Professional Documents
Culture Documents
PROJECT REPORT ON
UNIVERSITY OF MUMBAI
SUBMITTED BY:
ACKNOWLEDGEMENT
My special thanks to Mrs. Ceena Paul (Professor-NLDIMSR) for her expert guidance and co-
operation. With her expert knowledge she constantly helped me, encouraged me and inspired
me to put more efforts in the project. She guided me from time to time with her expert
opinions and suggestions. I thank her, for without her guidance, the successful completion of
the project would not have been possible.
I would like to extend my thanks to Prof. Pius Moraes (Program Head-NLDIMSR, Part time MBA
course) who were open to discussion and clarifications that helped me in working out many of
the theoretical and practical problems of the project.
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CERTIFICATE
M.F.M
During academic year 2016-2019 this has been carried out by her
under our supervision and guidance.
Introduction
Banking in India originated in the first decade of 18 century with The General Bank of India
coming into existence in 1786. This was followed by Bank of Hindustan. Both these banks are
now defunct. The oldest bank in existence in India is the State Bank of India being established
as "The Bank of Bengal" in Calcutta in June1806.
The Reserve Bank of India formally took on the responsibility of regulating the Indian banking
sector from1935. After India's independence 1947, the Reserve Bank was nationalized and
given broader powers.
Currently (2007), banking in India is generally fairly mature in terms of supply, product range
and reach-even though reach in rural India still remains a challenge for the private sector and
foreign banks. In terms of quality of assets and capital adequacy, Indian banks are considered to
have clean, strong and transparent balance sheets relative to other banks in comparable
economies in its region. The Reserve Bank of India is an autonomous body, with minimal
pressure from the government. The stated policy of the Bank on the Indian Rupee is to manage
volatility but without any fixed exchange rate-and this has mostly been true.
The Modern Banking Functions are Fund based and Non-Fund based functions. These functions
of a bank are those in which banks extend various services to their customers or add their
commitments to certain transactions undertaken by their clients and charge their fees/
commissions for the services rendered by them / their commitments added to the transactions
undertaken by the clients. The activities popularly known as ‘Non-fund facilities’ provided by
Banks.
The major non-fund based facilities that are considered as a part of regular credit facilities are
Letter of Credit and Bank Guarantee. As a part of their Non-fund based functions banks allow
Letter of Credit and Bank Guarantee facilities for their customers to meet their requirements.
Thus, we conclude that the Letter of credit and Bank guarantee comes in a plethora of
confusing forms NDGUISES. It is understood in different ways in different parts of the world.
But, once the basics are understood, it is wonderfully adaptable and uniquely user friendly tool
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2. DESIGN OF STUDY
The exchange of goods and services across national boundaries brings greater problems to both
buyer and seller than domestic business. These problems arise from the diversity of customs,
standards, currencies, local regulations, languages and legal systems that are spread across the
world. To an extent, the globalization of the past half century has reduced the barriers and
anomalies, but the great majority persists.
This project aims to introduce traders, bankers and buyers and sellers of all types to one of the
most widely employed mechanisms for reducing the financial risks of trade, the Documentary
Letter of Credit and Bank Guarantee. The Letter of credit and Bank guarantee comes in a
plethora of confusing forms ND GUISES.
It is understood in different ways in different parts of the world. But, once the basics are
understood, it is wonderfully adaptable and uniquely user friendly tool for businessmen
and women worldwide.
It is worthwhile, at this stage, remembering the key barriers that present themselves to the
average exporter and importer.
The importer wants to be sure that he will get his goods on time and in good order. He wants
to ensure performance.
He does not want to pay for something that he cannot be reasonably sure of getting.
The exporter wants to be sure that, once he has performed his part of a contract he gets
rewarded. He wants to secure payments.
3.1 INTRODUCTION
The difference between fund-based and non-fund based credit assistance lies mainly in the
cash outflow. While the former involves all immediate cash outflow, the latter may or may not
involve cash outflow from a banker. In other words, a fund based credit facility to a borrower
would result in depletion of actual liquidity of a banker immediately whereas grant of non-fund
based credit facilities to a borrower may or may not affect the banker’s liquidity. This is, of
course, not to suggest that there is more risk in fund-based lending than non-fund based
lending, on the contrary, the experience of bankers, in general, has been that the risk exposure
in, non-fund based credit facilities has been much higher than fund-based facilities. This is
found to be due to lack of proper appraisal on the part of the banker of an application for non-
fund facilities. It is therefore, to be appreciated that proposals for both the fund-based and
non-fund based limits deserve and call for the same standard of scrutiny and appraisal.
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4.1 INTRODUCTION.
These are called non-fund based financing (or quasi-credit facilities) because, at the time of
opening of the letter of credit or bank guarantee, no amount, as such, becomes immediately
payable. But, these facilities do involve some financial commitment on the part of the bank in
as much as the bank is required to pay the amount of the bill (drawn under the L/C, and in
meticulous compliance of all the terms and conditions stipulated therein), in the event of the
applicant (borrower) refusing or being unable to honor the bill on presentation, at the material
time.
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The bank, however, is within its rights to proceed legally against the applicant (borrower) on
the basis of the letter of request (counter guarantee and indemnity) executed by the applicant,
at the time of the issuance of the Letter of Credit, on a duly stamped paper.
Similarly, no amount becomes payable by the bank at the time of execution of the B/G, but as
per the undertaking (commitment) given by the bank, under the B/G issued, the bank will have
to make the payment of the amount, covered under the B/G by the beneficiary concerned. The
bank may make the required payment by debit to the applicant’s account, even if sufficient
balance may not be available therein. The amount so overdrawn may have to be deposited by
the applicant, in the due course, failing which the bank may prefer to file a civil suit against the
applicant to cover the amount, on the basis of the counter-guarantee executed by the applicant
on the stamped paper, at the time of the issuance of the Bank Guarantee.
