay
only after receipt of documents of title to goods to his satisfaction.

Letter of credit is an independent document in itself as provided vide

article 3 of UCPDC which states that: "Credits, by their nature, are
separate transactions from the sales or other contract(s) on which they
may be based and banks are in no way concerned with or bound by
such contract(s), even if any reference whatsoever to such contract(s) is
included in the credit." This article is very important and has a direct
bearing on the relationship of the opener with bank. Many disputes have
arisen due to the reference of sale contract in the letter of credit. The
letter of credit is issued in accordance with the instructions of the
applicant who should provide complete and precise instructions to the
bank to avoid any dispute later. The undertaking of a bank to pay,
accept and pay drafts or negotiate and/or to fulfil any other obligations
under the credit is not subject to claims or defences by the Applicant
resulting from his relationship with the issuing Bank or the Beneficiary.

Another very important provision which is very vital to letter of credit

operations is regarding disputes emanating from the quality/quantity of
goods covered under a letter of credit. Article 4 of UCPDC states:
"In credit operations all parties concerned deal with documents, and not
with cods, services and/or other performances to which the documents
may relate.

An important point which emerges from the above article is that any
dispute regarding the quality/quantity of the goods may have to be
settled outside the terms of letter of credit. Letter of credit thus provides
no protection on this account and the applicant must specify submission
of necessary weight certificate/quality analysis certificates etc. as
considered necessary to satisfy himself regarding the goods on the basis
of these documents alone.
Sample of Letter of Credit
TYPES OF L/C

Revolving L/C

Revocable L/C

Irrevocable L/C

Stand By Letter L/C

Confirmed L/C

Back to Back L/C

Red Clause and Green L/C

Transferable L/C

Acceptance L/C

Types Of Letter of Credit

 Revocable Letter of Credit: This may be amended or cancelled without

prior warning or notification to the beneficiary. Such letter of credit will
not offer any protection and should not be accepted as beneficiary of
credit.

 Irrevocable Letter of Credit: This cannot be amended or cancelled

without the agreement of all parties thereto. This type of letter of credit is
mainly in use and offers complete protection to the seller against
subsequent development against his interest. It may, however, be
mentioned here that every letter of credit must clearly indicate whether it
 is revocable or irrevocable. In the absence of such indication the credit
shall be deemed to be irrevocable. The beneficiary, on receipt of credit,
must therefore, examine that the letter of credit is not indicated as
revocable.

 Transferable Letter of Credit: A transferable letter of credit is one that

be transferred by the original (first) beneficiary to one or more second
benefiaries. It is normally used when the first beneficiary does not supply
the merchandise himself but is a middleman and thus wishes to transfer
part or all of his rights and obligations to actual suppliers as second
beneficiaries. The letter of credit is transferable only if it is specifically
stated as transferable'. In case the credit is silent about it, the L/C will be
deemed to be transferable. Further the L/C can be transferred only once
which in other words means that 2nd beneficiary cannot transfer it to any
other person. Under a transferable letter of credit the second beneficiary
assumes the same rights and obligations as that of the original
beneficiary.

 Back to Back Letter of Credit: A letter of credit which is backed by

other letter of credit is termed as 'back to back' credit and is also used
when middleman is involved in a sale transaction. Such transaction
offers additional security of the letter of credit to the bank issuing back to
back L/C. However, for successful completion of the entire transaction it
must be ensured that back to back L/C is opened on the worse terms as
compared to the terms under; the original letter of credit.

 Revolving Letter of Credit: The concept of revolving letter of credit is

best illustrated by the following example:Let us presume that goods of
the total value of Rs.60 lacs are required to be purchased over a period
of one year and requirement of those goods at a time is proximately
Rs.10 lacs. If the terms of payment are under L/C the buyer may have
two options as under:
(i) To open an L/C for Rs.60 lacs valid for 1 year and permit part
shipment, or
(ii) To open letters of credit for Rs.10 lacs each on six different
occasions.

