Non fund-based Credit

1. Introduction
Bank Guarantee
1. Definition
2. Types of Bank Guarantees
3. Issue of Bank Guarantees -Points to be considered
4. Invocation of Bank Guarantees
Letter of Credit
1. Definition
2. Mechanism of a LC
3. Difference between LC and BG
4. Parties in a LC transaction
5. Relationship between the various parties involved in an LC transaction
6. Role of Uniform Customs & Practices for Documentary Credit (UCPDC)
7. Types of Letter of Credit
8. Documents under a LC
9. Issue of Letter of Credit -Points to be considered
Co-acceptance of Bills
1. Definition
2. Mechanism of Co-acceptance of Bills
3. Co-acceptance of Bills -Points to be considered
Miscellaneous
1. Interchangeability between different non-fund based facility

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Non fund-based Credit
Introduction
1) The fund-based facilities provided by banks require immediate outlay of funds which must be provided
beforehand. In contrast, the non-fund based facilities are essentially in the nature of promises made by banks to
third party to provide monetary compensation on behalf of their clients if certain situations emerge or certain
conditions are fulfilled.
2) In the wake of globalization of economy and increasing trades between parties situates far apart the non-fund
based facilities are playing a far more important role, where banks act as intermediaries between the buyers and
sellers, the providers and recipients of services or the contractors and the contractees.
3) These non-fund based facilities may be in the nature of (a) bank guarantees or (b) letter of credit issued by banks
or (c) co-acceptance of bills.
4) Three important features of non-fund based facilities are that (a) the facility does not require immediate outlay
of funds and therefore the cost of such facilities tend to be lower than the cost of fund-based facilities charged
by the banks; (b) a bank guarantee or a letter of credit issued by a bank on behalf of its client is an off-balance
sheet item in the books of the client, which enables the latter to prepare a more appealing balance sheet; (c)
banks earn fee based incomes in course of providing non-fund based facilities which is the second most important
source of income for the banks, next only to interest income on fund based facilities.
5) However, from the view point of the lending bank, the non-fund based facilities provided are generally not
treated as off-balance sheet exposure. Bank guarantees and letter of credit issued by banks appear as contra
entries on both the assets and liabilities side of the balance sheet. Besides, banks are required to maintain
capital adequacy against these assets, based on their risk weights and hence has to bear a definite amount of
cost for raising capital that meet capital adequacy norms.
6) The inherent risks in a non-fund based credit proposition are the same as attached to a fund based credit
proposition. This is because, in the event of a counterparty default, the non-fund based credit facility
immediately crystallizes in to fund based credit facility.

Bank Guarantee

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Definition:-Section 126 of the Indian Contract Act, 1872 defines a guarantee as a contract to perform the
promise or discharge the liability of a third person in case of his default. Thus the following emerges from the
definition
1) There are three parties involved in a contract of guarantee viz the applicant i.e. the client on whose behalf the
guarantee is issued, the beneficiary to whom the guarantee is issued and the guarantor ie the party which issues
the guarantee (in case of bank guarantee it is the bank);
2) Guarantee acts as a collateral contract which is enforced only when terms and conditions of the main contract
are not fulfilled.

Types of Bank Guarantees: - In all cases of bank guarantees issued, the role of the issuing bank is confined to
compensate the beneficiary in monetary terms in case of default of the principal, and not in any other forms. From
this view point one may argue that all the guarantees issued by the bank are financial guarantees. However a
distinction is always drawn based on the purpose of issue of the guarantee. The two distinct types of bank guarantees
are financial guarantee and performance guarantee. Often the domain of the two categories overlap and a clear-cut
demarcation becomes difficult.
1) Financial guarantee: - A financial guarantee may be seen as a certificate issued by the bank to compensate the
beneficiary in case the principal fails to meet the financial obligation. Issue of a financial guarantee therefore,
involves the general credit appraisal process which is the domain of the banker. Examples include deferred
payment guarantee (explained later).
a) Deferred payment guarantee: - In a contract of DPG the buyers bank executes a guarantee on behalf of the
buyer of machinery, to the sellers bank. On the strength of such guarantee, the sellers banker discounts the
sellers bills drawn on the buyer and pays the seller. Those discounted bills are presented to buyer by the
sellers bank on maturity and the buyer repays his obligation in installments by retiring those bills. In many
respect DGP is a substitute of term loan except that in case of DGP the buyer is primarily liable to pay to
sellers bank. All the risk aspects of the credit proposal relating to issue of DGP have therefore to be
examined with the same rigour as in the case of the term loan. The credit analyst has to ensure that the
buyer will be in a position to generate cash accruals sufficient to retire the bills on the respective maturity
dates.

2. Negotiates and gives DPG

Buyers Bank Sellers Bank

7. Makes payment

6. Puts bills for acceptance on

1. Requests for DPG

5. Discounts and pays money

4. Puts bills for discounting

respective due dates

Buyer Seller
3. Supplies Machine/Goods etc

2) Performance guarantee: - A performance guarantee may be seen as a certificate issued by the bank to
compensate the beneficiary in case of short performance or non-performance by the principal. Issue of a
performance guarantee therefore involves an assessment of the technical competency to execute a contract
successfully which may not fall in the domain of the banker. Thus while issuing performance guarantee the bank
should be very cautious in the sense that liability of the bank does not extend beyond compensation of loss in
monetary terms, i.e. the bank is not called upon to complete the task which the client has not been able to
perform. Examples include
a) Bid Bond: - These are BGs issued in lieu of earnest money/security deposit that a bidder has to deposit
before bidding against a tender. These bonds generally do not exceed 5% of the value of the contract. The
BGs/Bonds have a fixed expiry date that coincides with the expected date of completion of the bidding
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 process. On completion of the bidding process, the bonds of unsuccessful bidders are returned to
unsuccessful bidder. On the other hand the organisation awarding the contract calls upon the successful
bidder to sign the contract. If the successful bidder does not sign the contract, the organisation usually
invokes the bid bond. Bid bonds are therefore in the nature of performance guarantees where the issuing
bank promises to compensate the organisation awarding the contract in case the principal fails to act in a
specific way.
b) Mobilization advance/Advance payment guarantee: - Advance payment guarantees are issued by banks on
behalf of customers who are in the business of execution of major export orders, implementation of turnkey
projects, construction contracts, major servicing projects etc. which entail high outlay of funds. Such
providers of products/services need funds in advance from time to time for purchase of raw materials,
making labour payments etc. The buyer or receiver of service however releases the advance payment only
after a bank issues an advance payment guarantee, which ensures repayment of the advance amount, in case
the later partially or fully fails to complete the contract in time. As a matter of caution the bank may insert
a clause that guaranteed amount should be automatically reduced in proportion to the value of goods
delivered or services performed in course of execution of the contract.
c) Retention money guarantee: - In construction contracts, it is common for the employers to retain a small
portion (usually not exceeding 10%) of the payments released by them in stages. This is in order to take care
of any expenses or looses which the employer might have to incur in future on account of mistakes on the
part of the contractor. Since such retention of payments adversely affects the cash flow of the contractor,
the employer agrees to release the retention money if the contractor submits a BG for an equivalent
amount. The amount involved in the BG is limited to the extent of the amount retained by the employer. The
liability under BG extinguishes when the contractor completes his job to the satisfaction of the employer.
The contractor then substitutes the retention money guarantee with maintenance bond.
d) Maintenance bond/Warranty bond: - When the contractor successfully completes the job, the employer may
still like to play safe and would ask the contractors to submit a fresh BG that would protect the former
against the former against any mistake/fault/defect in the work which may surface later. This is in the
nature of a warranty and is also known as warranty bonds. By its very nature warranty bonds are
performance bonds and are usually issued for a year or so. The liability against such guarantees is usually
limited to 5% of the contract amount.