Thus, it is for the aforesaid reasons that the L/C and B/G are referred to as Non-Fund Based
working capital financing. And, accordingly, one should not harbor any misconception that L/C’s
and B/G’s do not involve any financial commitments and risk. These facilities (L/C and B/G) are
also referred to as Quasi-(or Semi) Credit Facilities for the same reasons.
And, as these facilities also involve financial risks, the amount, and the terms and conditions of
the L/C’s and B/G’s, are also determined by the banks, on the basis of all the precautions taken,
as is done at the time of granting Fund Based credit facilities (like stock cash credit), whereby
the borrower gets the right to withdraw the amount immediately after sanction of the limit, of
course, within the over-all credit limit sanctioned and the Drawing Power (DP) available at the
material time. Accordingly, the limits for L/C and B/G were also being stipulated well within the
MPBF (Maximum Permissible Bank Finance). But now, the limits of the L/C’s and B/G’s are
sanctioned separately and are independent of the ABF (Assessed Bank Finance)
The major non-fund based facilities that are considered as a part of regular credit facilities are
letter of Credit and Bank Guarantee. As a part of their non-fund based functions banks allow
Letter of credit and bank guarantee facilities for their customers to meet their requirements.
Banks charge commission for the services rendered by them and commitments on the pact of
the bank these are allowed after making out a very careful and detailed assessment of borrower’s
requirement and capacity. Only need based facilities are extended after
Reserve Bank of India has also issued detailed guidelines to commercial banks in respect
of non-fund based credit facilities. Some of the important points to be kept in view in
this regard are discussed below:
Letters of Credit
Bank should normally open letters of credit for their own customers who enjoy credit
facilities with them Customers maintaining current account only and not enjoying any
credit limits should not be granted L/C facilities except in cases where no other credit
facility is needed by the customer.
The request of such customer for sanctioning and opening of letter of credit should be
properly scrutinised to establish the genuine need of the customer. The customer may
be, required to submit a complete loan proposal Including financial statements to satisfy
the bank about his, needs and also his financial resources, to mire the bills drawn under
Where a customer enjoys credit facilities with some other bank, the reasons for his
approaching the bank for sanctioning L/C limits have to be clearly stated. The bank
opening L/C on behalf of such customer should invariably make a reference to the,
existing banker of the customer.
In all cases of opening of letters of credit, the bank has to ensure that the customer is
able to retire the bills drawn under L/C as per the financial arrangement already
finalised.
Guarantees
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The conditions relating to obligant being a customer of the bank enjoying credit facilities as
discussed in case of letters of credit are equally applicable for guarantees also. In fact, guarantee
facilities also cannot be sanctioned in isolation.
Financial guarantees will be issued by the banks only if they are satisfied that the customer will
be in a position to reimburse the bank in case the guarantee is invoked and the bank is required
to make the payment in terms of guarantee.
Performance guarantee will be issued by the banks only on behalf of those customers with
whom the bank has sufficient experience and is satisfied that the customer has the necessary
experience and means to perform the obligations under the contract and is not likely to commit
any default.
As a rule, banks will guarantee shorter maturities and leave longer maturities to be guaranteed
by other institutions. Accordingly, no bank guarantee will normally have a maturity of more than
10 years.
Banks should not normally issue guarantees on behalf of those customers who enjoy credit
facilities with other banks.
Co-acceptance of Bills
Limits for co-acceptance of bills will be sanctioned by the banks after detailed appraisal of
customer's requirement is completed and the bank is fully satisfied about the genuineness of
the need of the customer. Further customers who enjoy other limits with the bank should be
extended such limits.
Only genuine trade bills shall be co-accepted and the banks should ensure that the goods
covered by bills co-accepted are actually received in the stock accounts of the borrowers. The
valuation of goods as mentioned in the accompanying invoice should be verified to see that
there is no overvaluation of stocks.
The banks shall not extend their co-acceptance to house bills/ accommodation bills drawn by
group concerns on one another.
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 office of
the accepting bank.
When the value of total bills discounted/purchased (which have been co-accpeted by other
banks) exceed Rs.20 lakh for a single borrower/ group of borrowers prior approval of the Head
Office of the co-accepting bank shall be obtained by the discounting bank in writing.
Banks are precluded from co-accepting bills drawn under Buyer's Line of Credit schemes of
financial institutions like IDBI, SIDBI, and PFC etc. Similarly banks should not co-accept bills
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drawn by NBFCs. Further, banks should not extend co-acceptance on behalf of their
buyers/constituents under the SIDBI scheme.
However, banks may co-accept bills drawn, under Seller's Line of Credit schemes for Bill
Discounting operated by the financial institutions like IDBI, SIDBI, and PFC etc. without any limit
subject to buyer's capacity to pay and the compliance with exposure norms applicable to the
borrower.
Where banks open L/C and also co-accept bills drawn under such L/C, the discounting banks,
before discounting such co-accepted bills, must ascertain the reason for co-acceptance of bills
and satisfy themselves about the genuineness of the transaction.
Co-acceptance facilities will normally not be sanctioned to customers enjoying credit limit with
other banks.
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LETTER OF CREDIT (LC)
5.1 INTODUCTION
5.3 MEANING
5.6 TERMINOLOGY
• With open account, the parties may depend on long experience of each other. They may each
have checked the other with a credit agency. The exporter may have insurance against bad
debts. Certainly he will have confidence in the quality of his contract and the impartial
competence of the local courts. Goods and services are regularly traded in this manner in North
America, Western Europe and parts of the Far East. National barriers are not seen as legal
barriers.
• Advanced Payments are less common, but are used in the contracting and heavy engineering
industries, where substantial work is required and goods are tailor made. If a buyer cancels a
contract, it should not be too much of a problem for a supplier of bricks to find an alternative
sale. But manufacturers of power stations tend to build to order. In these cases, the seller often
has to request his bank to issue an advance payment guarantee in favor of the buyer to secure
an advance payment. This is a simple document wherein a bank undertakes to pay the money
advanced back to the buyer if he states that the seller has failed to deliver.
