Unit 3: Letter of Credit and Loan Commitments

Quasi Credit Facilities

Quasi Credit Facilities are indirect financial support provided by banks without disbursing actual cash immediately. These are Non-Fund Based (NFB) Facilities, where the bank’s commitment stands as a guarantor, rather than a direct lender.

Advantages of Non-Fund Based (NFB) Facilities

Advantage	Description
1. No Immediate Cash Outflow	Bank does not lend money upfront, reducing borrower’s interest burden.
2. Enhances Business Credibility	Shows financial strength and trustworthiness in trade or contractual dealings.
3. Reduces Working Capital Pressure	Ensures liquidity remains intact for business operations.
4. Support for Trade/Projects	Helps businesses in procurement and performance without blocking funds.
5. Lower Charges vs Loans	Only commission/fees apply, which are lower than interest on fund-based loans.

Types of Non-Fund Based (NFB) Facilities

Type	Purpose
1. Bank Guarantee (BG)	Bank promises to pay if borrower defaults; used in tenders, contracts.
2. Letter of Credit (LC)	Bank ensures payment to seller/exporter on behalf of buyer/importer.
3. Standby Letter of Credit	Similar to a guarantee; used when performance/payment default occurs.
4. Performance Guarantee	Ensures satisfactory project completion by contractor/supplier.
5. Bid Bond Guarantee	Issued during bidding; guarantees serious participation by bidder.
6. Advance Payment Guarantee	Protects buyer’s advance payment if supplier fails to deliver.
7. Deferred Payment Guarantee	Ensures buyer will pay over time as per contract terms.

Types of Letters of Credit (LC)

Type of LC	Purpose/Features
1. Revocable LC	Can be modified/cancelled without consent of the beneficiary. Rarely used.
2. Irrevocable LC	Cannot be changed without agreement of all parties. Most commonly used.
3. Confirmed LC	A second bank guarantees payment, reducing risk for exporter.
4. Unconfirmed LC	Only the issuing bank promises payment.
5. Sight LC	Payment is made immediately upon document presentation.
6. Usance/Deferred LC	Payment is made after a specified credit period (e.g., 30, 60 days).
7. Back-to-Back LC	Two LCs issued — one to the supplier, one to the buyer — to facilitate trade.
8. Standby LC	Used as a guarantee; payable if buyer defaults.
9. Revolving LC	LC can be reused for multiple transactions within a limit and time.
10. Transferable LC	Beneficiary can transfer LC to another party (e.g., a supplier).

Assessment of LC Limits (Letter of Credit Limits)

LC Limit is the maximum amount a bank allows a business to utilize for opening Letters of Credit (LCs). The assessment ensures that the borrower can honor the LC liabilities when due.

Assessment Criteria	Explanation
Past Trade Volumes	Volume/value of past imports/exports by the borrower.
Working Capital Requirements	LC limits are part of the working capital financing.
Cash Flow Position	Future cash inflows/outflows to ensure LC payments on due date.
Creditworthiness & Credit Rating	Financial health, credit history, risk rating of borrower.
Collateral Offered	Security (fixed/movable assets) against potential defaults.
Bank’s Internal Exposure Norms	Based on risk appetite and regulatory limits (RBI norms for India).
Past LC Usage and Repayment Track	Experience with handling past LCs and timeliness of payments.

Bills Purchase / Discounting under LC

Term	Explanation
Bills Purchase/Discounting	Bank provides immediate funds to seller by buying the bill under an LC.
Process	Seller ships goods → presents bill to bank → bank discounts bill → pays seller.
Under LC Protection	Bank is assured of payment by LC-issuing bank, lowering risk.
Tenor-Based	Sight LC: Immediate payment; Usance LC: Payment after credit period.
Charges/Interest	Bank deducts interest for the credit period before paying seller.
Risk Mitigation	Bank checks authenticity of LC, buyer’s credit, and shipping documents.

Loan Commitments & Un-Funded Lines of Credit

A. Loan Commitments

Term	Explanation
Loan Commitment	A promise by the bank to lend money in the future, subject to terms.
Types	Revolving Credit Line, Term Loan Commitment, Standby Credit Lines.
Binding Contract	Legally enforceable; borrower pays commitment fee for unused portion.
Example	Bank agrees to lend ₹50 lakh over 1 year; borrower draws as needed.

B.  Un-Funded Lines of Credit (Non-Fund Based Limits)

These are credit facilities without immediate disbursement of funds, involving bank guarantees or LCs.

Characteristic	Details
No Cash Disbursed Initially	Bank’s obligation exists, but funds are only paid if default occurs.
Contingent Liability	Shown as off-balance-sheet exposure until activated.
Usage	For trade finance, project execution, import/export transactions.
Lower Charges vs Loans	Only commission or guarantee fees are charged.
Examples	LC, Bank Guarantee, Performance Guarantee, Standby LC, etc.