Issue of Bank Guarantees -Points to be considered

1) RBI Norms-precautions to be taken while issuing BG for prevention of frauds: - In its master circular dated 1 st
July, 2011, RBI has advised BG issuing banks to take care of certain points while issuing BGs. We discuss below
some of the most important points in this context
i) The issuing bank should confine themselves to the provision of financial guarantees and exercise due caution
with regard to performance guarantee business.
ii) At the time of issuing financial guarantees, banks should be satisfied that the customer would be in a
position to reimburse the bank in case the bank is required to make payment under the guarantee.
iii) In the case of performance guarantee, banks should exercise due caution and have sufficient experience with
the customer to satisfy themselves that the customer has the necessary experience, capacity and means to
perform the obligations under the contract, and is not likely to commit any default.
iv) Banks should guarantee shorter maturities and leave longer maturities to be guaranteed by other
institutions. No bank guarantees should normally have a maturity period of more than 10 years.
v) Banks should avoid giving unsecured guarantees in large amounts having medium and long term period.
vi) Banks should avoid undue concentration of unsecured guarantee commitments to particular group of
customers/trades.
vii) In exceptional cases, banks may give deferred payment guarantees on an unsecured basis for modest amount
to first class customers who have entered in to deferred payment arrangements in consonance with
Government Policy.
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 viii) Unsecured guarantees on account of any individual constituent should be limited to a reasonable proportion
of the banks total unsecured guarantees.
ix) Guarantees in behalf of the individual should also bear a reasonable proportion of the constituents equity.
x) Guarantees executed on behalf of any individual constituent, or a group of constituents, should be subject to
prescribed exposure norms.
xi) Banks should normally refrain from issuing guarantees on behalf of customers who do not enjoy credit
facilities with them.
xii) Banks should issue BGs in serially numbered security forms. This is in order to prevent unaccounted issue of
guarantees, as well as fake guarantees. Besides, BGs above a particular cut-off point decided by the bank
(Rs.50,000, as suggested by RBI) should be issued under two signatures. Banks may also decide on a lower
cut-off point. Preferably BGs should be issued in triplicate (one copy each for the branch, beneficiary and
controlling office). Such a system will reduce the scope for malpractices, losses arising from wrong
perception etc.
xiii) Banks should, while forwarding guarantees, caution the beneficiaries that they should, in their own interest,
verify the genuineness of the guarantee with the issuing bank.

2) Appraisal of Bank Guarantee requirements of an enterprise:-An appraisal of bank guarantee requirements of an

enterprise requires the same degree of expertise and skill on the part of the credit analyst vas is required in case
of fund-based limit. We discuss below some of the important aspects which need close examination while
assessing and appraising a proposal for providing a BG limit
a) Qualitative aspects
i) Purpose of BG: - The purpose of BG proposed to be issued should be examined in the context of the
usual business requirements of the client. For this purpose, a reference to the constitution (Partnership
Deed in case of firm. MOA in case of company) of the proposer may be of required help to the credit
officer.
ii) Frequency of issue: - An examination of the frequency of issue of such BG assists the credit officer in
understanding the pattern of the business, when the BG requirement arises and expected cash flow of
the customer.
iii) Financial or performance guarantee: - The credit officer should examine whether the proposed BG is a
financial guarantee of performance guarantee. Issue of a financial guarantee involves the general credit
appraisal process which is the domain of the banker. Issue of a performance guarantee involves an
assessment of the technical competency to execute a contract successfully which may not fall in the
domain of the banker. Thus while issuing performance guarantee the bank should be very cautious in the
sense that liability of the bank does not extend beyond compensation of loss in monetary terms, i.e. the
bank is not called upon to complete the task which the client has not been able to perform.
iv) Amount of BG proposed:-The amount of BG proposed should be specific and unambiguous. It should not
contain any clause which imparts a variability of the guarantee amount in any case.
v) Track record:- The past record of the applicant specially in relation to cases where BGs were invoked,
cause of invocation, response of the customer to such cases and the time taken to make good the loss to
the bank, are important parameters in the context of decision making in this regard.
vi) Present balance outstanding: - If the customer already enjoys BG limit, the total of present balance
outstanding against the unexpired BGs must be given a close look before a decision is taken on further
issue by credit officer.
vii) Collateral security and margin:- As in case of all credit appraisal, the collateral security offered and
the margin retained against the non-fund based credit exposure has a vital say in the decision making
process.
viii) Counter guarantee: - A counter guarantee signed by the applicant in favour of the issuing bank in a
standard format is generally insisted upon while issuing a guarantee. The counter guarantee serves as an
additional security wherein the applicant promises to recompense the bank with the guaranteed amount
and the associated charges, should the guarantee be invoked.

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 b) Quantitative aspects: - A quantitative assessment of BG requirement of customer is essential to determine
the amount of BG to be issued. Two cases has been explained below through illustration

Illustration-1-Quantitative assessment of BG limit for continuous requirement:

Case: - Smart Transformers (P) Ltd manufactures high voltage transformers and its captive buyers are the
State Electricity Boards (SEB). The company regularly bids for orders against the orders issued by the various
SEBs of the country. The company is a client of your bank and it has requested the bank for providing a
suitable BG limit.
The company needs to submit the BGs to the SEBs generally on three occasions.
a) First, every bid against a tender must be accompanied with a BG @ 5% of the tender value.
b) Secondly, every successful bidder has to submit a BG in lieu of security deposit @ 10% of the value of
supplies to be made.
c) Thirdly, SEBs demands a retention money BG @ 5% of the value of each supplies made or bills submitted
in lieu of retention.
The company has established its business on the base of quality products and has emerged as a reputed
player in this market segment. So far, it has managed with deposits made in the form of FDs, which had
serious implications on its cash flow. The SEBs has now agreed to accept BGs in lieu of cash securities.
For the ensuing financial year, the company anticipates that at any point of time, about 20 tenders would
be in the process of bidding, involving an aggregate tender value of Rs.20 crores. Besides, the company
expects to be in the process of executing about 10 tenders (with aggregate value of Rs.10 crores).
Please workout a suitable BG limit for the company.
Solution:- Calculation of the BG limit
Sl No. BG Type Calculation Amount
1 Bid bond 5% of Rs.20.00 crores Rs.1.00 crores
2 Security deposit 10% of Rs.10.00 crores Rs.1.00 crores
3 Retention money bond 5% of Rs.10.00 crores Rs.0.50 crores
Total BG limit Rs.2.50 crores

Illustration-2-Quantitative assessment of BG limit for a single contract:

Case: - XYZ Ltd, a turnkey construction company is planning to bid in a tendering process, and is hopeful of
winning the bid on the strength of its experience, technical expertise and its ability to quote low. The
contract amount is approximately Rs.10 crores. As per the practice, the employer (the organisation inviting
the bids) requires the bidder to submit a bid bond of 5% of the contract amount. The successful bidder then
has to submit a performance bond and an advance payment bond each involving 10% of the contract
amount. It is in the practice with the employer to deduct 10% of each contract payment made to the
contractor. They, however, release the retained amount on submission of a retention money bond of an
equivalent amount. On completion of the contract work, the contractor has to submit a maintenance bond
involving 5% of the contract value. It is expected that the finalization of the allotment process would take
around 6 months after the submission of the bid bond. The contract would take about 24 months to
complete. After completion, the contractor has to provide a service warranty of 12 months.
Please make a quantitative assessment of the BG limit to be granted.
Solution:-
Type of BG Start date BG outstanding Amount of BG Cumulative
period balance
Bid bond 0 month 0-6 month Rs.50 lacs Rs.50 lacs
Performance bond 6 month 6-30 month Rs.100 lacs Rs.100 lacs
Advance payment 6 month 6-30 month Rs.100 lacs Rs.200 lacs
bond
Retention money bond 6 month 6-30 month Rs.100 lacs Rs.300 lacs
Maintenance bond 24 month 30-42 month Rs.50 lacs Rs.50 lacs
Hence the maximum amount of BG to be granted is Rs.300 lacs and not Rs.400.00 lacs

Invocation of Bank Guarantees

1) Banks to be more prompt in procedural compliance when invocation is made: - BGs are treated as equivalent
to cash by the beneficiaries. In view of this, it is necessary that the issuing banks respond to the invocation of