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Both these techniques assume that each party is not worried that the goods are within the
control of the party that has been paid (or part paid). If they wish to ensure that control over
the goods is not transferred until they are paid for, they can agree to a documentary collection.
5.3 MEANING
Article 2 of UCPDC defines a letter of credit as under:
The expressions "documentary credit(s) and standby letter(s) of credit used herein (hereinafter
referred to as "credit(s)" means any arrangement, however, named or described whereby a
bank (the issuing bank), acting at the request and on the instructions of a customer (the
applicant of the credit) or on its own behalf.
Or
- Authorises another bank to effect such payment, or to accept and pay such bills
of exchange (Draft(s)),
Or
For the above purpose the branches of a bank in different countries are considered another
bank.
Letter of credit is a written undertaking by a bank (issuing bank) given to the seller (beneficiary)
at the request and in accordance with the instructions of buyer (applicant) to effect payment of
a stated amount within a prescribed time limit and against stipulated documents provided all
the terms and conditions of the credit are complied with".
Letters of credit thus offers both parties to a trade transaction a degree of security. The seller
can look forward to the issuing bank for payment instead of relying on the ability and
willingness of the buyer to pay. He is further assured of payment being received on due date
enabling him to have proper financial planning. The only condition being attached is submission
of stipulated documents and compliance with the terms and conditions of credit. The buyer on
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the other hand will be obliged to pay only after receipt of documents of title to goods to his
satisfaction.
Letter of credit is an independent document in itself as provided vide article 3 of UCPDC which
states that: "Credits, by their nature, are separate transactions from the sales or other
contract(s) on which they may be based and banks are in no way concerned with or bound by
such contract(s), even if any reference whatsoever to such contract(s) is included in the credit."
This article is very important and has a direct bearing on the relationship of the opener with
bank. Many disputes have arisen due to the reference of sale contract in the letter of credit.
The letter of credit is issued in accordance with the instructions of the applicant who should
provide complete and precise instructions to the bank to avoid any dispute later. The
undertaking of a bank to pay, accept and pay drafts or negotiate and/or to fulfil any other
obligations under the credit is not subject to claims or defences by the Applicant resulting from
his relationship with the issuing Bank or the Beneficiary.
Another very important provision which is very vital to letter of credit operations is regarding
disputes emanating from the quality/quantity of goods covered under a letter of credit. Article
4 of UCPDC states:
"In credit operations all parties concerned deal with documents, and not with cods, services
and/or other performances to which the documents may relate.
An important point which emerges from the above article is that any dispute regarding the
quality/quantity of the goods may have to be settled outside the terms of letter of credit. Letter
of credit thus provides no protection on this account and the applicant must specify submission
of necessary weight certificate/quality analysis certificates etc. as considered necessary to
satisfy himself regarding the goods on the basis of these documents alone.
Confirming Bank. A letter of credit substitutes the credit worthiness of the buyer with that of the issuing
bank. It may sometimes happen especially in import trade that the issuing bank itself is not widely
known in the exporter's country and exporter is not prepared to rely on the L/C opened by that bank. In
such cases the opening bank may request other bank usually in the country of exporter to add its
confirmation which amounts to an additional undertaking being given by that bank to the beneficiary.
The bank adding its confirmation is known as confirming bank. The confirming bank has the same
liabilities towards the beneficiary as that of opening bank.
Negotiating Bank. The bank who negotiates the documents drawn under letter of credit and makes
payment to beneficiary.
The function of advising bank, confirming bank and negotiating bank may be undertaken by a single
bank only.
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5.4 Parties involved in an LC Letter of Credit - LC
The major parties involved in a letter of credit are discussed below. We can classify mainly eight
main parties involved in a Letter of Credit.
Beneficiary is one of the main parties under letter of credit. Beneficiary of Letter of
credit gets the benefit under Letter of credit. Beneficiary is the party under letter of
credit who receives amount under letter of credit. The LC is opened on Beneficiary
party’s favor. Beneficiary party under letter of credit submits all required documents
with is bank in accordance with the terms and conditions under LC.
Advising bank is another party involved under LC. Advising bank, as a part of letter of
credit takes responsibility to communicate with necessary parties under letter of
credit and other required authorities. The advising bank is the party who sends
documents under Letter of Credit to opening bank.
Confirming bank is one of the other parties involved in Letter of Credit. Confirming
bank as a party of letter of credit confirms and guarantee to undertake the
responsibility of payment or negotiation acceptance under the credit.
Reimbursing Bank is one of the parties involved in an LC. Reimbursing bank is the
party who authorized to honor the reimbursement claim of negotiation/ payment/
acceptance.
The complete mechanism of a letter of credit may be divided in three parts as under:
1. Issuing of Credit. Letter of credit is always issued by the buyer's bank (issuing bank) at
the request and on behalf and in accordance with the instructions of the applicant. The
letter of credit may either be advised directly or through some other bank. The advising
bank is responsible for transmission of credit and verifying the authenticity of signature
of issuing bank and is under no commitment to pay the seller.
The advising bank may also be required to add confirmation and in that case will assume
all the liabilities of issuing bank in relation to the beneficiary as stated already. Refer to
diagram given below for complete process of issuance of credit.
