Banking Management

Unit- NINE

Off-Balance Sheet Activities

By
Arpan Paudel
The purpose of this chapter is to learn about different types of Bank
guarantees and letter of credit that bankers issue to facilitate domestic as
well as international trade.
Bank Guarantee
 It is commitment given by a bank on behalf of its customer
for the execution of the committed work in a stipulated
manner.
 In case of violation of the terms, Bank is liable to make
good the losses.
 Is a contingent liability for a bank and is thus reflected as
an off balance sheet item
Risks involved in Guarantee
 Credit Risk (Risk of failure to obey the terms and conditions by the
counterparty)
 Operational Risk (Risks related to human errors, frauds, natural disasters
etc.)
 Foreign Currency Risk (Risk of adverse movements in exchange rates)

 Why bear these risks?

• Return eclipses the magnitude of risk.

• Source of:
 Commission income
 Cost free Deposits
 Opens the door for other forms of facilities

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Parties to a Guarantee

 Principal - the Applicant

 Guarantor - the Bank

 Beneficiary – the firm to which the guarantee is issued.

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Parties to a Guarantee

Guarantor

Principal Beneficiary
Subjects of Guarantee

 Date (Issue, Effective and Expiry)

 Beneficiary’s name and address
 Principle’s name and address
 Summary of nature of work
 Guarantee Amount
 Tenure of Guarantee

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Types of Bank Guarantee
1. Bid Bond (BB)
2. Performance Bond (PB)
3. Advance payment guarantee ( APG )
4. Credit Supply Guarantee (CSG)
5. Financial Guarantee (FG)
6. Guarantee Vs Counter Guarantee
7. Letter of Credit (LCs)

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Types of Guarantee
 1. Bid Bond
 It is guarantee issued by bank for its customer for margin
amount that must be deposited.
 Often called for in support of contract tenders, particularly in
international trade situations.
 Provides the beneficiary with a financial remedy if the applicant
fails to fulfill any of the tender conditions.
 Normally submitted with the other documents called for in the
invitation to tender and remain valid during the period of tender,
plus a grace period to allow the beneficiary to make demand.

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Types of Guarantee (contd..)
 2. Performance Bond
 Most common form of guarantee, used in a variety of
situations.
 Normally required at the time of commencement of the
contract and will extend over the duration of the contract,
plus a grace period to allow the beneficiary to make
demand in the event of non-performance of the obligations
covered by the guarantee.

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Types of Guarantee (contd..)
 3. Advance Payment Guarantee
 Used where the applicant calls for the provision of a sum
of money at an early stage of the contract. The beneficiary
can recover the amount paid in advance, or a part thereof,
if the applicant fails to fulfill their underlying contractual
obligations.
 May provide for pro rata reductions to the guarantee
amount on presentation of certain documents or on a
specified date or dates.
 Duration will depend on the underlying contract, but many
run up to the anticipated date of the final delivery, plus a
grace period to allow the beneficiary to make demand in
the event of non-performance of the obligations covered by
the guarantee.

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Types of Guarantee (contd..)
 4. Credit Supply Guarantee
 Often used to cover the non-payment of a debt(s) rising
under a transaction or over a period of time.
 Provides financial security to the beneficiary should the
applicant fail to make payment for the goods or services
supplied. Such guarantees will invariably run up to the
final scheduled date of payment, plus a grace period to
allow the beneficiary to make demand in the event of non-
payment.

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Types of Guarantee (contd..)
 5. Financial Guarantee
 It is a guarantee issued by a bank in favor of another bank as a security for
the loan .
 Because of the high risk involved, financial guarantee can be issued by a
bank only when the exposure exceeds the single obligor limit (funded
facility of 25% of core capital) from the bank.
 Thus, this form of guarantee is used for borrowers with large debt
requirements.

 6. Counter Guarantee
 Guarantee issued in favor of other bank to provide facility to specified
borrowers.
 Is more relevant where the beneficiary and applicant are in different
geographical locations
 The counter guarantee of the bank is the major source of security for the
Principal.

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Stages of Guarantee
 Issuance of Guarantee :
 Requirements:
• Application, Tender document, Commission, Security
 Evaluation:
• Creditworthiness of the borrower
• Purpose of the guarantee
• Security provided by the guarantee
• Compliance with rules
 Approval from competent authority
 Issue of Guarantee:
• Specific format/general format

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Stages of Guarantee (contd..)

 Amendment of Guarantee
 Guarantees can be amended in terms of its value, dates and
tenor.
 Requirement
• Application of borrower, request of beneficiary, commission.
 Evaluation
• Evaluate the performance of applicant
• The justification of guarantee extension
• Status of security
• Expiry of the guarantee
• Compliance with rules
 Approval from competent authority
 Amendment of guarantee
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Stages of Guarantee (contd..)

 Settlement of Guarantees
a. Through expiry/completion of purpose (Revocation)
 Requirements
• Request of the applicant and the beneficiary
• Expiry of the effective dates
b. Invocation
 Requirements
• Claim letter from the beneficiary
 Source
• Payment by applicant
• Creation of force loans in the name of the applicant
for the deficit amount after recovering margin
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amounts.
Important Points

 Can be issued only by Commercial Banks and

Development Banks.
 Security, Margin, Approval Process and Authority are
very critical
 Proper Evaluation at the time of approval of limits will
be crucial in profitable operations. Because once the
guarantee is issued, there is very little banks can do.
 Updated information and filing system are equally
important to properly monitor the progress.

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LETTER OF CREDIT
(Documentary Credit)
 Definition:
- An undertaking issued by a bank for the account of the
applicant (buyer) to pay to the beneficiary (seller) the
value of the letter of credit, provided that the terms and
conditions evidenced by documents presented, are
complied with

In other words:
- A letter of credit substitutes a bank’s creditworthiness,
which is generally well known or easily ascertainable for
that of its customer, which may not be as well known.