 Confirmed Letter of Credit: The advising bank may be requested to add

its confirmation to the credit..The confirmation constitutes the undertaking
of the bank, to effect the payment, upon presentation as it counters, of
confirming documents

 Red Clause and Green Clause Letter of Credit: All letters of credit as
discussed above provide a sort of guarantee of payment against
documents which are drawn strictly in terms of subject letter of credit. In
other words the benefit of L/C accrues only when shipment of goods is
 completed. Red Clause Letter of Credit goes a step further and authorises
the advising bank to grant an advance to the beneficiary at the
pre-shipment stage itself. The advance by the advising bank shall be
recovered at the time of negotiation of documents under that L/C. In case,
however, no shipment is effected by the beneficiary and he fails to present
documents under L/C, the bank making advance under red clause letter of
credit will claim reimbursement of advance made from the issuing bank.
Green Clause L/C is one which authorizes the bank to grant
further finance to exporter for storage of goods in the name of the bank,
payment of dockyard, port and insurance charges etc.before the
shipment is taking place.

 Acceptance Letter of Credit: An acceptance Letter of Credit is the one

which provides for drawing of drafts by the beneficiary on usance basis.
Normally such usance drafts being drawn on the importer, the
documents are to be delivered to him by opening the bank (after
receiving them from the beneficiary through the negotiating bank)
against mere acceptance of the usance draft. Such letters of credit are
therefore, considered unsecured credits from advances point of view and
therefore attracts all careful considerations which a normal clean
advance demands.

 Standby Credit: Similar To a normal letter of credit, this differs in that it

is a default instrument, whereas a normal L/C is a payment instrument. A
standby credit is only called upon in the event of the applicant’s failure to
perform. Standby letter of credit is very similar in nature to a bank
guarantee. Standby credits were first developed by banks in United
States after World War II and enable domestic banks to compete with
foreign banks in international business transactions. It is an alternate to
guarantee bonds because of legal restrictions on banks from issuing
guarantees. Japanese banks also issue Standby credits for similar
reasons Standby credit differs with traditional letter of credit. In a
traditional credit the beneficiary is entitled for payment once he is able to
submit the documents prescribed in the credit within the stipulated time.
In Standby credits the beneficiary is eligible for payment from the issuing
bank when the applicant fails to perform his obligation.
  

In short, standby credit is a document which:

a) The Issuer, usually a bank

b) At the request of its customer, applicant.

c) Agrees that the beneficiary will be paid.

d) Before the credit's expiry.

e) Upon the beneficiary's presentment of

i. Its demand for payment and

ii. Any documents evidencing the applicant's non-performance or
 default

This gives the applicant an opportunity to specify the documents that are to be
presented by the beneficiary for claiming payment. In most of the cases it will
be a certificate of default of payment by the importer / applicant on due date.
This is one of the most convenient facilities preferred by the importer client
and also the overseas seller. Under this arrangement, importer client can get
the consignment directly from the overseas seller. Bank undertakes to pay the
overseas seller only in case of default by the importer. Less number of
documents are called for in this transaction.

Step 1: Goods are dispatched to the buyer.

Step 2: Buyer fails to make the payment.

Step 3: On default by the buyer, the beneficiary presents the prescribed

documents for payment to the confirming bank.

Step 4: On receipt of the documents, the Confirming Bank scrutinizes the

documents thoroughly and if the documents are drawn in order without any
discrepancy makes payment to the exporter/beneficiary of the LC.

Step 5: Confirming bank dispatches the documents to the Issuing bank.

Step 6: Issuing bank on receipt of documents from the confirming bank,

scrutinizes the documents and reimburses the confirming bank and debits the
importer.

Step 7: Issuing Bank sends the documents to the importer for collection of
payment.
Step 8: Importer makes the payment to the issuing bank

Parties to a Letter of Credit

1. Applicant/Opener.
It is generally the buyer of the goods who gets the letter of credit
issued by his banker in favour of the seller. The person on whose
behalf and under whose instructions the letter of credit is issued is
known as applicant/ opener of the credit.