Sales Contract
Buyer Applicant Sales Beneficiary
(1)
Issuance of Credit
Buyer’s Bank
Advising Bank
Issuing Bank
Confirming Bank
(3)
NON-FUND BASED
Supply of Goods
Buyer Seller
Payment to
Beneficiary (7) Documents of
Negotiation (6)
Reimbursement (9)
3. Settlement of Bills Drawn under Letter of Credit by the opener. The last step
involved in letter of credit mechanism is retirement of documents received under L/C by
the opener,
On receipt of documents drawn under L/C, the opening bank is required to closely
examine the documents to ensure compliance of the terms and conditions of credit and
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present the same to the opener for his scrutiny. The opener should then make payment
to the opening bank and take delivery of documents so that delivery of goods can be
obtained by him. This aspect of L/C transaction is represented as under:
(5)
Buyer Seller
(1)
Applicant Beneficiary
Payment
(11) (2) (10) (7) (4) (6)
(8)
Advising / Confirming
Buyer Bank
(3)
Issuing Bank Negotiating Bank
It may, however, be mentioned here that every letter of credit must clearly indicate
whether it is revocable or irrevocable. In the absence of such indication the credit shall
be deemed to be irrevocable. The beneficiary, on receipt of credit, must therefore,
examine that the letter of credit is not indicated as revocable.
The letter of credit may provide drawing of documents either on D.P. basis in which case
the documents will be delivered against payment or on D.A. basis in which case the
documents will be delivered against acceptance. The letter of credit may also call either
for demand documents which are required to be paid on presentation or usance
documents the payment of which will be required to be made after an agreed period of
usance. All these will be required to be settled at the time of finalising the sale contract
and clear instructions to the bank in this regard will have to be given at the time of
opening of the letter of credit.
There are a few special types of credits in vogue offering a degree of' convenience in
operations. Brief details of these credits are given below:
Revolving Letter of Credit. The concept of revolving letter of credit is best illustrated
by the following example:
Let us presume that goods of the total value of Rs.60 lacs are required to be
purchased over a period of one year and requirement of those goods at a time is
proximately Rs.10 lacs. If the terms of payment are under L/C the buyer may have
two options as under:
(i) To open an L/C for Rs.60 lacs valid for 1 year and permit part shipment, or
(ii) To open letters of credit for Rs.10 lacs each on six different occasions.
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Option (i) not only requires very high limits from the bank but will result in high cost of
operations by way of commission charges. Option (ii) involves a lot inconvenience as the
L/C will be required to be opened six times.
To obviate such difficulties, a revolving L/C can be opened under which the amount of
L/C is renewed/reinstated after the original L/C amount has been utilised. Thus a
revolving L/C for Rs.10 lacs valid for one year may be opened the above example. After
negotiation and settlement of bills drawn under this C, the L/C amount may again be
reinstated by the bank. The amount reinstated such a manner will again become
available for negotiation.
The transfer of credit is, however, not to be confused with the right of assignment of
benefits to which the beneficiary may become entitled under a letter of credit. The
beneficiary is having right to assign the proceeds to which may be or may become
entitled under the provisions of applicable law even case of non-transferable credits.
These transferable credits are very much in vogue in export trade. The important points
to be noted while dealing with transferable credits are stated low:
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(i) The L/C should clearly indicate that it is transferable. In the absence of such
indication the L/C would be deemed to be not transferable.
(ii) The 1st beneficiary under a transferable L/C has a right to transfer in part or
whole to other parties (2nd beneficiaries). For this purpose he has to request the
advising bank to issue an advice of transfer to the 2nd beneficiary (ies). The
charges of the bank for effecting transfer are payable by the first beneficiary
unless otherwise stated.
(iii) The advice of transfer issued by the bank along with copy of the original credit
will be taken as a complete letter of credit for almost all practical purposes.
Back to Back letter of Credit. A letter of credit which is backed by other letter of credit is
termed as 'back to back' credit and is also used when middleman is involved in a sale
transaction. Such transaction offers additional security of the letter of credit to the bank
issuing back to back L/C. However, for successful completion of the entire transaction it
must be ensured that back to back L/C is opened on the worse terms as compared to the
terms under; the original letter of credit.
Red Clause Letter of Credit. All letters of credit as discussed above provide a sort of
guarantee of payment against documents which are drawn strictly in terms of subject letter
of credit. In other words the benefit of L/C accrues only when shipment of goods is
completed. Red Clause Letter of Credit goes a step further and authorises the advising bank
to grant an advance to the beneficiary at the pre-shipment stage itself. The advance by the
advising bank shall be recovered at the time of negotiation of documents under that L/C. In
case, however, no shipment is effected by the beneficiary and he fails to present documents
under L/C, the bank making advance under red-clause letter of credit will claim
reimbursement of advance made from the issuing bank
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5.6. TERMININOLOGY
The English name “letter of credit” derives from the French word “accredit if”, a power to do
something, which in turn is derivative of the Latin word “accreditivus”, and meaning trust. This
in effect reflects the modern understanding of the instrument. When a seller agrees to be paid
by means of a letter of credit s/he is looking at a reliable bank that has an obligation to pay
them the amount stipulated in the credit notwithstanding any defense relating to the
underlying contract of sale. This is as long as the seller performs their duties to an extent that
meets the credit terms.
It has the initial responsibility of ensuring that the applicant is both creditworthy. The latter
consideration is important to all parties to a trade transaction, as so much depends on trust.
Fraud is the constant companion of trade finance.
It has a duty of care and information. As mentioned above, banks see more trade transactions
than their customers and can advise on methods and warn of dangers.
Then, once a credit is opened, the bank is placing itself as a substitute for the buyer (applicant)
and must pay if the conditions of the credit are fulfilled.
The advising bank has the obligation of authenticating the credit once it has received it and
passing it promptly on to the beneficiary (UCP article 7). It also has the responsibility of
authenticating and advising all amendments.
The confirming bank takes over the payment responsibilities of the issuing bank as far as the
beneficiary is concerned, although it still has the obligation of the issuing bank for ultimate
reimbursement.
Whichever bank has responsibility for deciding whether documents are in order and should be
either paid (if sight) or taken up (if usance), takes on a heavy set of obligations, which are dealt
with at length in UCP article.
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5.8 STANDARD FORM OF DUCUMENTATION
When making a payment for a product on behalf of the customer, the issuing bank must verify
all the documents and drafts confirm precisely tot the terms and conditions of the letter of
credit. Although the credit can require an array of documents, the most common documents
that must accompany the draft include:
(i) Commercial Invoice is a bill for the goods shipped to the buyer. It is the
accounting document for seller’s claim on the buyer for goods sold to the buyer.
