A Holistic Approach in Assessment of Non-fund Based Limits and it’s Precautionary Measures

In assessment of the working capital of a borrower, banks shall consider the two types of facilities i.e. Fund based and Non-fund Based facilities. Fund based facilities refer to the facilities for drawing cash and funds as per requirement of the concerned borrower. In other Non-fund based facilities given by the bank where actual funds are not involved. Through these facilities banks facilitate trade transactions by offering their commitment/promise/undertaking to pay in case the buyer (banks customer) fails to pay the seller and seller remains unpaid. The financial guarantee/ assurance is offered by banks to facilitate the trade transaction through a suitable instrument to cater to the needs of buyer and seller. Non-funded instruments are designed in such a way whereby the seller of the goods or services gets financial commitment by a solvent person like bank subject to the compliance of terms and conditions as mentioned in the related trade instrument.

Non fund based facilities are not sanctioned in isolation. For example, a customer wanting to import machine would be sanctioned a term loan and the LC will be opened to import the machinery. Alternatively, it could be a customer with working capital who will need to open an LC for importing some material. A guarantee will be given to a customer who is executing an order and is enjoying a working capital or term lending facilities. Given this non-fund facilities will, eventually get converted into term loan or working capital. In view of this non-fund facilities will call for almost equal level of credit appraisal. In addition to it there will be due diligence which is unique to the type of non-fund limit. The non-fund facilities are divided in to three broad categories as under:

• Letter of Credit
• Guarantees
• Co-acceptance of Bills

How the non-fund limits play a role in Business:

• Facilitates trade: domestic & international
• Helps in reducing fund based working capital requirement
• Helps seller to get immediate payment though credit extended by seller’s Bank
• Bank intermediates and earns income through commission

Letter of Credit: ( definition )

An arrangement by means of which a bank (issuing bank)acting at the request of a customer (applicant) undertakes to pay to a third party(beneficiary)an amount by a given pre determined date according to agreed terms and conditions against presentation of stipulated documents.

Factors influencing in Assessment Non-fund based limits:

• Means and standing of applicant; Known through by compiling net worth/ means report the prospective borrower
• What purpose the facility serves in business operation, Bank to understand business model of the borrower.
• Study on working capital cycle of the business
• Source of repayment (retire / honor facilities on due date)
• Amount of purchases under given facility such as amount raw purchase under letter of credit etc.
• Business turnover of the firm
• Assessments details & maximum expected outstanding
• Nature of goods: Marketability, Seasonality, Susceptibility to price changes
• Import duty on purchases
• Currency fluctuations/ risk
• Crystallization facilities on failure / default of the borrower

Assessment of Letter of Credit:

Working capital limit under letter of credit depends on how much of raw material procured under LC and time period required for completion of one LC transaction. Before knowing on time required for one LC transaction, we have to understand two terminologies i.e. Lead time and Usance period.

Lead time:

This is the time taken for supply of goods (to be purchased on LC basis) from the date of placing order till goods reaches to the customer. This period depends upon certain factors such as nature of product, demand and supply situation, distance between place of customer and of supplier, mode of transport i.e. by road, air, water etc. For example buyer place order to buy 100 units from it’s suppler x. The supplier x said, he required one month time to procure raw material to produce good and then required further 15 days time to transport goods. It means the total lead time in this case is 45 days (i.e. 30+15 days)

Usance Period:

This is the period of credit given by the supplier to make the payment for the goods supplied which depends upon the nature of business practice and mutual agreement of the customer and supplier. In other terms it is credit period extended by the supplier. This is done in case of DA LC (Documents against Acceptance) where documents are delivered to buyer to get goods delivered against acceptance that the payment shall be paid on due date. Unlike in case of DP LC (documents against Payment), no credit is extended by the supplier and documents (title to goods) delivered only after receipt of the payment.

As shown above example the customer is eligible for LC limit of Rs.100 lakhs. For instance no credit period is allowed by supplier i.e. usance period is zero as the case we saw in DP LC. The limit shall be arrived at Rs.37.50 Lakh considering time period of 1.50 month for one LC transaction and with eight LC transactions in a year.

