Various types of guarantees are issued by the banks on behalf of their customers. Bank Guarantees (BG) is also known as Letter of Guarantees which can be broadly classified as (i) Financial Guarantees and (ii) Performance guarantees. Earnest money Deposit guarantee or Bid Bond Guarantee, Guarantee for Payment of Customs duty (specific or continuing), Advance Payment Guarantee (APG), Deferred Payment Guarantee (DPG), Shipping Guarantee, Performance guarantee, Retention Money guarantees etc are some of the prominent types of guarantees issued by the banks.
Bank Guarantee or letter of guarantee is a fee-based credit facility extended by the banks to their customers. The non-fund based facilities are the letter of guarantee or letter of credit by the banks wherein banks get fee income and Since there is no immediate outflow of funds from the banks they are also known as the non-fund based facility. However in the case of non-fund based credit facility, the bank has to discharge the financial liability of the contract agreed to the guarantee or documentary credit, if the contract is partly or fully not performed by the customer.
Financial guarantees are issued by the banks whenever a contract is awarded to their customer, who is generally a contractor of civil work or a supplier of goods, machinery, equipment by a Government Department or a large industrial undertakings, the customer is under obligation to deposit cash security or earnest money as a token of due compliance of the terms and conditions of the contract. This cash security provided by the contractor or supplier is forfeited by the Government Department or the company which awarded the contract, in the event the contractor or supplier fails to comply with the terms stipulated in sanction. The customer normally will have an option to furnish a bank guarantee in lieu of cash security, so that his working funds are not unnecessarily blocked. The guarantees issued by banks for above purpose is called financial guarantee wherein the banks undertake to pay the guaranteed amount during a specified period on demand from the beneficiary. The examples of Financial Guarantee are as under.
Guarantee for Earnest money Deposit (Local Tender)/Bid Bond Guarantee (international tender):
[ A bid bond guarantee is a guarantee issued by the bank to the effect that bidder would not withdraw the bid before the expiry of bid/tender period or in case the contract is awarded to the bidder that he would comply with the terms of the tender and enter into the contract.].
Guarantee for Payment of Customs duty (specific or continuing):
a customer may require a guarantee favouring custom department for payment of customs duty covering import of raw materials. It means that the guarantee covers custom duty in arrears to the Customs Department by the customer up to a limit (stating maximum of amount) of guarantee undertaken by the bank.
Advance Payment Guarantee (APG)
Although Advance Payment guarantee is associated with the financial guarantee it has the inherent risk of performance guarantee Advance payment guarantees are issued on behalf of the (i) Supplier of raw materials/finished goods or (ii) on behalf of a contractor for an execution of contract when he receives the advance payment. Since supplier receives an advance from the purchaser for the supply of raw material or finished goods on a future date, it is a substitution of working capital funds. In the case of execution of the contract, if any one of the terms of the contract is not fulfilled, the guarantee is likely to be invoked. While accepting the request from the customer for APG limit the banker should thoroughly analyse all risk factors.
Deferred Payment Guarantee (DPG)
In the cases of purchase of capital goods/machinery where the seller offers credit to the buyer and buyer’s bank guarantees the due payments to the seller. Here the seller draws drafts of different maturities on the buyer which are accepted by the buyer and co-accepted by the Buyer’s bank. Thereby the buyer’s bank guarantees due payment of those drafts drawn by the seller which represents the total consideration of the contract of sale/supply. The seller avail the refinance from his bank against co-accepted bills. DPG involves substitution of the term loan. Hence procedure applicable for assessment of term loan must be followed for DPG limit viz. projection under operating statement, Funds flow statement, DSCR, BEP etc.
Shipping guarantee is issued to the shipping company to release the goods by the shipping companies on the basis of bank guarantee. Shipping guarantee is issued due to the arrival of the consignment (Ship carrying the goods already arrived) but non-receipt of relative documents of title to goods.
Performance guarantees are issued by the banks on behalf of a Service Contractor, who has to effectually perform all the conditions of the contract between him and the department/company that awarded the contract. The bank has to discharge the financial liability of the contract agreed in the guarantee, if the contract is partly or fully not performed by the customer. Such type of guarantees issued by the bank is called Performance Guarantee. Many a time the terms of the contract may be of highly technical in nature and bank is generally not expected to know the technical aspects of the contract. Therefore the bank assumes only the financial liability of the contract. Since the issuance of performance guarantee is more complicated and risky, before issuing performance guarantees, the bank has to ensure that the customer has sufficient experience in the line of business and he has capacity and means to carry out the obligation under the contract.
Retention Money guarantees
Retention money is a part of the amount payable to the contractor, is retained and payable at the end after successful completion of the contract. Retention Money guarantee is issued to ensure that retention money withheld by the beneficiary is released to the applicant (contractor) so that he gets sufficient working capital to complete the contract.