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 bank guarantees by the beneficiaries in a positive manner i.e. without protests, delay and demur, if the
invocation has been done in accordance with the terms of the bank guarantee issued. However, it has been a
general experience that on receipt of the notice of invocation, the issuing bankers refer the matter to the
controlling authorities seeking approval for honouring the obligation under the guarantee issued. This obviously
causes a delay on the part of the banks in honouring the guarantees, when invoked. This tends to erode the value
of the bank guarantees and the image of the issuing bank as well. Besides, it also provides an opportunity to the
beneficiary to move the court for obtaining injunction order.
2) Opinion of apex court in relation to honouring of invocation: - It is also often experienced that the applicant
on whose behalf the BGs are issued move to lower courts against the invocation of BGs by the beneficiaries. In
many cases, the lower courts issue injunctions restraining honouring of the BGs by the issuing banks despite
reiterations made by Supreme Court times and again that the principles relating to bank guarantees and
invocation thereof is well settled. Views of the Supreme Court in relation to such situations in various cases are
stated below
i) In the case of Dwarikesh Sugar Industries Ltd. vs. Prem Heavy Engineering Works (P) Ltd the Court stated that
The Apex court strongly deprecates the tendency of the subordinate courts in not applying the settled
principles and in passing whimsical orders which necessarily has the effect of granting wrongful and
unwanted relief to one of the parties.
It is the time that this tendency needs to be stopped
The law relating to invocation of such bank guarantee is by now well settled. When in the course of
commercial dealings an unconditional bank guarantee is given or accepted, the beneficiary is entitled to
realise such bank guarantee in terms thereof irrespective of any pending disputes. The bank giving such
guarantee is bound to honour it as per its terms irrespective of any dispute raised by its customer
ii) In the case of U.P. Co-operative Federation (P) Ltd. vs. Singh Consultants and Engineers (P) Ltd the Court
stated that
We are, therefore, of the opinion that the correct position of law is that commitments of banks must be
honoured free from interference by the courts and it is only in exceptional cases, that is, to say, in case of
fraud or any case where irretrievable injustice would be done if bank guarantee is allowed to be encashed
the court should interfere.
3) Payment of the invoked amount:-
i) In normal case: - As the liability of an issuing banker under the bank guarantee is absolute, the issuing
banker is required to pay the amount when invoked. Invocation in writing can be made by the beneficiary at
any time before the expiry of the guarantee period. Sometimes, invocation is done by telex/telegram also.
ii) In case of foreign beneficiary: - If the bank guarantee is invoked by any foreign beneficiary, the issuing bank
is responsible for payment of income tax/ withholding tax to the Indian tax authorities. Such amount of tax
should be deducted from the amount of payment and it is desirable that the guarantee bond specifically
mentions this conditions.
iii) In case of injunction is issued by court: - In such cases the issuing bank may withhold the payment of the
invoked amount till the injunction is lifted. However the liability of the bank under the bank guarantee
continues in the meantime. It would perhaps be in order for issuing banks to recover commission for the
extended period as well, and an appropriate clause should be incorporated in the counter guarantee for this
purpose.

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Letter of Credit/ Documentary Credit
Definition:
1) A Letter of Credit (LC) simply defined, is a written instrument issued by a bank at the request of its customer, the
Importer (Buyer), whereby the bank promises to pay the Exporter (Beneficiary) or exporter's bank (called the
accepting bank, negotiating bank, advising bank, or paying bank), a specified sum in a specified currency, for
goods or services, provided that the Exporter presents all documents called for within a fixed timeframe as
stipulated in the LC, and meet all other terms and conditions set out in the LC. A LC is also commonly referred to
as a Documentary Credit.
2) These documents almost always include a clean bill of lading or air waybill, commercial invoice, and certificate
of origin.
3) From the importers point of view, using a letter of credit reduces the risk of having to pay for goods in advance
or having to pay for goods or services that do not match the product descriptions in the letter of credit. From the
exporters point of view a LC substitutes the creditworthiness of the buyer with the creditworthiness of a bank.
4) However, the banking system does not take on any responsibility for the quality of goods, genuineness of
documents, or any other provision in the contract of sale. In order to avoid ambiguity of the terminology used in
writing a letter of credit the International Chamber Of Commerce (ICC) has suggested specific terms (called Inco
terms) that are now almost universally accepted and used. Unlike a bill of exchange, a letter of credit is a
nonnegotiable instrument but may be transferable with the consent of the applicant.

Mechanism of a LC:
1) The seller and the buyer enter in to a sales contract in which they agree that payment shall be made by a LC.

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2) The buyer (applicant of the LC) applies to a bank (issuing bank) at his place of business for the opening of a LC in
favour of the seller (beneficiary). In his application, the buyer specifies the terms & conditions to be
incorporated in the LC which the seller must comply before a specific sum is released.
3) The issuing bank issues the LC, thus undertaking a definite obligation of effecting payment to the seller's or
exporter's bank (called the accepting bank, negotiating bank, or paying bank) a specified sum in a specified
currency and in a specific manner, as spelled out in the LC provided the seller meets precisely-defined conditions
and submits the prescribed documents within a fixed timeframe as stipulated in the LC documents.
4) The issuing bank sends the letter of credit to the advising bank in the exporter's country.
5) The advising bank notifies the exporter that a letter of credit has been opened in his favor.
6) The exporter dispatches the goods in accordance with the conditions defined in the letter of credit.
7) The exporter provides the appropriate documents to the advising bank to document that the goods were
dispatched in agreement with the letter of credit conditions.
8) The advising bank examines the documents whether these strictly comply with the terms and conditions of the
credit. If the documents meet the requirements, the advising bank makes payment to the seller in the manner
stipulated under the credit.
9) The advising bank then sends the documents to the issuing bank, which examines the documents and if it find
that documents comply with the terms of LC then it reimburses the advising banks of the payments made by it to
seller.
10) In the next step the issuing bank send the documents to the buyer (applicant) and obtains reimbursement in the
manner agreed when he opened the LC. With this documents importer can take delivery of the goods. (In
practice, the bank advises the applicant to arrange and deposit adequate funds in his (applicants) account with
the bank. The bank utilizes this money to make all the payments along with the commission, and additional
charges if any in order to honour the credit.)
Communication of Credit through SWIFT: - The communication of LC credit amongst banks takes place through
SWIFT (Society for the Worldwide Interbank Financial Telecommunication) network. SWIFT is a co-operative
organization dedicated to the promotion and development of standardized global exchange for financial
transaction information. The Society operates a messaging service for financial messages, such as letters of
credit, payments, and securities transactions, between member banks worldwide. SWIFT's essential function is
to deliver these messages quickly and securely -- both of which are prime considerations for financial matters.
Member organizations create formatted messages that are then forwarded to SWIFT for delivery to the recipient
member organization.

3. Issues a LC and sends a copy of LC to the advising bank

Buyers/Issui 8. Submits the export documents along with reimbursement request Sellers/Advi
ng Bank sing Bank
9. Makes payment to advising bank
7. Examines the documents and makes payment

4. Notifies that a LC has been opened in his favour

2. Applies for issuing an LC

Buyer/Impor 5. Dispatches the goods Seller/Export

ter er
1. Negotiation and finalization of terms of sale/export.

Difference between LC and BG: - Bank Guarantees and LCs are financial instruments often used in inland or
international trade when suppliers or vendors do not have established business relationships with their counterparts.
The difference between the two instruments is that
1) LC ensures that a transaction goes successfully as it was originally planned. While, BG minimizes losses once
transactions dont go as planned.

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2) When LC is issued the issuing bank is primarily liable to make payment to supplier once the goods are sent as per
terms of LC and other conditions specified in the LC are fulfilled by the supplier. Seller need not wait for the
buyer to make payment. However in case of BG, the seller has to wait for the buyer to make payments and if the
buyer defaults than the issuing bank stands on the shoes of the buyer and the liability of the issuing bank to make
payment arises.

Parties in a LC transaction: - A transaction in a LC may involve several parties at different stages. The various parties
with different right and responsibilities are as follows.
1) Applicant: - It is the buyer of importer who applies to his bank for issuing a LC in favour of the seller.
2) Beneficiary: - It is the person in whose favour the credit has been issued. Generally the credit is issued in favour
of the seller/exporter of the goods.
3) Issuing bank: - The bank with which the applicant applies and opens LC in favour of the beneficiary is the issuing
bank.
4) Advising bank: - It is the bank which intimates the beneficiary that an LC has been issued in his favour and
advises the beneficiary of the steps to be taken to en-cash the LC. The advising bank may be a branch of issuing
bank or some other bank with which the issuing bank establishes contact for proper disposal of the LC in favour
of the beneficiary.
5) Confirming bank: - The LC issuing bank is the confirming bank. But the beneficiary may desire to have an
additional confirmation from a bank in his own country which provides its own independent undertaking for
making payment in addition to that of the issuing bank. The beneficiary generally desire such additional
confirmation when he fees that there is a political risk in dealing with the country with which issuing bank is
situated. Such confirmation protects the beneficiary against failure or defaults of the issuing bank in meeting the
promises made in the LC. When a bank situated in the country of the beneficiary adds its confirmation than it is
called Confirmed LC and the confirming bank charges additional fees for such confirmation.
6) Nominated/Negotiating bank: - The issuing bank may nominate another bank in the beneficiarys country to
which the beneficiary presents its documents and from which it obtains payment of the sum against LC. The role
of a nominated/negotiating bank may be played by an issuing bank, an advising bank, or another bank, depending
on the terms of the LC.