Commercial Invoice would normally contain the following information:
- Every seller, by the mere act of selling, makes a warranty that the seller’s title is
good and that the transfer is lawful as to passage of title. A warranty of title may be
specifically excluded, or the circumstances may be such as to prevent the warranty
from arising. The latter situation is found when the buyer has reason to know that
the seller does not claim to hold the title or that the seller is purporting to sell only
such right or title as the seller or a third person may have. For example, no warranty
of title arises when the seller makes the sale in a representative capacity, such as a
sheriff, an auctioneer, or an administrator of a decedent’s estate.
- It is a document which the shipper indemnifies the shipping company against the
implications of claims that may arise from the issue of a clean Bill of Lading when the
goods were not loaded in accordance with the description in the Bill of Lading.
- There are two different letters of indemnity: letters of indemnity for quantitative
clauses and letters of indemnity for non-quantitative clauses. When the Bill of Lading
forms the basis of a documentary credit, the bank demands a clean Bill of Lading.
This is a Bill of Lading without reservations by the captain.
- If for one reason or another, the goods were not loaded as prescribed, the captain
may want to put reservations on the Bill of Lading. By doing so, the Bill of Lading is
no longer clean and the bank will not give documentary credit. In order to remedy
this, it is custom to put the reservations not on the Bill of Lading, but on the mates
receipt and to draw up a letter of indemnity which the shipper indemnifies the
captain (the shipping company) against the potential implications thereof.
Imagine that a business called the Acme Electronics from time to time imports computers from
a business called Bangalore Computers, which banks with the India Business Bank. Acme holds
an account at the Commonwealth Financials. Acme wants to buy $500,000 worth of
merchandise from Bangalore Computers, who agree to sell the goods and give Acme 60 days to
pay for them, on the condition that they are provided with a 90-day LC for the full amount. The
steps to get the letter of credit would be as follows:
• Acme goes to The Commonwealth Financials and requests a $500,000 letter of credit,
with Bangalore Computers as the beneficiary.
• The Commonwealth Financials can issue an LC either on approval of a standard loan
underwriting process or by Acme funding it directly with a deposit of $500,000 plus fees
between 1% and 8%.
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The Commonwealth Financials sends a copy of the LC to the India Business Bank, which
notifies the Bangalore Computers that payment is ready and they can ship the
merchandise Acme has ordered with the full assurance of payment to them.
On presentation of the stipulated documents in the letter of credit and compliance with
the terms and conditions of the letter of credit, the Commonwealth Financials transfers
the $500,000 to the India Business Bank, which then credits the account to the
Bangalore Computers by that amount.
• Note that banks deal only with documents under the letter of credit and not the
underlying transaction.
• Many exporters have misunderstood that the payment is guaranteed after
• Receiving the LC. The issuing bank is obligated to pay under the letter of credit only
when the stipulated documents are presented and the terms and conditions of the
letter of credit have been met accordingly.
• Although a commercial letter of credit transfers the credit from the importer to the
issuing bank, there is still a chance that even the issuing bank is unable to make the
payment. So, the exporter can seek additional protection by getting a confirmed letter
of credit where the advising bank also insures the payment. It will add to the cost of
doing business for the exporter.
• The exporter may need cash before the payment date as per the deferred payment
clause. In this case, the advising bank can pay the agreed amount to the exporter after
deducting a discounting fee before the actual payment is made by the importer. Such an
arrangement is called discounting the letter of credit.
2. No blocking of funds:
- The exporter gets immediate payments from the bank when he submits full set of
negotiable documents to the bank. If the documents are drawn as per the terms of
letter of credit the bank pays the exporter full. Therefore, the exporter does not
have to block his funds.
5. No Bad debts
- As the payment of guaranteed by the opening bank, the exporter is from the
problem of bad debt. In case the exporter holds a confirm letter of credit, there is
double guarantee by the opening bank and confirming bank.
6. Certainty of payments:
- The importer cannot refuse to take possession of the goods and to clear the
payment when the terms of payment is letter of credit. This problem of non-
possession and non-payment may arise in case of D/P and D/A.
- While accepting a letter of credit, the exporter guarantees to meet the requirements
of buyer as mutually agreed as per the terms and conditions mentioned in letter of
credit. So the liability of meeting all required parameters are with supplier failing
which bank may not accept documents under such transaction. Bank may debit
certain charges against the discrepancy of documents also if proper documentary
proof has not been submitted along with other shipping documents. So, if the
exporter does not follow strictly with the terms and conditions of letter of credit
with 100% compliance of documentation, the payment will not be effected by bank.
- Under letter of credit opening procedures, there are certain bank charges and other
costs. If buyer insists seller to pay such costs, the said charges will be additional
expenses for the supplier.
- If exporter is aware that the credit worthiness of buyer is favorable and sound, he
does not need to open a letter of credit to transact with such buyers. However, he
agrees on opening LC based on the requirements of buyer to enjoy the advantage of
opening LC by buyer. In such cases, meeting of all terms and conditions under letter
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of credit is the major responsibility of exporter. Apart from meeting additional
documentation procedures, exporter needs to spend additional expenses also.
- As I have mentioned in other articles in the same website, an exporter must verify
the authenticity of opening bank. The Letter of Credit opening bank should be a
prime banker. I have experienced many cases of fraudulent LC opening bank who
were not a prime banker who does not have proper ‘stand’ to follow the guidelines
of uniform customs and practice of documentary credit. So the strength and stability
of LC issuing bank is a prime factor while discussing about the demerits of Letter of
Credit.
- Policy of a country may affect the business transaction between countries. If a cold
ware is being continued between two countries, due to political reason, the trade
bilateral agreement between such countries may become void, resulting to effect
the guidelines of uniform customs and practice of documentary credit. This is
another demerit of LC for a seller.