2. Opening bank/issuing bank.

The bank issuing the letter of credit.

3. Beneficiary.
The seller of goods in whose favour the letter of credit is issued.

4. Advising Bank.
Notification regarding issuing of letter of credit may be directly
sent to the beneficiary by the opening bank. It is, however,
customary to advise the letter of credit through sane other bank
operating at the place/country of seller. The bank which advises
the letter of credit to the beneficiary is known as advising bank.

5. Confirming Bank.
A letter of credit substitutes the credit worthiness of the buyer with
that of the issuing bank. It may sometimes happen especially in
import trade that the issuing bank itself is not widely known in the
exporter's country and exporter is not prepared to rely on the L/C
opened by that bank. In such cases the opening bank may request
other bank usually in the country of exporter to add its confirmation
which amounts to an additional undertaking being given by that
bank to the beneficiary. The bank adding its confirmation is known
as confirming bank. The confirming bank has the same liabilities
towards the beneficiary as that of opening bank.

6. Negotiating Bank.
The bank who negotiates the documents drawn under letter of
credit and makes payment to beneficiary.
The function of advising bank, confirming bank and negotiating bank
may be undertaken by a single bank only.
Letter of Credit 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 L/C 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 L/C mechanism covering the liabilities and
rights & both the applicant and the beneficiary are understood for
maximum advantage.
 
The complete mechanism of a letter of credit may be divided in two 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 letter of credit may either be advised directly or through
some other 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. Refer to diagram given below for complete
process of issuance of credit.

Letter Of Credit Mechanism-Issuing Of LC

Establishing a Letter of Credit

Stage 1: Buyer and seller conclude a contract of sale, specifying the terms of
sale and settlement by L/C. Buyer instructs his bank to issue L/C as per L/c
application and sales contract
Stage 2: Issuing Bank verifies its own customer’s (Applicant’s)
creditworthiness, if satisfied, issues a letter of credit and sends it to its
corresponding bank (Advising Bank) in the city/country of Beneficiary (Seller).
Issuing Bank Authorities the Reimbursing bank honor reimbursement claims
under L/C.
Stage 3: Advising of a L/C to Beneficiary by Advising bank with/without adding
confirmation

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 L/C and draw necessary documents as required under L/C.
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. The entire process of negotiation is diagrammatically
represented as under:
Negotiation of Documents under Confirmed Credit

Stage 1: The beneficiary after shipping the goods presents the prescribed
documents for payment to the confirming bank

Stage 2: On receipt of the documents, the Confirming Bank scrutinizes the

documents thoroughly and if the documents are drawn in order without any
discrepancy makes payment to the exporter/beneficiary of the LC.

Stage 3: Confirming bank dispatches the documents to the Issuing bank.

Stage 4: Issuing bank on receipt of documents from the confirming bank,

scrutinizes the documents and reimburses the confirming bank and debits the
importer.

Stage 5: Issuing Bank sends the documents to the importer for collection of
payment.

Stage 6: Importer makes the payment to the issuing bank

PRECAUTION
 

Important points/precautions which must be noted by the

openers/beneficiaries at various stages of operations under a letter of credit
are now discussed hereunder:
 
At the Time of Opening of a Letter of Credit

 Letter of credit offers almost complete protection to the seller but the
buyer is put to many disadvantages and has to make payments against
documents only. Before agreeing to open a letter of credit in favour of
the seller, the opener must be satisfied with the creditworthiness and
general reputation of the seller. Entire success of an L/C transaction
depends on proper conduct of the seller. Confidential report on the seller
must be obtained at the time of first transaction with him.
 Letter of credit also does not offer any protection for the quality/ quantity
of goods supplied under the L/C. It would, therefore, be necessary to
know the nature of goods and specify submission of quality
reports/inspection reports from an independent agency to ensure receipt
of goods of proper quality .This is particularly important in case of import
of chemicals and such other goods.