Relationship between the various parties involved in an LC transaction

1) The relationship between the buyer and the seller: - In an LC transaction, the buyer opens a credit in favour of
the seller, and the seller obtains payment from the bank against the strength of the LC instead of demanding
payment directly from the buyer. If the LC expires when the seller is still unpaid, the seller is entitled to claim
the purchase price from the buyer in terms of the underlying contract. However, the buyer may deduct any loss
suffered due to the failure of the seller to use the LC.
2) The relationship between the buyer and the issuing bank: - In order to fulfill its contractual obligation, the
buyer (acting as the applicant) opens a LC in favour of the seller (the beneficiary of the LC). The buyer gives
instructions to the issuing bank in his application, clarifying the terms and conditions which the bank has to
ensure before making payment. By accepting the terms and conditions mentioned in the application form, the
issuing bank enters in to a contractual relationship with the buyer. The contract is independent from the contract
between the seller and the buyer. Under this contract, the bank undertakes to issue an LC and to effect payment
to the beneficiary upon presentation of documents strictly in compliance with the terms and conditions of the
credit. The banker has to perform his duties to the best of his ability and has to exercise good faith towards the
applicant. On the other hand, the applicant must indemnify the bank after carrying out the instructions. In
practice, the bank advises the applicant to arrange and deposit adequate funds in his (applicants) account with
the bank. The bank utilizes this money to make all the payments along with the commission, and additional
charges if any in order to honour the credit.

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3) The relationship between the issuing bank and the correspondent bank: - If correspondent banks are invited
into the transaction, a contractual relationship is established between the issuing bank and the correspondent
bank. The agreement between the issuing bank and the correspondent bank governs their rights and liabilities.

Role of Uniform Customs & Practices for Documentary Credit (UCPDC)

1) In a LC transaction, there are many parties involved, spread over different geographical regions and countries.
These parties function under different legal systems and jurisdictions, and settlement of any dispute arising out
of any terms and conditions of LC through normal legal channel may become a very complicated legal process.
2) It was against this backdrop that codification and publication of a common set of rules applicable to documentary
credits were done at the request of International Chamber of Commerce. It is known as Uniform Customs &
Practices for Documentary Credit (UCPDC). It was first introduced in 1933 and has undergone several revisions.
3) Governments of most trading countries have subscribed to this document and therefore UCPDC is valid in those
countries. However, in order to ensure that the rules of UCPDC apply to a documentary credit it is necessary to
declare in a LC that it is being subject to the provisions of UCPDC.
4) UCPDC is not an international convention as it does not create a formal agreement between states nor it is a law,
as the ICC being a non-governmental organisation, does not possess legislative authority. The UCPDC is a
compilation of internationally accepted banking customs and practice regarding the LC. It is the most successful
harmonizing measure in the history of international commerce, which has removed plethora of technical
problems that would have undermined the smooth operation of LC.

Types of Letter of Credit

1) Revocable and Irrevocable LC: - A revocable LC can be revoked or changed without the consent of the
beneficiary, up to the time the documents are presented. A revocable LC affords the beneficiary little protection;
therefore, it is rarely used. An irrevocable Letter of Credit cannot be cancelled or changed without the consent
of all parties, including the exporter. Unless otherwise stipulated, all LC are irrevocable. Moreover the concept of
revocable LC has been withdrawn under the latest version of UCPDC-2007. Thus an LC can be only irrevocable in
nature from June-2007.
2) Sight Credit and Acceptance (Usance) LC: - A further differentiation is made between Letters of Credit,
depending on the payment terms. If payment is to be made at the time documents are presented, this is referred
to as a Sight Credit. As per UCPDC convention, banks are allowed a reasonable time to examine the documents.
Such time cannot exceed 7 banking days following the day of the receipt of the documents. Within this time
frame banks have to take a decision whether to accept the documents and make payments, or to refuse
acceptance of the documents in case documents are not as per terms of LC.
Alternatively, if payment is to be made at a future date after the expiry of a fixed time after sight (e.g. 60 days
after sight); this is referred to as an Acceptance/Usance Credit. The period of credit granted is popularly called
usance. In practice the beneficiary draw a usance draft on the buyer or the issuing bank or the confirming bank,
depending on the terms of the credit. When the usance draft is presented along with the documents, the draft is
accepted instead of making payment at sight. The beneficiary is advised that the amount covered by the draft
will be paid on prefixed future date if the documents are found to be in conformity with the credit terms.
3) Back-to-back LC and Transferable LC: - Many trading house accept order of supply/export in their name. The
trading houses, in turn, procure the commodities from different party. The trading house being a well-known
party to buyer/importer, the buyer/importer may draw the LC in favour of the trading house. On the other hand
the trading house, which acts as a middleman between the actual supplier and importer, in order to assure the
actual supplier of payment, may request their bank to issue LC in favour of the actual supplier on the strength of
the existing LC already established in his favour. These LCs are called back-to-back LCs. The first LC issued in
favour of the middleman is distinct from the second LC issued in favour of the actual supplier, though both the
LCs is part of the same commercial transactions.

11
 A transferable LC allows the original beneficiary/trading house/middleman to transfer his rights under a LC
(drawn by the buyer/importer) to another party or parties who may be the actual suppliers of the goods. To be
transferable, a LC must be so marked by the issuing bank which can only do so on the applicants specific
instructions. Transfer of a LC can be made on specific application by the original beneficiary/trading
house/middleman to the authorized transferring bank. Depending on whether the LC permits partial shipments,
fractional amounts may be transferred to more than one beneficiary. The LC however, can be transferred only
once, the secondary beneficiaries cannot transfer their rights to a third party.
The difference between back-to-back LC and transferable LC is that, in case of back-to-back LC the original LC is
not transferable and thus benefit under the LC is passed on to third party by creating separate LC on the strength
of the original LC. On the other hand, in case of transferable LC, as the name suggests the LC is itself
transferable and thus benefits under the LC can be directly transferred to third part without creating another LC.
4) Standby LC: - Generally in case of LC, once the seller/exporter performs his bit of obligation he presents the
documents stipulated in the LC to the bank to obtain payment. But, where the seller and buyer agree to a
Standby Letters of Credit, than it implies that the parties to the transaction has agreed in another mode of
payment and the Standby LC acts as a protection which the seller shall resort to only if the buyer fail to make
payment in that other agreed mode.
Standby Letters of Credits are used in a variety of forms. Most commonly they are used for Bid Bonds,
Performance Bonds, Advance Payment, Guarantees, Warranty Bonds, and to secure financial obligations of
obligors. Often suppliers ask their buyers to provide Standby Letters of Credits as security for goods sold on open
account.
It is also important to recognize the distinction between Guarantees and Standby Letters of Credits. Both Standby
Letter of Credits and Guarantees obligate the Issuing Bank to make payment to a beneficiary in the event of a
default. However, the distinction is attributable to the rules and laws under which each instrument is issued.
Typically Guarantees are issued subject to local laws while Standby Letters of Credits are issued subject to
Uniform Customs and Practice Rules or International Standby Practice Rules.
5) Revolving LC: - Sometimes, a buyer may need a specific type of merchandise on a regular basis or he may desire
for a bulk purchase which can be delivered in multiple consignments. In such cases, the seller may lay down a
condition that a revolving credit be issued in his favour guaranteeing payment against individual consignments.
The text for such a credit may be different from usual LC covenants. For example, the text may read as Amount
of credit Rs.1.00 lacs revolving 11 times to maximum Rs.12.00 lacs. In this case, as soon as the first installment
of Rs.1.00 lac has been utilised and payments made, the credit automatically becomes valid for the next tranche
of Rs.1.00 lac until the maximum amount of Rs.12.00 lacs under the LC is utilized. Usually, the revolving LC
mentions the specific date of individual installments of credit for utilisation. For example, the text may read as
Credit amount Rs.1.00 lac revolving every month for the same amount, for the first time in January-2011, for
the last time in December-2011, maximum amount payable under the credit Rs.12.00 lacs . At times, an
installment with a fixed date is omitted or only partially used. It is common practice to use the word
cumulative and non-cumulative in the text in these situations. These phrases precisely indicate whether the
unutilised installments or balances may be or should not be added to the later installments. As per Exchange
Control Manual, revolving LCs should not be ordinarily issued for import of goods into India without the prior
approval of the RBI.