- A best caliber of personnel is required to monitor and navigate the process of letter
of credit to provide no room for even minute discrepancy of documents.
- Compared to other modes of payment, the expenses for opening, negotiating and
other procedures of letter of credit is high. This is another disadvantage of Letter of
credit for an exporter. This is another disadvantage of letter of credit for an
exporter.
- Currency fluctuation is another disadvantage of Letter of credit. Normally
buyer/importer places purchase orders once in a year and opens letter of credit
accordingly. The exchange rate may differ at the time of shipping goods, from the
time of opening LC. The exporter receives payment after shipment. So, if any loss
due to fluctuations in foreign currency contracted under letter of credit, need to be
beard by him. This is also one of the major demerits of LC.
- Currency fluctuations may also effect on price variation to procure raw materials for
the buyer/exporter, resulting hike of cost of production in turn the exporter/seller
cannot hike the selling price, as the purchase order agreement already signed by
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accepting letter of credit for whole shipments under one LC. So currency fluctuation
also is a threat under letter of credit which is treated as other disadvantages of
letter of credit.
- While accepting a LC, the supplier guarantees to meet the terms and conditions of
letter of credit with documentary proof. This is one of the major advantages of LC to
an importer/buyer. This assurance provides security to buyer for future business
plan.
- Since buyer is the holder of Letter of credit, Bank acts on behalf of buyer. Opening
bank remits amount only after satisfaction of all terms and conditions of letter of
credit with documentary proof. This arrangement protects importer and minimize
time, as bank acts on behalf of him.
- A letter of credit transaction reduces the risk of non-performance by the supplier, as
the supplier prefers LC than other transactions due to various reasons which protect
him than the buyer. This is an advantage for the buyer on fulfillment of meeting
commitments on shipments.
- Another advantage of letter of credit to a buyer/importer is that the exporter/seller
receives payment of exported goods only after shipment and meeting of all
necessary requirements under LC terms and conditions with presentation of
documentary proof including evidence of shipment.
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- Unlike other shipments, a shipment under Letter of credit is treated with most care
to meet delivery schedule and other required parameters by the exporter. The
documents receive by buyer promptly and quickly with complete sets. Unless
meeting delivery schedule and prompt documentation, the supplier does not get his
payment from opening bank. This is one of the major advantages of LC for an
importer is concerned.
- An importer/buyer is concerned; he can plan his payment schedule properly by
anticipating the requirements under letter of credit. This arrangement makes
importer for easier planning.
- Based on timely delivery schedule, buyer receives goods on time thereby he can
execute his business plan smoothly and efficiently, in turn satisfying his clients
promptly and effectively.
- One of the major disadvantages of letter of credit is that LC is operated on the basis
of documentation and not on the basis of physical verification of goods on
its quality, quantity or other parameters. In other words, an LC issuing bank can
effect payment to beneficiary of LC on the basis of documentation produced as per
the terms and conditions of letter of credit. The parties under letter of credit do not
have any right to physically verify the contents of goods. So, if the buyer needs to
confirm and satisfy on the quality of goods he buys, he can appoint an inspection
agency of international repute and instruct exporter to enclose certificate of such
inspection by mentioning a condition in letter of credit.
- Once opened a confirmed and irrevocable letter of credit, the importer/buyer
already tied up with the said business credit line and cannot change in between. Due
to various reasons, especially on selling price variation, if buyer needs to stop his
export order he cannot do so.
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The following points may help exporters avoid the misunderstandings and discrepancies that
can disrupt trade transactions. When examining your letter of credit and preparing
documentation, verify the following:
1. is the letter of credit irrevocable? Remember, an irrevocable L/C can only be canceled once
your consent is received.
2. What bank has committed itself to pay? As the beneficiary, are you satisfied that this bank
can pay? If not, then you may wish to request the importer to have letter of credit confirmed by
a major bank.
3. Is your name and address, and that of your buyer, spelled correctly on all documents?
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4. Is the amount of the credit sufficient to cover the shipment? Here, you should take into
consideration factors that depend on the terms of the sale, such as Ex Works, or FOB . . . is
there any inland freight or agent’s charges?
5. Is there sufficient tolerance allowed on the quantity to be shipped? If you are not sure of the
exact amount, you may want to amend the L/C to state about or approximately (10% more or
less) immediately before the amount and quantity.
6. Does the letter of credit describe the merchandise correctly? Remember, the way it is
described on the L/C dictates the way it must be described on all documents presented for
negotiation.
8. Does the place of destination quoted by you agree with the L/C?
9. Do the expiration and shipping dates give sufficient time to effect shipment and assure
payment?
12. If the letter of credit stipulates shipment to be effected on a named vessel or vessels of a
named steamship company, can you comply with this requirement?
15. Can you obtain properly executed shipping, consular, and other documents to conform to
the letter of credit terms?
The following outlines some of the terms and conditions called for in a Letter of Credit, and
what they mean to you, the exporter.
1. Beneficiary: this is the name and address of the exporter. Check for correctness in the
spelling, address, etc.
2. Currency & Amount: indicates the total amount that can be drawn under the Letter of Credit.
The words “about”, “approximately” or “circa” before an amount indicates the amount may
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vary up to +/ - 10%. Other variances may also have been used, i.e. amount and quantity - +/-
5%.
3. Partial shipments – if not allowed, you must ship all goods in one shipment.
5. Transferable Credit: if allowed, provides the exporter with the flexibility to “transfer” a
portion or all of the Letter of Credit to a third party (generally a supplier of goods). More on
transferable Letters of Credit later.
8. Latest date of shipment: the goods must have been shipped by this date as evidence by
shipping documents.
9. Presentation period: number of days after date of shipment, within which the exporter must
present documents to the appropriate bank counters, but within the validity of the Letter of
Credit. If not specified, 21 days.