 The opener has to submit an L/C application to the opening bank. The
instructions contained in the L/C for application is the mandate for the
issuing bank and letter of credit will be issued in accordance with this
application. It is, therefore, necessary that complete and precise
information must be given in the L/C application form specifying therein
the description, unlit rate and quantity of the goods covered under IX
and details of documents required in absolute clear and unambiguous
terms. The reference to underlying sale contract must be avoided as far
as possible. The L/C application must nevertheless contain all the
required/information based on which L/C could be opened by the bank.

 After the L/C has been issued by the bank, a copy thereof must be
obtained immediately. The L/C must be scrutinised to ensure that it has
been properly issued and is in conformity with L/C application.
Discrepancy, if any, must be brought to the notice of opening bank
immediately.

At the time of Receipt of L/C and Negotiation of Documents

 
 On receipt of L/C from the opening/advising bank, the beneficiary must
ensure that the letter of credit is advised without any superimposed
clause. Sometimes an unauthenticated message may be received and
advised by the bank which may not be acted upon unless authenticity of
the message (L/C) is confirmed by the advising bank.

 The L/C must state on the face of if that it is irrevocable and must have
been issued by a bank of repute. If the issuing bank is not widely known,
confirmation from a local bank may be insisted upon before acting on
such a Credit.

 The L/C must be scrutinised to ensure that the terms indicated are in
conformity with the underlying sale contract. It does not contain any
ambiguous clauses and documents required therein can be completed. If
it has some conditions which cannot be compiled with, the matter should
immediately be taken up with opener for amendment of L/C. Shipment of
 goods before ensuring that all the terms and conditions can be complied
with may be risky as no protection will be offered under L/C.

 Necessary arrangement for shipment/despatch of goods shall be made

after acceptance of L/C. The shipment and despatch must be made as
per the terms of L/C and well within the period prescribed under L/C.

 After shipment of goods necessary documents must he prepared.

Extreme care must be taken to prepare the documents as the payment
will be dependent upon the acceptance of those documents under the
L/C. Even a minor mistake in spelling or punctuation may prove to be
enough ground for rejecting the documents. It is necessary that
complete knowledge of all the Articles of UCPDC relating to documents
must be obtained at the time of preparation of documents.

 The documents, complete in all respects, should then be presented to

the bank for negotiation. The negotiating bank must be requested to
closely examine the documents and indicate the discrepancies, if any.
Efforts should then be made to remove those discrepancies and
documents free of all discrepancies only must be negotiated.

 There may sometimes be some discrepancies which cannot be rectified

and two options are now available as under:
 (a   Get confirmation/authority of opening bank to negotiate
discrepant documents, or
(b)   Get the documents negotiated under reserve after giving
Suitable indemnity bond to the negotiating bank.
 The option (a) is more advantageous as it will ensure final payment at
the, time of negotiation itself. The option (b) may be exercised only in
exceptional circumstances as 'negotiation under reserve' does not offer
any guarantee as to acceptance of documents under L/C.

 The final authority of acceptance of documents lies with the opening

bank only who has to be given reasonable time for scrutinising the
documents. Documents under L/C are negotiated by banks in India with
recourse and if the documents are subsequently rejected by opening
bank due to any reasons the negotiating bank will recover the amount of
the beneficiary. It is, therefore, necessary that documents are always
drawn strictly in conformity with the terms of L/C.
 
 On receipt of advice of rejection of documents the negotiating bank must
be instructed to initiate necessary steps to safeguard the interest of the
beneficiary in light of various provisions of UCPDC.