Key Differences: Fund-Based vs Non-Fund Based

Feature	Fund-Based Credit	Non-Fund Based Credit
Cash Outflow	Immediate (e.g., loans, overdrafts)	No immediate outflow (e.g., LC, guarantees)
Income for Bank	Interest	Commission/Fees
Risk Level	Higher, due to cash involvement	Lower (except if default triggers fund outflow)

Bank Guarantee (BG)

A Bank Guarantee is a non-fund-based credit facility in which the bank promises to compensate the beneficiary if the borrower (applicant) fails to fulfill contractual obligations.

Types of Bank Guarantees

Type of Guarantee	Purpose/Use
1. Performance Guarantee	Ensures the contractor/vendor completes a project or performs as per contract.
	➤ Used in construction, infrastructure, supply contracts.
	➤ Beneficiary can claim if performance is unsatisfactory or incomplete.
2. Financial Guarantee	Guarantees a financial obligation, like repayment of loan, debt, or dues.
	➤ Used in repayment of lease, customs duty, taxes, or loan installments.
	➤ If applicant defaults on financial payment, bank pays the amount.
3. Deferred Payment Guarantee	Guarantees payment in installments over time, usually for capital goods.
	➤ Buyer purchases machinery/equipment; seller gets payment in agreed intervals.
	➤ If buyer fails to pay on due date, bank pays on buyer’s behalf.
4. Bid Bond Guarantee	Issued during bidding/tender process; guarantees serious bidding intent.
	➤ If bidder withdraws after winning, the bank pays compensation.
5. Advance Payment Guarantee	Guarantees refund of advance payment if seller doesn’t deliver goods/services.
	➤ Used in supply contracts when buyer pays advance.
6. Customs/Excise Guarantee	Guarantees payment of customs/excise duty, if applicant fails to pay.
	➤ Useful in import/export businesses.
7. Shipping Guarantee	Issued to shipping company to release goods without Bill of Lading.
	➤ Used when documents are delayed, but goods need to be received.

Key Differences: Performance vs Financial vs Deferred Payment Guarantee

Feature	Performance Guarantee	Financial Guarantee	Deferred Payment Guarantee
Purpose	Ensures project/service performance	Ensures payment of financial liability	Ensures future payments for goods/machinery
Beneficiary Type	Employer/client of contractor	Lender or government agency	Seller/supplier of goods
Trigger for Bank Payout	Non-completion/poor quality work	Payment default (loan, taxes, rent)	Failure to pay installments as agreed
Usage Sector	Construction, service contracts	Loans, taxes, leases	Capital goods trade, equipment purchase

Types of Performance and Financial Guarantees

Types of Performance Guarantees

Type	Purpose
Contract Performance Guarantee	Ensures contract completion as per terms (e.g., civil works, supply).
Warranty Guarantee	Ensures performance during warranty/defect liability period.
Maintenance Guarantee	Guarantees post-completion maintenance service of equipment/projects.
Supply Guarantee	Ensures timely and quality supply of goods/materials.
Service Guarantee	Ensures service provider performs duties as agreed in contract.

Types of Financial Guarantees

Type	Purpose
Loan Repayment Guarantee	Ensures borrower repays loan to lender.
Customs/Excise Duty Guarantee	Ensures payment of taxes/duties to government authorities.
Rental/Lease Guarantee	Ensures rent or lease payment to landlord or leasing firm.
Guarantee for Payment to Suppliers	Ensures buyer pays seller (if buyer defaults, bank pays).
Security Deposit Guarantee	Given instead of cash deposit; ensures obligations are fulfilled.

Assessment of Bank Guarantee (BG) Limit

Bank Guarantee Limit is assessed as part of overall credit exposure. The process ensures that the borrower has financial capacity to honor the guarantee.

Assessment Factors	Details
Financial Strength	Balance sheet, profit & loss, cash flow, net worth.
Past Track Record	History of timely repayment and use of BGs.
Nature and Size of Contracts	Larger contracts require higher BG limits.
Collateral/Security	Fixed deposit, property, or other assets offered as security.
Working Capital & Liquidity	Ensures sufficient funds to meet contingent liability.
Credit Rating	Internal or external credit score used for risk evaluation.
Regulatory Norms	Bank’s exposure norms and RBI guidelines (India) or Basel norms (globally).

Note: BG limits are part of Non-Fund Based (NFB) exposure and are monitored with contingent liability reports.

Period of Claim under Guarantee

Term	Explanation
Guarantee Period	Validity period of the guarantee (e.g., 12 months from date of issue).
Claim Period	Additional time beyond expiry to raise claim (commonly 1 to 3 months).
Total Liability Period	Guarantee Period + Claim Period = Total liability duration for the bank.
Expired Guarantees	Once claim period is over, the guarantee liability ceases.

Example: A Performance Guarantee valid till 31 Dec 2025 + Claim Period till 31 Mar 2026 = Total liability till 31 Mar 2026.