11. Banking Charges: as specified in the L/C. Generally each party pays for the banking charges
incurred in their own country.
- A Bank guarantee is a promise from a bank that the liabilities of a debtor will be met
in the event that you fail to fulfill your contractual obligations. ICICI Bank's Bank
Guarantees. Honor payment to your beneficiaries upon receipt of a claim
- A bank guarantee is a guarantee from a lending institution ensuring the liabilities of
a debtor will be met. In other words, if the debtor fails to settle a debt, the bank
covers it. A bank guarantee enables the customer, or debtor, to acquire goods, buy
equipment or draw down loans, and thereby expand business activity.
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A Bank Guarantee and a Letter of Credit are similar in many ways but they're two different
things. The main difference between the two credit security instruments is the position of the
bank relative to the buyer and seller of a good, service or basket of goods or services in the
event of the buyer's default of payment. These financial instruments are often used in Trade
financing when suppliers, or vendors, are purchasing and selling goods to and from overseas
customers with whom they don't have established business relationships.
The initial claim is still settled primarily against the bank's client, and not the bank itself. Should
the client default, then the bank agrees in the bank guarantee to pay for its client's debts. This
is a type of contingent guarantee. A bank guarantee is more risky for the merchant and less
risky for the bank. But this is not the case with a letter of credit.
While a letter of credit is a similar, the principal difference is that it is a potential claim against
the bank, rather than a bank's client. For example, a seller may request that a buyer be
provided with a letter of credit, which must be obtained from a bank and which substitutes the
bank's credit for that of its client. In the event that the borrower defaults, the seller would go
the buyer's bank for the payment.
The seller's risk is mitigated because it is unlikely that the bank will be unable to pay the debt. A
letter of credit is less risky for the merchant, but more risky for a bank.
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Banks accept full liability in both cases. With a bank guarantee, a client can default and the
bank assumes the liability. With a line of credit, liability rests solely with the bank, which then
collects the money from its client.
A bank guarantee, like a line of credit, guarantees a sum of money to a beneficiary. Unlike a line
of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations
under the contract. This can be used to essentially insure a buyer or seller from loss or damage
due to non-performance by the other party in a contract.
For example a letter of credit could be used in the delivery of goods or the completion of a
service. The seller may request that the buyer obtain a letter of credit before the transaction
occurs. The buyer would purchase this letter of credit from a bank and forward it to the seller's
bank. This letter would substitute the bank's credit for that of its client, ensuring correct and
timely payment.
A bank guarantee might be used when a buyer obtains goods from a seller then runs into cash
flow difficulties and can't pay the seller. The bank guarantee would pay an agreed-upon sum to
the seller. Similarly, if the supplier was unable to provide the goods, the bank would then pay
the purchaser the agreed-upon sum. Essentially, the bank guarantee acts as a safety measure
for the opposing party in the transaction
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Financial (Money) guarantee is of the nature where it is issued in-lieu of cash like Earnest
Money Deposit. The idea is not to lock cash in EMD and issue a guarantee. Performance
guarantee is of the nature where performance is guaranteed. Let us say a contract is completed
and the principal is holding a part of the payment for 6 months till the performance of the
goods supplied is judged. In such cases, the principal released the money by accepting a
guarantee.
Food Corporation of India (FCI), for example, usually stocks of paddy to the rice mills,
registered with them, so that they may process the paddy and return the rice to FCI. But, as
the stocks of paddy of high value, are generally issued, FCI may insist that some security
money, (to the extent of say, 10% or 20%of the value of the paddy, to be supplied at any
one time, from time to time), could be deposited with FCI, such that the party may give
back the rice of the required value, and any shortage could be recovered from such security
deposits. But, making such a huge deposit even by way of Bank's Term Deposit Receipts
(TDRs) may not be as easy or gainful for the companies. They may, therefore, approach
their bankers and apply for the issuance of a Bank Guarantee for the amount, instead of
depositing the cash or the TDR, as the security deposit.
Some companies insist on advance payment in cash or by way of a bank draft, towards the
cost of the goods to be supplied. For example, in early 1970s, TISCO did insist on advance
payment, of the full amount involved, in cash or by way of a bank draft. These will naturally,
mean loss of interest on the amount so paid in advance
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Performance Guarantees.
- This is a payment guarantee issued to your exporter for deferred or time payment of
the goods, and corresponding interest. ICBC undertakes to pay your exporter in the
event you are unable to pay the principal and interest as scheduled in the contract.
- Comparing to payment guarantee, this service can delay payment and increase the
payment frequency.
- Once the contract your company signed with the exporter enters into force
- Deferred Payment Guarantee is a guarantee for a payment which has been deferred
or postponed.
- The necessity to issue deferred payment guarantee arises in case of purchase of
capital goods like machinery. Deferred Payment Guarantee is issued by the bank at
request of customer when he purchases goods or machineries from a creditor on the
terms of payment after a specified time in lump sum or in instalments. The creditor
requires such deferred payment terms to be guaranteed by the bankers of the
principal debtor.
- In such guarantees, the banks are undertaking to pay the installments due under
the deferred payment schedule. Unlike all other Guarantees here the payment will
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have to be made by the bank on the accepted due dates and thereafter the
installment is recovered.
- Reserve Bank of India issues guideline from time to time to safe guard banks’
interest. Guideline issued by RBI regarding Deferred Payment Guarantee is as
under:-
- (i) Banks, which intend to issue deferred payment guarantees on behalf of their
borrowers for acquisition of capital assets should ensure that the total credit
facilities including the proposed deferred payment guarantees do not exceed the
prescribed exposure ceilings
- (ii) The proposals for deferred payment guarantees should be examined having
regard to the profitability / cash flows of the project to ensure that sufficient
surpluses are generated by the borrowing unit to meet the commitments as a bank
has to meet the liability at regular intervals in respect of the instalments due. The
criteria generally followed for appraising a term loan proposal for acquisition of
capital assets should also be applied while issuing deferred payment guarantees.