 
On Receipt of Documents under L/C
 
The negotiating bank will transmit the documents to the opening bank
after negotiation and obtain reimbursement in terms of the L/C. The
opening bank will be given a reasonable time to scrutinise the
documents and decide whether the documents are drawn in accordance
with the terms of credit and are acceptable or to reject the documents.
Reasonable time has since been specified by Article 13(b) of UCPDC
and it is not to exceed seven banking days following the day of receipt of
the documents. In case documents are rejected by the opening bank, it
must give due notice of such rejection to the negotiating bank by fastest
means and also place the documents at the disposal of the negotiating
bank. The receipt of documents will also be advised by the opening bank
to the applicant.
 
 Applicant must independently scrutinise the documents received
under L/C and ensure that the documents can be accepted. In case
any discrepancy is noted in the documents which are not acceptable,
the documents must be rejected and an immediate notice should be
given to the opening bank for such rejection. The opening bank may
be instructed to take up the matter with negotiating bank suitably.
Notice of rejection must invariably be given to the opening bank in
writing.

        The documents if acceptable must be taken upon due date for
which necessary financial arrangement shall be made in advance.
 
 Guarantees

Definations:

The bank guarantee is an instrument which business partners can use to

strengthen and/or secure and obligation in their contract. The Principal - the
party who requests that the guarantee is issued – applies to his bank for a
bank guarantee to be issued in favor of the Beneficiary – the party who will
receive the guarantee.

After examining and approving the Principal’s application, the bank draws up a
contract with the Principal - the Counter-Indemnity. The Counter-Indemnity
states, among other things, the rights and obligations of the Principal and the
bank in relation to possible payment for claims under the guarantee.
Once all of this is in place, the bank then issues the guarantee.
By issuing the guarantee the bank offers a security to the Beneficiary that is
separate from the Principal stability or will to fulfill his part of the contract. For
example, a guarantee can be issued to secure the repayment of an advance
payment if delivery does not take place.
Bank guarantees can also be used to secure performance under a contract.
Such a guarantee does not however mean that the bank completes the project
in the event of non-performance. Instead the bank’s undertaking is a payment
obligation. Funds are then available to the Beneficiary to enable him to, for
example, complete the project with another party.
In general banks issue two different kinds of guarantees: Accessory and Non-
Accessory guarantees.

A bank guarantee is a commercial instrument in the nature of a contract,

intended between two parties, to secure compliance with the contract. It is an
off-shoot of the main contract between two parties.

A bank guarantee is a guarantee made by a bank on behalf of a customer

(usually an established corporate customer) should it fail to deliver the
payment, essentially making the bank a co-signer for one of its customer's
purchases.
A commitment made by a bank to a foreign buyer that the bank will pay an
exporter for goods shipped if the buyer defaults.

This is a guarantee from the buyer's bank for a short period of time (usually 1
or 2 months) covering payment for shipment of product if there is a problem
with the principal LC.

Bank guarantee (BG) is guarantee given by a bank for a business. Thus a

bank guarantee implies a promise by the bank to repay the outstanding
amount of an individual or a business if that individual/business fails to repay
his debt. BGs are generally used as collaterals by corporate. When any
business wants to enter into a financial transaction with counterparty, the
counterparty may insist that a bank guarantee is put in place. Bank guarantees
may be issued for domestic as well as foreign business purposes.
This is a document issued by the bank on behalf and at the request of a
customer to third party for fulfillment of terms of contract as agreed between
them.

Bank guarantee overview

Guarantees can be divided into two kinds – those that are linked to the
underlying contract – an accessory relationship, and those that are
independent or an non-accessory relationship. The former are often referred to
as “Borgen” in Sweden. The latter category can be broken down further into
Demand Guarantees and Standby Letter of Credit.
  
A contract of guarantee can be defined as a contract to perform the
promise, or discharge the liability of a third person in case of his default.
The contract of guarantee has three principal parties as under:

The person who has to perform or

dischargethe liability and for whose
1.Principal debtor default the guarantee is given.

The person to whom the guarantee is

2.Principal creditor givenfor due fulfilment of contract by
principaldebtor. Principal creditor is also
sometime referred to as beneficiary.