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Letter of Credit
 Arrangement of making payment against documents or an
instrument
 A versatile tool for closing the gap that exists between
buyers and sellers.
 Payment undertaking given to the exporter by the
importer’s bank at the request of its customers
 Binding payment undertaking of issuing bank to the
exporter provided exporter can present documents
representing the goods supplied as per the LC terms

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LETTER OF CREDIT

• This documentary credit arrangement usually satisfies the seller's desire for
cash & the importer's desire for credit.
• It offers a unique & universally used method of achieving a commercially
acceptable undertaking by providing for payment to be made against
complying documents that represent the goods & making possible the
transfer of title to those goods.
• Unfortunately, fraudulent Documentary credits issued by a fictitious non
existing "Bank" are a fact of life. In some Instances, the "Beneficiary" receives the
Documentary Credit direct from some such "bank", i.e. without the intervention of a
known Advising Bank in the Beneficiary's country, which Advising Bank may be able to
check the apparent authenticity of the "Documentary Credit". This departure from
normal banking routine can signal danger. In other instances, the Advising Bank
purports to be a branch or office of the "Issuing Bank" but is an unknown name so far
as the Beneficiary is concerned. This, too can signal the need for caution. In all cases
the safeguard is for the "Beneficiary" to check with his own bank before relying, or
acting, on the “Documentary Credit”
• For a further detailed explanation of the definition of a documentary credit
refer to UCP 500 Article 2.

(UCPDC) Uniform Customs and Practice for Documentary Credits

 Seller
(Beneficiary) Buyer
Sales
Contract ( Applicant)

Shipment of Goods

Parties Involved GOODS

Advising/Confirming Application to Open L/C

PaymentNegotiation Payment Against Document
Presentation of Documents
Payment To Negotiating for Payment
Bank
Document Presented for
Payment
Opening L/C
Advising/Confirming/Negotiating Bank
Issuing Bank
Types of LC
 Security Wise
 Revocable : can be changed or cancelled by the issuing bank at any time and
for any reason.
 Irrevocable : cannot be changed or cancelled unless everyone involved agrees
(amendment needs approval by all)
 Confirmed Vs Unconfirmed:
 Eliminates issuing bank country and commercial risk
 If the issuing bank’s letter of credit is confirmed, the confirming bank
substitutes its own creditworthiness for that of the issuing bank’s and takes
on all duties and responsibilities of an issuing bank
 Must be requested by issuing bank to confirm credit
 If the issuing bank is not deemed creditworthy, or if there are country risk
issues a bank may refuse to add confirmation
Types of LC
 Payment Wise
 Sight LC:
• Payment to be made immediately to the beneficiary/seller/exporter upon presentation of the
correct documents.
• Importers wishes more time. Direct (TR) loan: usually 90 days to 180 days
 Straight Vs Negotiated:
• If obligations of opening bank extend only to the named beneficiary then it is straight LC
 Usance/Time/Acceptance L/C:
• Deferred Payment Letter of Credit: payable only at a predetermined time period
• Calls for usance drafts to be drawn on and accepted by the opening or paying bank.
i. Creation of the Acceptance
ii. Discounting the Acceptance when exporter is not willing to wait
 Red Clause LC: LC that carries a provision (traditionally written or typed in red ink) which
allows a seller to draw up to a fixed sum from the advising or paying-bank, in advance of the
shipment or before presenting the prescribed documents.

 Back to Back LC: Back-to-Back LCs are suitable for triangle trade. It is a trade where a
middleman located between the buyer (importer) and the seller (exporter).
Types of LC

 Others
 Transferable:
• beneficiary instructs paying or opening bank
• transfer must be authorized in the L/C
• second beneficiary must be domiciled in same country as the original beneficiary.
 Revolving LC: when purchasing continually from a foreign supplier

 Standby LC:
• Standby letters of credit are secondary payment method in international trade.
• Standby credits are used mainly in export and import business where litigation or
other non-payment actions may not be feasible.

• Guarantee of payment by a bank on behalf of their client.

• Majority of commercial letters of credit are issued subject to the latest version
of ISP (International Standby Practices).
• ISPs are the set of rules that governs the Standby letters of credit procedures.
Objectives

 It is widely accepted method of settling international

trade
 It gives a form of security to both the buyer and
seller as the payment is handled by the bank upon
the compliance of the stated conditions
 It brings the elements of confidence to the parties
involved.
LETTER OF CREDIT
 The main objectives of the parties to a transaction

The Buyer's objectives are:

 Contract Fulfillment
• To receive the correct quantity and quality of the goods purchased or
services required.
• To receive, in a timely manner and at the correct place, the goods purchased
or services required, and
• Assurance that he does not have to pay the seller until he is certain that the
seller has fulfilled his obligations correctly.
 Credit
• A managed Cash Flow, with the possibility of obtaining bank finance, and/or
• To differ payment as long as possible
 Convenience
• The convenience of using an intervening third party in whom both the buyer
and seller have confidence – such as a bank with its Documentary Credit
expertise - when payment is to be made
LETTER OF CREDIT

 The main objectives of the parties to a Transaction

The Seller's objectives are:

 Contract Fulfillment
• Assurance that he will be paid in full within the agreed time limit, &
• To deliver the contracted goods or services as quickly as possible
 Prompt Payment
• Prompt payment on completion of his contractual obligation, so as to
improve the liquidity of his business, &
• To receive payment of the correct amount and in the correct currency.
 Convenience
• The convenience of receiving payment at his own bank or through a bank
in his own country.
KNOW YOUR CUSTOMER
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