Non Fund Based Business

State Bank Staff College Hyderabad India

Letters of Credit
Facilitates trade domestic & international Helps in reducing working capital requirement for buyer Helps seller to get immediate payment though credit is extended by him Bank intermediates and lend its creditworthiness for which it charges the applicant Transactions are guided by UCPDC

Letter of Credit
An arrangement by means of which a bank (issuing bank) acting at the request of a customer (applicant) undertakes to pay to a third party (beneficiary) a predetermined amount by a given date according to agreed stipulations and against presentation of stipulated documents

Parties to a Letter of Credit Applicant (Buyer) Issuing Bank (opening bank) Beneficiary (Seller) Advising Bank Confirming Bank Negotiating Bank (Paying Bank) Reimbursing Bank

Negotiating Bank
CONTRACT

IMPORTER

EXPORTER
D O C S P A Y

OPENING BANK

ISSUE CREDIT DOCUMENTS PAYMENT

ADVISING BANK

NEGOTIATING BANK

Negotiating bank pays beneficiary first and reimbursement from the opening / confirming bank.

claims

Mechanics of Documentary Credit

CONTRACT GOODS IMPORTER DOCS SHIPPING COMPANY GOODS DOCS

EXPORTER

OPEN CREDIT OPENING BANK

ADVISING/

DOCUMENTS PAYMENT

NEGOTIATING

DOCUMENTS PAYMENT

BANK

Types of LCs
Security wise
Revocable Irrevocable Confirmed

Payment wise
Payment / deferred payment / instalment Acceptance Negotiation

Types of LCs
With advance payment
Red Clause Green Clause

Involving Middlemen
Transferable Back to Back

Others
Revolving
Standby

Opening of LC
Trade Control requirements Exchange Control requirements Credit norms of Central Bank UCPDC Provisions Banks Internal Credit Policies / procedures

Appraisal / Assessment
Means & standing of applicant Application details authorised person Purpose, sources of payment, relationship with turnover Assessment details & maximum expected outstandings Nature of goods marketablility, Seasonality, susceptibility to price changes Import Duty Currency risk Crystallisation

Exercise on Assessment
Annual Cost of Raw materials purchased under LCs Rs. 1903.85 crore Imported - Rs.504.73 crore Indigenous Rs.1399.12 crore

Average usance period for Imports 30 days from shipment Lead time 3 months Local Purchases Lead time 1mth Usance for local purchase 1 month Local purchase without LCs Rs.650 crore

Exercise on Assessment
Monthly purchase of imported RM = 42.06 (D) Avg usance period for imports = 1 month (E) Lead time = 3 months (F)
Total of E & F = 4 months (G) Required LC limit for imported RM = DxG= Rs.168.24 crore (L)

Exercise on Assessment
Monthly purchase of indigenous RM = Rs.116.59 crore (H) Avg usance period for local purchases = 1 month (I)

Local Purchases Lead time 1mth (J) Total of (I) + (J) = 2 months (K) LC limit required for indigenous RM = (H) x (K) = Rs. 233.19 crore (M)

Exercise on Assessment
Total LC limit required = L+M = Rs. 401.43 crore say Rs.400 crore.

Treatment of stocks covered by Usance LC

Lien should be earmarked against advance value of stocks for the outstanding usance LC bills This ensures provision of margins on the stocks covered by usance LCs right from the time the stocks are bought on credit backed by the Banks commitment. Thus, it ensures that the margin is available well before the CC a/c is debited for the matured LC bill. In some cases it is quite possible that the units may not be in a position to provide margins right from the time of purchases against LCs. In such cases, based on merits, earmarking of lien for the value of usance LC bills outstanding against the aggregate market value of all the securities (including the LC stocks) may be permitted instead of against the advance value of securities.

Devolvement of LC (Precautions)
The limits for demand LCs and usance LCs should be assessed separately with ample justifications. The usance period should not, generally, exceed the production cycle. In case of bulk imports, establishment of LCs for longer usance period may be considered selectively. When liability under LC is met by creating an irregularity in the Cash Credit account, the relative LC limit should not be released for opening further LCs till the account is adjusted. In other words, the liability should not be marked off in LC liability register merely because of retirement of documents. The relative liability should be marked off only after the account is regularised. In case of devolvement, if the irregularity in the account is not adjusted within 15 days, or if the LC devolved earlier is not adjusted, no further LCs should be opened without adequate margin.