The person who gives the guarantee.

3.Guarantor or Surety

Types of Guarantees

Different types of bank guarantees issued by a bank are as follows:

 Tender Guarantee
This is usually issued for an amount equal to between 1 and 2 percent of the
contract value.
It gives the beneficiary compensation for additional costs if the party
submitting the tender does not take up the contract and it must be awarded to
another party.

 Performance Guarantee
Normally issued for an amount equal to between 5 and 10 percent of the
contact value, this guarantee assures payment to the beneficiary in the event
that the contractor fails to fulfill contract obligations.
  Advance Payment Guarantee
This enables the beneficiary to get a refund of advance payments made in the
event of default by the contractor. It is issued for the full amount of the
advance payment, but may contain reduction clauses, which enable a
reduction in the maximum amount upon evidence of progressive performance.

 Retention Money Guarantee

Most major projects call for stage payments as work progresses. Often the
beneficiary retains a percentage of the payment (retention money) from the
contractor, as cover for any hidden defects in the completed work. A retention
money guarantee allows for immediate release of retention money to the
contractor.

 Facility Guarantee
This is normally not trade related. Its purpose is to provide security to another
bank to advance money to an individual or company. It is often used when a
company does not have any credit record and wishes to expand offshore.

 Maintenance Guarantee
This ensures that the contactor does not abandon the contract after
completion of the construction phase, but continues to honor any maintenance
obligations as per the original agreement.

 Customs Guarantee
Contractors often need to import equipment temporarily to carry out a contract.
Import duty would normally be payable, but the customs authorities will grant
exemption if the contractor undertakes to re-export the equipment on
completion of the contract. The contractor then has to provide the customs
authority with this guarantee, which prevents the contractor from selling the
goods in the domestic country, instead of re-exporting them.

 Shipping Guarantee
This enables the buyer to obtain release of the goods from the carrier, despite
the bill of lading being lost or delayed.

What should a bank guarantee contain?

Ideally the underlying contract should contain clauses regarding how the
guarantee(s) should be issued. All instructions for the issue of guarantees
should be clear, precise and avoid excessive detail. Listed Below are a
number of the different points which can be contained in the various guarantee
types. Note: most of these points should be mandatory; others will depend on
the type of guarantee involved.
A definition of the parties involved.
Direct Guarantee (3-part) Principal, Issuing bank and Beneficiary, Indirect
Guarantee (4-part) Principal, Instructing Party, Issuing bank and Beneficiary.
Due to the cause of this it would be highly advantage

A reference to.
The underlying transaction requiring the issue of the guarantee.

The guarantee amount

The maximum amount payable and the currency in which it is payable.

The period of validity.

Guarantees should expire on a specific date (“expiry date”) or on presentation
to the Guarantor of the document(s) specified for the purpose of expiry (“expiry
event”). If both an expiry date and an expiry event are specified in a
guarantee, the guarantee shall expire on whichever of the two occurs first,
whether or not the guarantee and any amendment(s) thereto are returned.

Documentation.
Any demand for payment under the guarantee should be in writing and in
addition to other documents which may be specified in the guarantee, for
example, a certificate by an architect or engineer, a judgment or an
arbitrational award, be supported by a written statement (whether in the
demand itself or in a separate document or documents accompanying the
demand and referred to in it) stating that the Principal/ Applicant is in breach of
his obligation(s) under the underlying contract(s) or, in the case of a tender
guarantee, the tender conditions and the respect in which the
Principal/Applicant is in breach.

A reduction clause.
A guarantee may contain express provision for reduction of the guarantee
amount. The amount is reduced by a specified or determinable amount or
amounts on a specified date or dates or upon presentation to the Guarantor of
the document(s) specified for this purpose in the guarantee.

