Credit Risk Management Course Instructor: Mr.

Rajesh Thapa, Senior Lecturer, Apex College

Unit VI: Non-Fund Based Operations 5 hours

Bank guarantees; letter of credit: meaning and types, establishing letter of credit, parties involved, basic
documents, risk assessment in letter of credit.

Bank Guarantees:

Bank guarantees are non-fund based credit facility provided to the customer. Guarantees are in the form of
letters and act as commitment by the bank to the beneficiary that in event of the non-performance by the
customer, bank will be ready to compensate up to the amount guaranteed.

Basically bank guarantees are of following types:

1. Bid Bond Guarantee

Bid Bond Guarantee:

Bid Bond Guarantee is required by the contractor/ service provider for bidding the tender issued by the
various government and non government organizations. Such tender notice is published in the national
daily newspaper. Customer bids on suitable tender depending upon their nature of business, competency,
qualification and field of expertise. To bid on such tender, customer requires Bid Bond Guarantee from
reputed commercial banks.

It is the guarantee that the winning bidder will undertake the contract under the terms at which they bid.
Generally Bid Bond Guarantee is equivalent to 2.50% of contract amount. For e.g. if a tender notice for
contract/project for publishing course books of Grade 7-10 is Rs. 10,000,000/-, Bid Bond Guarantee
required to bid for the contract should be Rs. 250,000/-So the customer requests the bank to issue Bid Bond
Guarantee worth Rs. 250,000/-

Bank charges commission for issuing Bid Bond Guarantee per quarter. For e.g., 0.20% per quarter of
guarantee amount.

Performance Bond Guarantee:

Performance Bond Guarantee is the guarantee issued by the bank guaranteeing satisfactory completion of a
contract/project by the customer. It is the guarantee that the customer will perform on the contract/project
as per the terms and conditions of contract and execute it within stipulated time period.

Once the customer wins the bidding or contract through Bid Bond Guarantee issued by the bank, the
customer is required to submit Performance Bond Guarantee to the beneficiary of the contract/project for
signing the final contract paper. So contract becomes effective once Performance Bond Guarantee is
submitted by the customer.
Credit Risk Management Course Instructor: Mr. Rajesh Thapa, Senior Lecturer, Apex College

Generally Performance Bond Guarantee is equivalent to 5.00% of contract amount. For e.g. if a tender
notice for contract/project for publishing course books of Grade 7-10 is Rs. 10,000,000/-, Performance
Bond Guarantee required to sign and execute the contract should be Rs. 500,000/-So the customer requests
the bank to issue Performance Bond Guarantee worth Rs. 500,000/-

Bank charges commission for issuing Performance Bond Guarantee per quarter. For e.g., 0.25% per quarter
of guarantee amount.

Advance Payment Guarantee:

Advance Payment Guarantee (APG) is used to get advance payment released for starting works under
contract/project. Some projects are huge in nature. With APG, customer will get certain percentage of
contract amount in advance to start the project work. For this, customer requests the bank to issue APG so
that it can get portion of project fund in advance. The fund received in advance is utilized in purchasing
stocks, opening Letter of Credit (LC) and covering other preliminary expenses related to the project.

Generally APG is equivalent to 20.00% of contract amount. For e.g. if a contract/project amount for
publishing course books of Grade 7-10 is Rs. 10,000,000/-, APG required would be Rs. 2,000,000/-So the
customer requests the bank to issue APG worth Rs. 2,000,000/-After submitting APG amounting Rs.
2,000,000/- to the project beneficiary, the customer will be given same amount in the form of cheque to
carry out works under the project.

Bank charges commission for issuing APG per quarter. For e.g., 0.375% per quarter of guarantee amount.

Custom Bond Guarantee:

Custom Bond Guarantee (CBG) is used for releasing imported raw materials from the custom office from
the bonded warehouse facility. CBG is generally used by the customers who are into export based
manufacturing business. Such party has to import raw materials from other countries for production of
finished goods. Raw materials imported from other countries enter the custom point and are stored in the
warehouse facility of custom office. In order to release the imported raw materials, the customer has to
present CBG issued by the bank to the custom office. Then only such raw materials are released to the
customer.

The other purpose of a custom bond is to guarantee the payment of import duties and taxes. CBG will be
released once the finished goods made from the raw materials are exported. It usually takes 6-9 months for
the entire process.

Bank charges commission for issuing CBG per quarter. For e.g., 0.50% per quarter of guarantee amount.

Letter of Credit:

A letter of credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on
time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the
bank will be required to cover the full or remaining amount of the purchase.
Credit Risk Management Course Instructor: Mr. Rajesh Thapa, Senior Lecturer, Apex College

LC is a written undertaking from a bank to pay a beneficiary against the delivery of a specified set of
documents.