Whenever limit assessed under MPFB (Maximum Permissible Bank Finance), it takes care entire working capital requirement of the borrower. In instance LC also meant for meeting working capital need (purchase of raw material), Bank to carve out the LC facility from the total limit arrived under MPBF and balance portion of the limit is extended in form of fund based exposure i.e. cash credit facility. Few cases the borrower may be request for with-in-which facility of fund based limit. Under such circumstance, limit are permitted after working out the eligibility under each head of facility and over all exposure shall be within MPFB.

While assessing the limits in larger borrower accounts where the requirement of LC is very huge running into crores, where Bank to ensure how the LC are honoured on due date and availabilityof cash flows are checked even by obtaining cash budget or increase the margin component upfront or step-up method so the bills are retired on due date with out resorting to devolvement of the LC.  In all cases of opening of letters of credit, the LC opening bank has to ensure that the customer is able to retire the bills drawn under LC as per the financial arrangement already finalised.

While extending LC for procuring the capital goods, Bank to ensure a proper term loan tie-up is made to retire the bills are due date.

Treatment to stock covered by Usance LC:

• Lien should be earmarked against advance value of stock for the outstanding usance LC bills.
• This ensure provisions of margin on the stock covered by usance LCs right from the time the stocks bought on credit backed by the Bank’s commitment.
• Thus it ensure that the margin is available well before the cash credit account is debited for the matured LC bills
• In some cases it is quite possible that the units may not be in a position to provide margin right from the time of purchase against LCs. In such cases, based on merits, earmarking of lien for the value of usance LC bills outstanding against the aggregate market value of all the securities (including the LC stocks) may be permitted instead of against the advance value of securities.

Devolvement of LC (precautions):

• The limits for demand LCs and usance LCs should be assessed separately with ample justifications.
• The usance period should not generally exceeds the product cycle.
• In case of bulk imports establishments of LCs for longer usance period may be considered selectively.
• When liability under LC is met by creating an irregular in the cash credit account. The relative LC limit should not be released for opening further LCs till the account is adjusted.
• In other words the liability should not be marked off in in LC liability registered within 15 days or if the LC devolved earlier is not adjusted, no further LCs should be opened without adequate margin

Scrutiny:

• Level of sundry creditors in the accepted projections in case of Usance LCs
• Compare with operating cycle
• Margin & security depending on track availability of funds
• Irregularity to be rectified before fresh LCs are opened
• Continuous devolvement is a warning signal

Bank Guarantee: (definition)

Bank Guarantee is the commitment given by the issuing Bank (Guarantor) to the beneficiary. If the claim is made by the beneficiary within the guarantee period and as per the terms and conditions of the Bank Guarantee, then the Bank should make the payment without fail and also without any delay.

Bank guarantees can be Inland (which are issued in favour of Beneficiary within the country) as well as Foreign (which are issued in favour of Beneficiary outside the country)

Necessity for Bank Guarantee:

• In lieu of security deposit/ earnest money deposits for participating in tender
• Mobilizing advance/ advance money before commencement of the project and for money to be received in various stages of project implementation.
• In respect of raw material supplies or for advances by the buyers
• In respect of due performance of specific contracts by the borrower and for obtaining full payment of the bills
• Performance guarantee for warranty period on completion of contract which would enable the suppliers to realize the proceeds without waiting for warrantee period to be over
• To allow unit to draw funds from time to time from the concerned indentors against part execution of contracts etc.

Appraisal of Bank Guarantee:

• Nature of the business
• Purpose – for genuine business requirement
• Need for BG –Related to normal trade/business
• Nature of Bank Guarantee – Financial / Performance
• Amount of BG – needs to be specific
• Applicant’s financial strength / capacity
• Past record in respect of BGs issued earlier
• Present outstanding on account of BGs already issued
• Margin
• Collateral security offered

Assessment of Bank Guarantee:

There are no prescribed norms for assessment of Bank Guarantee requirements, it should be need based.Need based assessment of Non-Fund Based facilities shall be done in the same fashion and care should be taken like Fund Based limits as these limits also have a financial implication. Requirement of Bank Guarantee (BG) limits by way of performance / EMD / Bid Bond etc. are supplementary support to business and the same should not be factored within the MPBF.