Effective clause.
A guarantee enters into effect on the date of issuance unless the terms of the
guarantee expressly provide that such entry into effect is to be at a later date
or is to be subject to conditions specified in the Guarantee and determinable
by the Guarantor. Advance Payment Guarantees usually contains such a
condition and do not allow for the guarantee to come into effect until the
advance payment has been received by the Principal/Applicant. Whether or
not the guarantee is transferable

Reference to applicable rules.

ICC Uniform Rules for Demand Guarantees (URDG458)
ICC International Standard Practices (ISP98)
Additional points to consider before signing a contract.
• Who pays the Issuing Bank’s charges/commission/fees?
• How should the guarantee be drafted?
• Which law and jurisdiction should apply?
The RBI guidelines for sanctioning guarantee facilities have already been
discussed earlier in this chapter. Reserve Bank lays a great emphasis on
banks to make prompt payment to the beneficiaries in terms of guarantees
issued by them as and when such guarantees are invoked. Other important
points/ precautions in respect of availing of these facilities from banks are
discussed hereunder:
 
 As a rule, banks should avoid giving unsecured guarantees in large
amounts and for medium and long term period. They should avoid undue
concentration of such unsecured guarantee commitments to particular
groups of customer and/or trades.

 Unsecured guarantees on account of any individual constituent should

be limited to a reasonable proportion of the bank's total unsecured
guarantees. Guarantees on behalf of individual should also bear a
reasonable proportion to constituent's equity.

 In exceptional cases, banks may give deferred payment guarantees on

an unsecured basis for modest amounts to first class customers who
have entered into deferred payment arrangements in consonance with
Government policy. But such unsecured guarantees should be
accommodated within the limits indicated above.

 Guarantees executed on behalf of any individual constituent, or a group

of constituents, should be subject to prescribed exposure norms.

 When any bank reaches a stage where it is likely to exceed the norm, it
should not undertake any further commitment on account of guarantees.

 Suitable arrangements may be made to keep a watch from time to time

about the outstanding guarantees of the bank so as to ensure that it
does not exceed the norm.

 
It is essential to realise that guarantees contain inherent risks and that it
would not be in the bank's interest or in the public interest generally to
encourage parties to over-extend their commitments and embark upon
enterprises solely relying on the easy availability of guarantee facilities.
 
 The guarantees are issued by the banks against counter guarantees
given to the banks by the customer. The banks may also require a
cash margin and/or other securities as per sanction.

 Indian Banks Association has prescribed a standard guarantee form

which is generally issued by the banks. Guarantees may be issued
in serially numbered security forms.

 After the period of guarantee has expired efforts should be made to

arrange return of the guarantee by the beneficiary to the bank.

 Banks are not allowed to execute guarantees covering

inter-company deposits/ loans accepted by NBFC/firms from other.
NBFC/firms.

 Banks may issue guarantees favouring the financial institutions or

other banks or lending agencies for the loans extended by the latter,
on fulfilment of prescribed conditions.

 However, in regard to rehabilitation of sick/weak industrial units, in

exceptional cases, where banks are unable to participate in
rehabilitation packages due to temporary liquidity constraints, such
banks may extend guarantees in favour of the banks which take up
their additional share. These guarantees will remain in existence till
such time the banks providing additional finance against guarantees
are re-compensated.

 Guarantees can be issued favouring HUDCO/ State Housing Boards

and similar bodies/organisations for the loans granted to private
borrowers who are unable to offer clear and marketable title to
property. However, banks must satisfy themselves regarding the
capacity of the borrowers to adequately service such loans.

 Banks may issue guarantees on behalf of their clients in favour of

Development Agencies/Boards (like IREDA, NHB etc.) for obtaining
soft loans/other forms of development assistance.
 Banks have discretion to issue guarantees favouring other lending
agencies, in respect of infrastructure projects alone provided the
guarantor bank also takes a funding share in the project to the
extent of at least 5% of the project cost and undertakes normal
credit appraisal, monitoring and follow-up of the project.
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