Documents under a LC: - There may be various documents which may be required to be enclosed under cover of a
LC. Some of the important documents to be enclosed are as follows
1) Transport documents: - Transport documents may include a bill of lading (a detailed list of a ship's cargo in the
form of a receipt given by the master of the ship to the person consigning the goods), airway bill, a lorry receipt
or a railway receipt etc.

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2) Insurance documents: - The type of insurance documents varies with the type of goods, the risk covered, the
destination, and the party bearing the risks. Most common risks covered under the insurance documents are the
risk of fire, shipwreck, pilferage, loss on account of war etc.
3) Bill of exchange: - One of the common documents covered under a letter of credit is a bill of exchange drawn by
the supplier of goods. Bill of exchange is a legal document that establishes liability of the various parties. Most of
the countries have prescribed detailed legal provisions in respect to bills of exchange, and therefore, the local
laws take precedence over the provisions of UCPDC in this regard. Bills of exchange generally attract stamp duty
in most of the countries. It is therefore necessary to exercise caution while examining these documents to ensure
that there is no incidence of under stamping/inchoate stamping.
4) Commercial invoice: - Commercial invoice is a key document under a LC transaction. It is a record of compliance
with the main parameters of the original agreement between the buyer and the seller. Government departments
also place a great degree of importance to this document in course of verification. Relevant information
contained in an invoice include names of parties, description of goods, quantity, amount, shipping terms,
shipment details, usance period etc. While dealing with the documents under LC, it is necessary to closely
examine the commercial invoice, so that no intra-document inconsistency remains which may lead to discrepancy
in the credit process.
5) Special invoice: - Exports made to some specific countries calls for special invoices. For example, in respect to
exports made to Latin America, and Middle East countries, the invoice is required to be legalized by the
diplomatic mission of the importing countries. Export made to some African countries, New Zealand & Australia
etc require a consular invoice. It is necessary that the legal requirements in respect to these special invoices are
properly complied with. The credit officer should examine the covenants of the LC keeping these factors in
consideration.
6) Certificate of Origin: - This document provides the necessary details about the country in which the product is
grown or manufactured. Sometimes, this document also provides information on the local material and labour
content of the product. This is an important document for the purpose of custom clearance at the importing
centre.
7) Packing List: - A packing list of goods is often one of the most important documents required under an LC. The
list content varies widely depending on the type of goods exported. However, as a general rule, a packing list
provides the following information:
A general description of goods;
Net & gross weight of the individual packages;
Weight & measurement of each master carton;
Details of buyer, seller, shipping particulars etc.
8) Inspection Report/Quality Certificate: - This is a report issued by an external agency nominated by the buyer for
the purpose of obtaining an independent confirmation that the quality of the goods shipped conforms to the
standards stipulated in the contract.
9) Beneficiarys Certificate: - The buyer often stipulates a condition regarding a certificate to be issued by the
beneficiary stating that all the requirements necessary to facilitate customs & port formalities have been
complied with. Generally, all LC stipulate enclosure of a Beneficiarys Certificate.

Issue of Letter of Credit -Points to be considered

1) General aspects
a) The issuing bank should ensure that the applicant is dealing with issuing bank only otherwise dealing with
other bank simultaneously may jeopardize the interest of the issuing bank over the title of the relative
goods. It is therefore advisable that a suitable clause may be incorporated in the loan agreement in order to
prevent the applicant from approaching other banks for additional funds, non-fund based limit etc without
the consent of the issuing bank.
b) It is necessary that the application-cum-guarantee form is in banks standard format and is adequately
stamped as an agreement. The application for LC should not contain any contradictory clause or any clause
impossible to fulfill and which violates the law of the country.

13
 c) LC against documents which do not confer on the issuing bank a full and undisputed title to the relative
goods should not ordinarily be issued.
d) Banks usually obtain a margin from the applicant against the amount of LC to be issued. In case of an LC
relating to working capital requirements (say, for procurement of raw materials), the amount of margins
obtained against LC is on the lines of margin stipulated against working capital credit requirements.
Whatever the margin money is stipulated the credit officer should constantly monitor the operating account
of the borrower, in order to ensure that there is a continuous accumulation of fund leading to a 100% margin
build-up by the time the bills against LC matures for payment. This may be done by setting aside the funds
from operating account on a regular basis.
e) When the issuing bank hands over the documents (received from exporting countries bank) to
buyer/importer against payment it is known as delivery of documents against payment (D/P). When the
issuing bank hands over the documents (received from exporting countries bank) to buyer/importer against a
legally enforceable promise to pay at a later date it is known as delivery of documents against acceptance
(D/A). An issuing bank may grant delivery against acceptance (D/A) facilities only to the applicants of
undoubted standing and where the security available is much more than the value of the LC. Under other
circumstances, only delivery against payment (D/P) bills should be accepted and documents of the title of
the goods parted with after the receipt of the payment. [In practice, the bank advises the applicant to
arrange and deposit adequate funds in his (applicants) account with the bank. The bank utilizes this money
to make all the payments along with the commission, and additional charges if any in order to honour the
credit.]
f) Each LC should be complete and precise in itself. It should not call for an irrelevant documents e.g. sale
contract, proforma invoice, etc.
g) Onerous clause in LC: - Sometimes, the beneficiary or applicant of the LC, are in a monopolistic position due
to presence of onerous clause in LC. These clauses pose multifarious risks for the bank issuing the LC and
thus a close examination is necessary for their elimination. Some of the examples of onerous clause in LC are
as follows:
The date of payment may be extended by the applicant at his discretion by informing the bank in
writing.
Interest may be paid at a predetermined rate fixed by the applicant.
Goods are to be sent on Carriers and are not required to be insured against any risk while in transit.
In case the value of consignment exceeds due to increase in the price of the goods, excise duties or
other levies, full payment will be made by the issuing bank nevertheless such value exceeds the LC
limit.
Payment under LC shall not be withheld or delayed by reason of non-delivery or delay in delivery of any
goods or for any objections made by the buyer/importer or for any other reason whatsoever.
2) Appraising a proposal for opening an LC: - While issuing an LC, the issuing bank takes up a future financial
commitment that contains all the risks applicable to a fund based exposure assumed by a bank. It is of utmost
importance that the appraisal of LC facility is done entirely on the lines of appraisal of fund based exposure. This
is because the amount involved is essentially a fund based facility, though the funds are provided on deferred
terms only. It is therefore necessary that while appraising the proposal for issuing an LC, the issuing bank
undertakes an analysis of all these factors, which are relevant in appraisal of regular fund based limit as well. In
the following sections, we shall discuss both the qualitative and quantitative aspects of appraising a LC facility.
a) Qualitative aspects
i) Purpose of LC: - The purpose of LC proposed to be issued should be examined in the context of the
usual business requirements of the client. For this purpose, a reference to the constitution (Partnership
Deed in case of firm. MOA in case of company) of the proposer may be of required help to the credit
officer.
ii) Frequency of issue: - An examination of the frequency of issue of such LC assists the credit officer in
understanding the pattern of the business, when the LC requirement arises and expected cash flow of
the customer.