Statutory Guarantees
- These guarantees are issued by banks favoring courts and other statutory authorities
guaranteeing that the customers will honor his commitments imposed upon him
under the law, failing which the bank will compensate to the extent of the amount
guaranteed. These are usually given in the form of bonds and format of these
guarantees are usually drawn by the courts or the concerned authority or are
already prescribed by the statute as per which the guarantee is required.
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GUIDELINES (GENERAL)
• Bank Guarantees (BG) comprise both performance guarantees (PG) and financial guarantees
(FG) and are structured according to the terms of agreement viz., security, maturity and
purpose.
• Banks should confine themselves to the provision of FG and exercise due caution with regard to
PG business.
• As a General Rule, bank guarantees shorter maturities and leave longer maturities to be
guaranteed by other financial institutions.
• Bank guarantees should not normally extend beyond 10 years. Banks may issue guarantees (BG)
for periods beyond 10 years taking into account the impact of very long duration guarantees on
their Asset Liability Management and in tune with their policy on issuance of guarantees beyond
10 years as approved by the Board.
•
Other guidelines
• Banks’ Boards have been given the freedom to fix their own policies on their unsecured
exposures including unsecured guarantees.
• Unsecured exposure is where the realizable value of the tangible security, as assessed by
bank/approved valuers/RBI inspecting officers, is not more than 10% ab-initio, of the
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outstanding exposure (funded and non-funded exposure including underwriting and similar
commitments).
• The rights, licenses, authorizations, etc. are not reckoned as tangible security whereas annuities
under Build-operate-transfer (BOT) projects and toll collection rights where there exists
provision to compensate the project sponsor if a certain level of traffic is not achieved can be
treated as tangible security.
• Avoid giving unsecured guarantees in large amounts for medium and long-term periods and
such commitments to particular groups of customers and/or trades.
• For individual constituent, unsecured guarantees should be limited to a reasonable proportion
of the bank’s total unsecured guarantees and constituent’s equity. The BG exposure on behalf of
any individual constituent or group is subject to the prescribed exposure norms.
• Not to encourage parties to over-extend their commitments as the BG contains inherent risks.
• Banks can give deferred payment guarantees on an unsecured basis for modest amounts to first
class customers in exceptional cases.
• While issuing FGs, banks should satisfy about customer’s ability/capacity to reimburse the bank
in case it is required to honor the commitments under the FG.
• In case of PG, banks should exercise due caution and 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.
• Banks should refrain from issuing BGs on behalf of customers who do not enjoy credit facilities
with them other than customers of co-operative banks against counter guarantee of the co-op.
bank which have sound credit appraisal and monitoring systems as well as robust Know Your
Customer (KYC) regime.
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7 Coacceptance of Bills:
1. Limits for coacceptance of bills will be sanctioned by the banks after detailed
appraisal of Customer’s requirement is completed and the bank is fully satisfied about
the genuineness of the need of the customer. Further customers who enjoy other limits
with the bank should be extended such limits.
2. Only genuine trade bills shall be coaccepted and the banks should ensure that the
goods covered by bills coaccepted are actually received in the stock accounts of the
borrowers. The valuation of goods as mentioned in the accompanying invoice should be
verified to see that there is no overvaluation of stocks.
3. The banks shall not extend their coacceptance to house bills/ accommodation
bills drawn by group concerns on one another.
4. Before discounting/purchasing bills coaccepted by other banks for Rs.2 lakh and
above from a single party, the bank should obtain written confirmation of the
concerned controlling office of the accepting bank.
5. When the value of total bills discounted/purchased (which have been coaccpeted
by other banks) exceed Rs.20 lakh for a single borrower/ group of borrowers prior
approval of the Head Office of the coaccepting bank shall be obtained by the
discounting bank in writing.
6. Banks are precluded from coaccepting bills drawn under Buyer’s Line of Credit
schemes of financial institutions like IDBI, SIDBI, and PFC etc. Similarly banks should not
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coaccept bills drawn by NBFCs. Further, banks should not extend coacceptance on
behalf of their buyers/constituents under the SIDBI scheme.
7. However, banks may coaccept bills drawn, under Seller’s Line of Credit schemes
for Bill Discounting operated by the financial institutions like IDBI, SIDBI, PFC etc.
without any limit subject to buyer’s capacity to pay and the compliance with exposure
norms applicable to the borrower.
8. Where banks open L/C and also coaccept bills drawn under such L/C, the
discounting banks, before discounting such coaccepted bills, must ascertain the reason
for coacceptance of bills and satisfy themselves about the genuineness of the
transaction.
CONCLUSION:
A fund based credit facility to a borrower would result in depletion of actual liquidity of a
banker immediately whereas grant of non-fund based credit facilities to a borrower may or may
not affect the banker’s liquidity.
The borrowers need such facilities not only for purchases of current assets or financing there of
or take benefit of certain services with the help of non-fund based facilities. They also need the
facilities for acquisition of fixed assets including their financing.
The second shipping docs is discrepant, because the shipping documents that fully utilizes the
L/C amount is deemed to be the last one, so if it does not comply with the L/C terms and
conditions by indicating the second item of the required goods it can be rejected.
A bank guarantee operates by way of a contract or agreement in which the bank itself stands as
guarantor to a particular advance made by a creditor to a debtor, independent of the
underlying contract and the primary contract of the person at whose instance the bank
guarantee is given.
Since the liability under co-acceptance of bills remain in the bank’s book for a shorter period
compared to LC bills, there is an opportunities to the importer to rotate the facility more
frequently as and when the preceding outstanding is eliminated.
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The Bibliography:
Books:
Name of
Name of
Sr No the Year Title of the Books
Publisher
Author
Internet:
www.google.com
www.wikipedia.org
www.investopedia.com
www.rushabhinfosoft.com/Webpages
https://www.caclubindia.com/Articles
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