Scrutiny
Level of sundry creditors in the accepted projections in case of Usance LCs Compare with operating cycle Margins & security depending on track record Cash budget monitoring to track availability of funds Irregularity to be rectified before fresh LCs are opened Continuous devolvement is a warning signal

Purchase of Bills Drawn Under LCs

Sales through LCs will be the basis for assessment of limits Only First class banks & Correspondents LCs Powers only for bills without discrepancy Bills on sister concerns - actual movement of goods to be verified Not part of ABF For bills with discrepancy, indemnity is to be obtained.

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Bank Guarantee
Guarantee is

A contract to perform the promise or discharge the liability of a third person in case of his default The contract of guarantee is distinctly different from the contract of indemnity. Indemnity is A contract by which one party promises to save the other from loss suffered by him by the conduct of the promissor himself or by the conduct of any other person

Bank Guarantee
Parties to the Contract of Guarantee Applicant : The principal debtor person at whose request the guarantee is executed Beneficiary : Person to whom the guarantee is given and who can enforce it in case of default. Guarantor : The person who undertakes to discharge the obligations of the applicant in case of his default.

Thus, the guarantee is a collateral contract, consequential to a main contract between the applicant and the beneficiary.

Bank Guarantee
Parties to the Contract of Indemnity
Indemnifier : person who promises to make good the loss Indemnified : Whose loss is to be made good

Necessity for Bank Guarantee

In lieu of security deposit / earnest money deposits for participating in tenders; Mobilisation advance/advance money before commencement of the project by the contractor and for money to be received in various stages like plant layout, design/drawings in project finance; In respect of raw material supplies or for advances by the buyers; In respect of due performance of specific contracts by the borrowers and for obtaining full payment of the bills Performance guarantee for warranty period on completion of contract which would enable the supplier to realise the proceeds without waiting for warranty period to be over; To allow units to draw funds from time to time from the concerned indentors against part execution of contracts, etc.

Appraisal of Bank Guarantee

The following aspects must be examined : Purpose for genuine business requirements ? Need for BG Related to normal trade / business ? Nature of Bank Guarantee Financial / Performance ? Amount of BG needs to be specific Applicants financial strength / capacity Past record in respect of BGs issued earlier Present outstanding on account of BGs already issued Margin Collateral Security Offered

Format for BG
Normally, BG should be issued on standardised format only. If some other format is required to be used for issue of BG, it should be ensured that the BG is : a] for a definite period, b) for a definite objective enforceable on the happening of a definite event, c) for a specific amount, d) in respect of bonafide trade/commercial transactions, e) not stipulating any onerous clause, and f) not containing any clause for automatic renewal of the BG on its expiry.

Limitation Clause
Nothwithstanding anything contained herein:
a) our liability under this Bank Guarantee shall not exceed Rs.___________ (Rupees __________________only); b) this Bank Guarantee shall be valid upto __________________; and c) we are liable to pay the guaranteed amount or any part thereof under this Bank Guarantee only and only if you serve upon us a written claim or demand on or before ___________________________ (date of expiry of Guarantee).

Invocation of BG
Important points The Banks liability under BG is absolute and independent and exclusive of any other contract entered into by the applicant and beneficiary. It is, therefore, obligatory on the part of the Bank to pay to the beneficiary without delay and demur the amount of BG on its invocation in accordance with the terms and conditions of the guarantee deeds. It is not necessary for the beneficiary to satisfy the Bank, about the default or the amount of actual loss suffered by him.

Types of Bank Guarantee

Financial - Guarantees customers credit worthiness Advance payment Retention money Security deposit Performance Guarantees obligations relating to capacity of customer to execute Bid-bond, performance bonds Inland , Foreign - export & import

Precautions
Should not be open ended Should stipulate maximum liability crystallised Should not contain onerous clauses Ensure customers ability to reimburse Other bank customer - ask why? Performance guarantee assess capacity of customer, means to carry out contract, experience Guarantee liability to have reasonable relation to equity of borrower Counter guarantee by authorised person

(BASED ON THE ESTIMATES AS ON 31.03.08)

i.Total Purchase of raw material during 2007-08 =1200 lacs ii. Monthly Purchase of RM under LC = 100 lacs iii. Av LC usance period required =60 Days iv.Lead time & Transit =30 Days v.Total time for which credit under LC is required (iii+iv)90 Days vi.LC limit required [(ii) (v) 365] =2.465 lacs vii.LC limit recommended =2.50 lacs

BG is a collateral contract, consequent to the main contract.

Indemnity only one contract between the indemnifier and the indemnified or beneficiary.

Under BG liability of the surety is secondary and arises only when the principal debtor defaults in fulfilling his obligation or promise.

In case of contract of indemnity the liability of the indemnifier is primary and unconditional

Guarantor posses certain rights which are not available to the indemnifier ie right of subrogation or reimbursement

Indemnifier cannot claim such reimbursement from anybody else.