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 iii) Amount of LC proposed:-The amount of LC proposed should be specific and unambiguous and supported
by documentary evidence. It should not contain any clause which imparts a variability of the guarantee
amount in any case.
iv) Track record:- The past record of the applicant in relation to cases where LCs were issued, cause of
issue, conduct of the applicant after the issue of the LC, are important parameters in the context of
decision making in this regard.
v) Present balance outstanding: - If the customer already enjoys LC limit, the total of present
commitment must be given a close look before a decision is taken on further issue by credit officer.
vi) Collateral security and margin:- As in case of all credit appraisal, the collateral security offered and
the margin retained against the non-fund based credit exposure has a vital say in the decision making
process.
vii) Critical assessment of the exposure: - As the issuing banks commitment to the beneficiary is absolute
and irrevocable, the issuing bank always runs the risk that the applicant may not honour his commitment
to pay and take delivery of the documents. It is similar to a situation where bank provides fund based
credit facilities to its customer and the customer defaults. In both the cases bank faces a risk of loss.
Therefore a critical appraisal of a letter of credit facility involves examination of the following aspects:
# Integrity of the applicant; # Credit worthiness of the applicant; # Financial strength and solvency of
the applicant; # Profitability of the business he engages in.
viii) Verification of the trade control regulations: - As a part of Indias commitment to WTO agreement, the
government has been progressively dismantling trade restrictions. Import of many commodities which
was earlier allowed to be carried on the basis of license issued by government authorities has been
abolished. As of now, trade control is not a major issue so far as the opening of the LC is concerned.
However the bank should ensure if any restriction is in force on import of any item.
ix) Verification of the exchange control regulations: -The focus of the exchange control regulations is to
ensure that the transaction is genuine, there is actual movement of goods and that the price being paid
is reasonable for the goods. The ultimate objective is to ensure that there is no unwarranted outflow of
foreign exchange reserve. Though the government has liberalized the foreign exchange regulations to
some extent for free flow of trade & commerce but the bank dealing in LC should remain vigilant in
order to ensure that customers do not circumvent the existing regulations by using mechanism of LC.
b) Quantitative aspects- In case of purchase of capital goods:-
i) LC limit to be granted: - When an LC is opened for purchase of an item of capital nature, the process of
determining the amount of LC to be granted is quite simple. Value of LC usually covers the price of the
capital good, net of advance payments made. This information is generally provided by the applicant,
which can also be verified from various documents. For large value items, an independent verification of
the price is advisable. This can also be entrusted to professional agencies having expertise in similar
jobs.
ii) Means of finance: - Once an LC is opened, the issuing banks liability to pay the amount under the LC is
absolute. It is for this reason that the issuing bank has to ensure that sufficient funds are available in the
LC account of the applicant to honour the LC on the due date.
The applicant may arrange the funds from his own sources or may request for a term loan to be granted
to ensure sufficient funds by the due date. In case the LC is supported by term loan then the credit
officer has to examine the viability of the term loan separately and additionally. Whatever may be the
source of fund, the credit officer should constantly monitor the LC account of the borrower, in order to
ensure that there is a continuous accumulation of fund leading to a 100% fund build-up by the time the
bills against LC matures for payment.
The position can be envisaged with a reasonable amount of certainty with the help of a cash budget
worked out along pragmatic lines. Each application for a LC facility therefore should be accompanied
with a suitable cash budget, to satisfy the bank that the customer will have sufficient funds at his
disposal to meet the liability under the credit on the due date. The credit officer should also examine
and analyse the cash budget and ensure that it has been drawn taking into account all the relevant
15
 factors. If the cash budget indicates that there is a less likelihood of adequate funds pooled at the
appropriate time, it would be necessary to make firm arrangements for funds with a bank or financial
institution before the LC facility is sanctioned.
c) Quantitative aspects- In case of purchase of raw materials, consumables etc:-
i) LC limit to be granted: - A limit for a LC facility for purchase of raw materials, consumables etc enable
the enterprise to procure raw materials and other important ingredients for production/manufacturing
purpose. Like in case of the purchase of an item of capital nature, also in the case of purchase of raw
materials, consumables etc the process of determining the amount of LC to be granted is quite simple.
Value of LC to be granted will be determined in case to case basis and should cover the FOB, CIF or C&F
value of the goods and should not include customs duty and other charges payable in India.
However in case of recurring purchase the LC limit to be granted is worked out in the following manner
Purchase cycle simply commences from the point of time
when order is placed till the time payment is made. Thus it
Purchase Cycle
365 X Annual purchases includes
under LC a) Time from placing the order to shipment, known as lead
time;
b) Time taken to deliver the goods, known as transit period;
c) Time taken to make payment, usance period;
ii) Means of finance: - Once an LC is opened, the issuing banks liability to pay the amount under the LC is
absolute. It is for this reason that the issuing bank has to ensure that sufficient funds are available in the
LC account of the applicant to honour the LC on the due date.
The applicant may arrange the funds from his own sources or may request for a working capital loan to
be granted to ensure sufficient funds by the due date. In case the LC is supported by working capital
loan then the credit officer has to examine the viability of the working capital loan separately and
additionally. Whatever may be the source of fund, the credit officer should constantly monitor the LC
account of the borrower, in order to ensure that there is a continuous accumulation of fund leading to a
100% fund build-up by the time the bills against LC matures for payment.
The position can be envisaged with a reasonable amount of certainty with the help of a cash budget
worked out along pragmatic lines. Each application for a LC facility therefore should be accompanied
with a suitable cash budget, to satisfy the bank that the customer will have sufficient funds at his
disposal to meet the liability under the credit on the due date. The credit officer should also examine
and analyse the cash budget and ensure that it has been drawn taking into account all the relevant
factors. If the cash budget indicates that there is a less likelihood of adequate funds pooled at the
appropriate time, it would be necessary to make firm arrangements for funds with a bank or financial
institution before the LC facility is sanctioned.
Illustration-1, Assessment of LC limit with cash budget technique
Case:-M/s ABC Machineries Ltd. requested the bank to open an LC for Rs.10.00 lacs on 01.01.2012 for
the purpose of procurement of raw material. The bills submitted by the supplier against the LC would
mature for payment by 31.03.2012. The credit officer wants to ascertain whether the current account
maintained by the company would have sufficient funds at the close of March 2012 so that the LC may
be honoured. For this purpose, the credit officer has gathered the following details on the future cash
flow pattern of the company.
Sales for November and December (actual) and January to March (projected) are given below. 10%
of the total sales are cash sales. 90% of the receivables generated during a month are collected on
an average one month from the date of sale. The balance 10% is collected two months from the
date of sale with no bad debt losses.
Month Nov 2011 Dec 2011 Jan 2012 Feb 2012 Mar 2012
Sales (In Rs.000s) 3000 3500 2500 2000 2500

The company plans to sell one old fixed assets at an estimated price of Rs.4.00 lacs in the month
of February for which definite arrangements have been made. Sales proceeds will be received in
cash in the month of sale.
Purchases for December (actual) and January to March (projected) are given below. The company
16
 enjoys credit for 30 days on purchase of raw materials
Month Dec 2011 Jan 2012 Feb 2012 Mar 2012
Purchases (In Rs.000s) 1000 800 1000 1200

Wages and other expenses are payable as and when falls due.
Month Jan 2012 Feb 2012 Mar 2012
Wages (In Rs.000s) 800 800 900
Other expenses (In Rs.000s) 500 500 500

The company has one term loan obligation. Repayment obligation of which is as follows
Month Jan 2012 Feb 2012 Mar 2012
Principal repayment (In Rs.000s) 500 500 500
Interest payment (In Rs.000s) 100 100 200

The company proposes to pay interim dividend of Rs.4.00 lacs in January 2012.
The company has to pay income tax in two installments during Jan 2012 and Mar 2012 of Rs.3.00
lacs and Rs.5.00 lacs respectively.
Opening cash balance in Jan 2012 is Rs.10.00 lacs.
Solution:-
Cash Budget
Jan 2012 Feb 2012 Mar 2012
Receipts
Receipts from cash sales 250 200 250
Receipts from prev. month sale 2835 2025 1620
Receipts from prior prev. month sale 270 315 225
Receipts from FA sales - 400 -
3355 2940 2095
Payments
Payments to raw materials suppliers 1000 800 1000
Wages & other expenses payment 1300 1300 1400
Loan repayment 500 500 500
Interest payment 100 100 200
Dividend payment 400 - -
Income tax payment 300 - 500
3600 2700 3600
Opening cash balance 1000 755 995
Add: Surplus/Deficit -245 240 -1505
Closing cash balance 755 995 -510
Decision
The above cash budget indicates that the company is likely to face a cash deficit to the extent of
Rs.5.10 lacs towards the close of March-2012. Thus unless the company is able to give firm
commitment that it will be able to arrange Rs.15.10 lacs by March-2012 the LC proposal may be
rejected.