Assessment of limit in case of contractor is explained as under to have clear understanding.

If at all any existing exposure outstanding same to be added to limit assessed as above and Bank guarantees getting expired/ returned during the review period shall be deducted so that total Bank Guarantee eligibility could be assessed.

The above example is pertaining to contractor, who required regular Bank Guarantee limit to meet business requirement. Few cases the requirement of Bank guarantee is only supplementary to business such as Bank guarantee may require to obtain licenses, furnish to customers to get rebate on custom duty on achieving certain level of exports, to meet a disputed liability with sales tax/ customs/ court in such situations Bankers to sanctioned limit on need based.

In recent past availing Bank guarantee for procuring raw material from supplier has become regular trend under such circumstances Bankers to thorough study on business model of the business so that at any point of time there shall not be any double finance extended to borrower by way of Bank guarantee and fund based Cash credit as the bank guarantee is serves in get the raw material from their whole sale dealer to extend of the Bank guarantee furnished.

To meet long term requirement Bank may sanctioned Deferred Payment Guarantee (DPG) in lieu of term loan and same procedure followed as we are sanctioning a term loan.

Precautions:

• Should not be opened ended (auto renewal)
• Should stipulate maximum liability – crystallized liability on invocation
• Should not contain onerous clauses
• Ensure customer’s ability to reimburse – available margin/ collateral security
• Other Bank customer – ask why?
• Performance guarantee – assess capacity of customer, means to carry out contract, experience in line of activity
• Guarantee liability to have reasonable relation to equity of borrower
• Counter guarantee by authorized person

Invocation of Bank Guarantee:

• The Bank liability under BG is absolute and independent and exclusive of any other contract entered into by the applicant and beneficiary
• It is therefore obligation on the part of the Bank to pay to beneficiary without delay and demur the amount of BG on its invocation in accordance with the terms and conditions of the guarantee deeds
• It is not necessary for the beneficiary to satisfy the Bank about the default or the amount of actual loss suffered by him

Co-acceptance of Bills: (definition)

Facilities of co-acceptance of bills and deferred payment guarantees are generally required for acquiring plant and machinery technically. These are taken as a substitute of term loan which requires detailed appraisal of the borrower’s needs and financial position as required in a sanction of term loan proposal. The effect of such facility is that once the bank co-accepts the bill it becomes commitment of the bank guaranteeing payment to beneficiaries. So the banker needs to be very careful in granting such facilities as banks undertake to pay on co- accepted bills despite funds position of the clients. RBI guidelines being as under:

1. Detailed appraisal of the customer’s requirement be completed and the bank needs to fully satisfy about genuine ness of the need of the customer.
2. Genuine trade bill of bona fide transaction only should be co-accepted. House bill/accommodation bill drawn on good concerns needs to be abided.

• Co-acceptance facilities will normally not be sanctioned to the customers enjoying credit limit with other banks.

1. Before discounting/ purchasing bills co-accepted by other Bank, Bank should obtain written confirmation of the concern controlling office of accepting Bank.
2. Once the bill is co-accepted a non-fund liability entry needs to be recorded in the books of the bank engaging the customers’ liability for the transaction

Co-acceptance of Bills:

• To ensure that co-acceptance facility is given to only those customers enjoying other credit facilities with the Bank.
• Only genuine trade bills should be co-accepted and it is to be ensured that the borrower has received the stock represented by the bills.
• To ensure that goods represented by the bills are not over valued
• No accommodation bills should ever be co-accepted
• Proper records of bills co-accepted must be maintained by the branches and appropriate charges are collected from the borrower for bills co-accepted
• Proper periodical returns of the bills co-accepted are filed with controlling authorities

Assessment:

While extending facility under co-acceptance, Bank ensure whether it is meant for capital goods or to meet the working capital. Same precaution as enumerated above are taken so that at any point of time there shall not be any double finance. Limit under co-acceptance is depending on extend of bills co-accepted.