Types of LC:

· Import/export — The same credit can be termed an import or export letter of credit depending on
whose perspective is considered. For the importer it is termed an Import LC and for the exporter of
goods, an Export LC.
· Revocable — The buyer and the issuing bank are able to manipulate the LC or make corrections
without informing or getting permissions from the seller. According to UCP 600, all LCs are
irrevocable, hence this type of LC is obsolete.
· Irrevocable — Any changes (amendment) or cancellation of the LC (except it is expired) is done by the
applicant through the issuing bank. It must be authenticated and approved by the beneficiary.
· Confirmed — An LC is said to be confirmed when a second bank adds its confirmation (or guarantee)
to honor a complying presentation at the request or authorization of the issuing bank.
· Unconfirmed — This type does not acquire the other bank's confirmation.

· Deferred / Usance — A credit that is not paid/assigned immediately after presentation, but after an
indicated period that is accepted by both buyer and seller. Typically, seller allows buyer to pay the
required money after taking the related goods and selling them.
· At Sight — A credit that the issuing bank immediately pays after inspecting the carriage documents
from the seller.
· Restricted — Only one advising bank can purchase a bill of exchange from the seller in the case of a
restricted LC.
· Unrestricted — The confirmation bank is not specified, which means that the exporter can show the bill
of exchange to any bank and receive a payment on an unrestricted LC.
· Transferrable — The exporter has the right to make the credit available to one or more subsequent
beneficiaries. Credits are made transferable when the original beneficiary is a middleman and does not
supply the merchandise, but procures goods from suppliers and arranges them to be sent to the buyer
and does not want the buyer and supplier know each other. The middleman is entitled to substitute his
own invoice for the supplier's and acquire the difference as profit. A letter of credit can be transferred
to the second beneficiary at the request of the first beneficiary only if it expressly states that the letter
of credit is "transferable". A bank is not obligated to transfer a credit. The terms and conditions of the
original credit must be replicated exactly in the transferred credit. However, to keep the workability of
the transferable letter of credit, some figures can be reduced or curtailed.
· Un-transferable — A credit that the seller cannot assign all or part of to another party. In international
commerce, all credits are un-transferable.
· Red Clause — Before sending the products, seller can take the pre-paid part of the money from the
bank. The first part of the credit is to attract the attention of the accepting bank. The first time the credit
is established by the assigner bank, is to gain the attention of the offered bank. The terms and
conditions were typically written in red ink, thus the name.
· Back to Back — A pair of LCs in which one is to the benefit of a seller who is not able to provide the
corresponding goods for unspecified reasons. In that event, a second credit is opened for another seller
to provide the desired goods. Back-to-back is issued to facilitate intermediary trade. Intermediate
Credit Risk Management Course Instructor: Mr. Rajesh Thapa, Senior Lecturer, Apex College

companies such as trading houses are sometimes required to open LCs for a supplier and receive
Export LCs from buyer.
· Standby Letter of Credit: — Operates like a Commercial Letter of Credit, except that typically it is
retained as a "standby" instead of being the intended payment mechanism. UCP600 article 1 provides
that the UCP applies to Standbys; ISP98 applies specifically to Standby letters of Credit; and the
United Nations Convention on Independent Guarantees and Standby Letters of Credit applies to a small
number of countries that have ratified the Convention.
Risk assessment in Letter of Credit:
LC is one of the safest methods of payment in international trade as it suits both buyer and seller under
contract of sale. It persuades the buyer and seller who may not know each other and are operating in
different countries to execute trade. However there are still risks inherent in LC to the parties involved in
the documentary credit process as highlighted below:
Applicant

· Non-delivery of Goods
· Short shipment
· Inferior quality
· Early / late shipment
· Damaged in transit
· Foreign exchange
· Failure of bank viz issuing bank / collecting bank

Issuing Bank

· Insolvency of the applicant

Fraud Risks

· The payment will be obtained for nonexistent or worthless merchandise against presentation by the
beneficiary of forged or falsified documents.

Sovereign and Regulatory Risks

· Performance of LC may be prevented by government action outside the control of the parties.

Legal Risks

· Possibility that performance of LC may be disturbed by legal action relating directly to the parties and
their rights and obligations under the documentary credit.

Beneficiary
Credit Risk Management Course Instructor: Mr. Rajesh Thapa, Senior Lecturer, Apex College

· Failure to comply with credit conditions

Force Majeure and Frustration of Contract

· Performance of a contract – including an obligation under a documentary credit relationship – is