Illustration-2, Assessment of fund-based and non-fund based (LC) limits in case of recurring needs
Case: - Arihant Barrels Ltd. (ABL) is a small-scale industrial unit manufacturing steel drums and barrels.
Its product enjoys a good reputation in the market. ABL has set-up an adequate infrastructure for
quality manufacturing. The raw-materials include cold rolled (CR) coils the main ingredients and
chemicals for processing. The company maintains all its accounts including the loan accounts with your
branch with a satisfactory conduct. Presently ABL enjoys a total credit limit of Rs.1.15 crores in the
following manner
Fund based limit
a) Cash credit (Hypo. of stocks) : Rs.25.00 lacs
b) Cash credit (bills) : Rs.10.00 lacs
Non-fund based limit
a) Letter of Credit : Rs.75.00 lacs

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b) Bank Guarantee : Rs. 5.00 lacs
ABL purchases most of its raw-materials from Dayal Steel Suppliers (DSL). DSL supplies raw-materials
against LCs issued by your bank in favour of DSL with a usance period of 90 days. The supplier would
discount the supply bills with its branch which would be sent to your branch for payment on maturity.
The time involved since the time purchase order is placed till the time goods are delivered in the
factory is approximately 15 days.
ABL has received bulk supply order from D-Bio to whom it has agreed to sell at 3 months credit which is
the general terms of sales of ABL. In order to meet the bulk supply order ABL has to increase its
production capacity for which it has to install additional machinery. ABL has approached your bank for
higher credit limits. You have advised the company to submit the enhancement proposal with necessary
projections.
After some time, ABL submitted the full proposal for enhancement of the credit limits. Though the
proposal mentions that the company plans to install new machinery to add to the capacity, they did not
approach the bank for any term loan. However, they requested the bank to enhance the fund based
limit to Rs.125.00 lacs and non-fund based limit (only LC) to Rs.150.00 lacs. They did not seek any
increase in the BG limit. Their request for enhancement is based on the following assumptions
a) The sales volume during the next year is projected at Rs.720.00 lacs, which is considered as
achievable. Because additional sales is on account of confirmed purchase order which they
recently received.
b) Cost of goods sold is 90% of the sales value. Raw-material consumption is 75% of the sales value.
c) Purchases under LCs are 80% of the total raw-material consumption. All other purchases are made
by making direct payment at the time of supply.
d) Raw material holding period is assumed to be 1.5 months of consumption. The aggregate holding
period for semi-finished and finished goods is assumed to be 15 days.
e) Other current assets and other current liabilities have been projected at Rs.12.00 lacs and
Rs.31.00 lacs respectively.
As a credit officer, please frame an opinion on the level of the credit facilities based on the figures
submitted as available with you.

Solution:-
Assessment of LC limit: On the basis of the information submitted LC limit to be permitted can be
worked out in the following manner.
Item Fig. Explanations
Sales Rs.720 lacs
Cost of goods sold Rs.648 lacs 90% of the sales value
Raw-material consumption Rs.540 lacs 75% of the sales value
Raw-material purchases under LC Rs.432 lacs 80% of the raw-material consumptions
Lead time + Transit time 15 days
Usance period 90 days
Purchase cycle 105 days Lead time + Transit time + Usance period
LC limit Rs.124 lacs (Purchase cycle 365) X Annual purchase
under LC
Thus, the company will be allowed an LC limit of Rs.124 lacs and not Rs.150 lacs as proposed.

Assessment of CC limit: Let us now compute the maximum CC limit permissible. For this we need to
project CA and CL on the basis of available information. Projections of CA and CL shall be made on the
basis of holding period despite the figures of CAs and CLs submitted by the borrower.
Current Assets Current liabilities
Items Calculation Amt. Items Calculation Amt.
Trade Creditors (432365) X 90 107 Raw material stock (54012) X 1.5 68
Other CL 31 SFG & FG (648365) X 15 27
Receivables (72012) X 3 180
Other CA 12
Permissible bank finance= Chargeable CA-25% of Chargeable CA-Creditors-Excess of OCL over OCA
= (68+27+180)-25% X (68+27+180)-107- (31-12)
= Rs.80 lacs
The permissible limit has been worked out to be Rs.80 lacs as against proposed limit of Rs.125 lacs.

18
Decision
Most importantly, no drawing power is permissible against inventory as the entire inventory is in
the nature of unpaid stock. It would therefore, be advisable to allot a CC limit against
receivables. Alternatively, credit can be released against receivables by way of discounting bills.
Secondly, the company may install the additional machinery by partly financing it through a term
loan, which will provide additional funds for managing working capital.

Illustration-3,Assessment of LC limit in case of recurring needs

Case: - A-One Electronics Ltd is engaged in manufacturing of electronic components used in
sophisticated avionics. The products are mostly exported to European countries, especially France. The
company has been relying mostly on the domestically available circuitry and the other requisite
components for manufacturing its final products. The broad financial parameters and figures relating
to performance of the company for the just concluded financial year and the previous financial year
are as under:
(Rs. in lacs)
Particulars 2011-12 2012-13
Paid-up capital 600 600
Tangible net worth (TNW) 2025 2220
TOL/TNW 1.13 1.07
Current ratio 1.36 1.34
Sundry creditors to current assets 12.15% 13.02%
Sales (Export) 1930 1750
FB limit enjoyed (including EPC) 630 570
Conduct of account Satisfactory Satisfactory
Irregularity On very few occasion On very few occasion
During the current year 2013-14, the company proposes to export goods worth Rs.2200 lacs. The
average requirement of raw-materials works out to about 75% of the cost of sales, which is
approximately 90% of the sales (export). However, of late, the buyer in France has been complaining
about the quality of consignments on quality grounds. In fact, they had even threatened twice to
reject the consignment on quality grounds. The company has now decided to import the entire
requirement of printed circuitry and chips from South Korea and/or Japan.
The important terms available are 3 months D/A (document against acceptance) from a South Korean
company and D/P (document against payment) from a Japanese company. The transit period is, on an
average 12 days in respect of imports from South Korea, and 20 days from Japan. Other miscellaneous
clearing time involved is 15 days (max). The company has kept its option open in regard to the choice
of the supplier for placing orders for import of the components. Further, since the company has long
relied upon its domestic suppliers for supply of circuitry, it does not want to sacrifice the existing
supply connection which has been a good source of supply on credit terms.
The company has requested you to provide a suitable combination of LC and other facilities if available
to take care of the situation.

Solution: - First of all, we need to have a look at the past financials of the company, to assess the
business trend and present financial position in the context of providing the necessary credit facility to
the company.
The sales have come down, presumably on account of reduction in the export sales on quality
considerations (raised by the buyer of France). This has also resulted in reduction of FB limit. However
the account of the company has not become irregular on account of reduction in the credit limits (as it
happens with many such companies). Prima facie, therefore, the company complies with the financial
discipline necessary in case of bank borrowings.
The deterioration in the current ratio (though marginal) appears to be mostly on account of companys
increased dependence on the trade creditors as sundry creditors to current assets have increased from
12.15% to 13.02%. However, the fact remains that the current ratio is still above the bench mark level
of 1.33. On the other hand, the TNW has increased significantly during the period despite the fact that
there is no infusion of capital. This gives credence to the fact that the companys profitability is strong
and downward liquidity is a temporary phenomenon which can be corrected if quality of export is
improved and the necessary credit facility is provided for the purpose.
The LC limit can be calculated in the following manner

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 Particulars South Korea Japan
Proposed export sales 2200 2200
Cost of sales 90% of export/ sales 1980 1980
Imported raw material consumption 75% of cost of sales 1485 1485
Transit period (T) 12 days 20 days
Others (L) 15 days 15 days
Usance period (U) 90 days Nil
Purchase cycle L+T+U 117 days 35 days
LC Limit (Purchase cycle 365) X Annual 476 142
purchase under LC
Decision
If the company intends to import from South Korea, than the company will need a LC limit of
Rs.476 lacs. In that case the company will enjoy a usance period of 90 days under D/A terms.
If the company intends to import from Japan, than the company will need a LC limit of Rs.142 lacs.
In that case the company should have improved cash flow situation as the company has to pay the
LC amount at sight under D/P terms. If the company assesses that it would face difficulty in
meeting payments under D/P than instead of seeking an LC limit it may explore the possibilities of
funding by an overseas bank (or, overseas branch of an Indian bank) under Buyers Credit facility. In
case Buyers Credit facility is provided to the company (importer), than the overseas bank will
make payment directly to the exporter even before goods are dispatched on the basis of a Letter
of Comfort/Letter of Undertaking (LoC/LoU) issued by the importers bank in India to that overseas
bank. LoC/LoU is a kind of promise/guarantee to make payment at an agreed future date. Such
LoC/LoU is issued to overseas bank by an Indian bank on the basis BG issued in favour of the Indian
bank by the importer. On the completion of the agreed tenure the company/importer will make
payment to the Indian bank which in turn shall make payment to the overseas bank. In the whole
process the company/importer will be able to negotiate the credit period.
Finally the company wants to keep the option of buying from domestic suppliers open. The bank
may support this by providing a suitable domestic LC limit within the overall limit of Rs.476
lacs/Rs.147 lacs with full interchangeability. However, in view of the complaints relating to the
quality of raw-materials, the company must be advised to purchase the components from a
standard domestic supplier only.

Co-acceptance of Bills
Definition:
1) The facility of co-acceptance is generally extended by banks as an alternative to LC facility.
2) Co-acceptance is a joint acceptance of usance bills by a bank in addition to their customer being a
buyer/importer in favour of the drawer being the supplier/exporter.
3) Such co-acceptance makes the buyer and the bank jointly and severally liable to the bill. It allows the
supplier/exporter the credit worthiness of a banker in addition to credit worthiness of the buyer/exporter in the
absence of which the supplier/exporter may not be willing to supply on credit.

Mechanism of Co-acceptance of Bills

1) The buyer/importer negotiates the terms of buying or importing with the seller/exporter.
2) The buyer applies with his bank for suitable limit for co-acceptance of bills.
3) Once co-acceptance limit is allowed by the bank, the buyer/importer contacts the seller/exporter for supply.
4) The seller/exporter dispatches the goods.
5) The seller/exporter draws usance bills on the buyer and sends the bill along with documents of title to the goods
to the buyers/importers bank.
6) The buyers/importers bank presents the bill to buyer/importer to accept the bill. Once accepted by the
buyer/importer the bank gives its acceptance to the bill and hand of the documents of title to the goods to
buyer/importer to take delivery of the goods.

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7) On due date, proceeds are sent to the seller or sellers bank by debiting the customers account. If the
customers account does not permit the payment to be made, the bank has to honour the obligation by making
alternative arrangements.

Co-acceptance of Bills -Points to be considered

1) RBI Circular- dated- July 1, 2013:- Reserve Bank has observed that some banks co-accept bills of their
customers and also discount bills co-accepted by other banks in a casual manner. These bills subsequently turn
out to be accommodation bills drawn by groups of sister concerns on each other where no genuine trade
transaction takes place. Banks, while discounting such bills, appear to ignore this important aspect presumably
because of the co-acceptance given by other banks. The bills, on maturity, are not honoured by the drawees and
the banks which co-accept the bills have to make payment of these bills, and they find it difficult to recover the
amount from the drawers/ drawees of bills.
An accommodation bill is one for which no consideration has been given by the drawer to the acceptor for the
purpose of accommodating some other party who is to use it and is expected to pay it when due. Example: P is
in need of Rs. 2000. He approaches Q for this purpose. Q agrees to help him and proposes P to draw a bill on
him. Which he would accept. P can get the bill discounted with his banker? On or before the due date P will
have to provide Q with the necessary funds to enable him to meet his acceptance. Thus P is in a position to
raise money for the term of the bill. Such a bill which has been drawn and accepted without consideration is
called an accommodation bill.

Banks also discount bills for sizeable amounts, which are co-accepted by certain Urban Co-operative Banks. On
maturity, the bills are not honoured and the co-operative banks, which co-accept the bills, also find it difficult to
make the payment.
Cases have also been observed where the particulars regarding co-acceptance of bills are not recorded in the
bank's books, with the result that the extent thereof cannot be verified during inspections, and the Head Office
becomes aware of the co-acceptance only when a claim is received from the discounting bank.
In the light of the above situation RBI has prescribed some important safeguards to be taken by banks while
dealing with co-acceptance of bills. A summary of such safeguard is given below:
a) While sanctioning co-acceptance limits to their customers, the need thereof should be ascertained, and such
limits should be extended only to those customers who enjoy other limits with the bank.
b) Banks should ensure that the goods covered by bills co-accepted are actually received in the stock accounts
of the borrowers.
c) The valuation of the goods as mentioned in the accompanying invoice should be verified to see that there is
no over-valuation of stocks.
d) Bills drawn by group concerns on each other should be subjected to greater scrutiny to ascertain that these
are not accommodation bills. Bank-wise limits should be fixed and it should be ensured that the co-accepting
bank has the capacity to redeem the obligation in case of need.
e) Care should be taken to see that the co-acceptance liability of any bank is not disproportionate to its known
resources position.
f) A system of obtaining periodical confirmation of the liability of co-accepting banks in regard to the
outstanding bills should be introduced.
g) Proper records of the bills co-accepted for each customer should be maintained, so that the commitments
for each customer and the total commitments at a branch can be readily ascertained, and these should be
scrutinized by Internal Inspectors and commented upon in their reports.
h) Proper periodical returns may be prescribed so that the Branch Managers report such co-acceptance
commitments entered into by them to the Controlling Offices. Such returns should also reveal the position of
bills that have become overdue, and which the bank had to meet under the co-acceptance obligation. This
will enable the Controlling Offices to monitor such co-acceptances furnished by the branches and take
suitable action in time, in difficult cases.

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 i) Co-acceptances in respect of bills for Rs.10,000/- and above should be signed by two officials jointly,
deviation being allowed only in exceptional cases, e.g. non-availability of two officials at a branch.
j) Before discounting/ purchasing bills co-accepted by other banks for Rs. 2 lakh and above from a single party,
the bank should obtain written confirmation of the concerned Controlling (Regional/ Divisional/ Zonal) Office
of the accepting bank and a record of the same should be kept.
k) When the value of the total bills discounted/ purchased (which have been co-accepted by other banks)
exceeds Rs. 20 lacs for a single borrower/ group of borrowers, prior approval of the Head Office of the co-
accepting bank must be obtained by the discounting bank in writing.
l) Banks should not co-accept bills drawn under Buyers Line of Credit Schemes introduced by IDBI Bank Ltd. and
all India financial institutions like SIDBI, Power Finance Corporation Ltd. (PFC), etc. Similarly, banks should
not co-accept bills drawn by NBFCs. However, banks may co-accept bills drawn under the Sellers Line of
Credit Schemes operated by IDBI Bank Ltd. SIDBI, PFC, etc. without any limit, subject to the buyers
capability to pay, and compliance with the exposure norms prescribed by the bank for individual/group
borrowers.
m) There have been instances where branches of banks open L/Cs on behalf of their constituents and also co-
accept the bills drawn under such L/Cs. Legally, if a bank co-accepts a bill drawn under its own L/C, the bill
so co-accepted becomes an independent document. The special rules applicable to commercial credits do
not apply to such a bill and the bill is exclusively governed by the law relating to Bills of Exchange, i.e. the
Negotiable Instruments Act. The negotiating bank of such a bill is not under any obligation to check the
particulars of the bill with reference to the terms of the L/C. This practice defeats the purpose of issuing the
L/C. The discounting banks should first ascertain from the co-accepting banks, the reason for such co-
acceptance of bills drawn under their own L/C and only after satisfying themselves of genuineness of such
transactions, they may consider discounting such bills.

2) Appraising a proposal for Co-acceptance of bills: -

Miscellaneous

Interchangeability between different non-funds based facility: - Sometimes, the clients request for
interchangeability between the different non-fund based credit facilities provided to them by the bank. For example,
assume that a client is provided with an LC limit of Rs.100 lacs and a BG limit of Rs.50 lacs respectively. At some point
of time, the individual balances in respect to these two facilities are at Rs.100 lacs and Rs.20 lacs respectively. The
enterprise now urgently requires additional LC of Rs.30 lacs. Under normal circumstances, the enterprise has to apply
for an enhancement of the existing LC limit and the issuing bank may examine the request in the usual manner. An
alternative is to apply for interchangeability of the two limits which would enable the enterprise to convert the
unused part of the facility to the other facility.
Since each type of non-fund based facility so granted are based on separate set of conditions, criteria, purposes, etc
it is therefore advisable to examine the following aspects before taking a decision on their interchangeability.

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1) Purpose of granting facility: - If both LC and BG facilities have been provided for working capital purposes, it
makes sense to allow interchangeability. In case, the two facilities are for different purposes, say, the LC is for
import of capital goods, and the BG is for working capital purposes, it may not be sensible to allow
interchangeability unless reassessment based on revised conditions is worked out.
2) Time horizon of risk: - Time horizon of risk exposure of the two facilities has to be compared before
interchangeability. BGs are generally issued for longer period than LC and thus risk tenure in BG is higher than
LC.
3) Nature of risk: - Even the nature of risk also may be different. For example, the risk associated with a
performance guarantee is distinctly different from that of a financial guarantee or LC.
4) Impact on fund based limit: - A usance LC limit sanctioned in favour of an enterprise impacts its level of trade
creditors which in turn also impacts the level of the fund based credit limit. A BG facility on the other hand saves
an enterprise from fund blockage and has little impact on the fund based credit limit.
5) Cash flow assessment: - Examination of cash flow projections is considered as vital at the time of opening of LC.
However, this is not a relevant practice in case of issue of BG (except in case of DPG).

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