Unit 03

Topics:
Quasi Credit Facilities: Advantages of Non-Fund Facilities, Various types of NFB Facilities,
Various types Letter of Credits, Assessment of LC limits, Bills Purchase/ Discounting under LC.
Loan commitments, Un-funded lines of credit and their characteristics
Various types of Bank Guarantees: Performance Guarantee, Financial Guarantees, Deferred
Payment Guarantees, Types of Performance and Financial Guarantees, Assessment of Bank
Guarantees Limit, Period of Claim under Guarantee.

Quasi-credit facilities, also known as non-fund facilities, offer several advantages for both lenders and
borrowers:

1. **Flexibility**: Non-fund facilities provide borrowers with flexibility in terms of usage. Unlike traditional
credit facilities where funds are disbursed upfront, non-fund facilities allow borrowers to draw funds as needed,
giving them greater control over their cash flows.

2. **Cost-Effectiveness**: Since interest is only charged on the amount drawn down, non-fund facilities can
be more cost-effective for borrowers, especially if they don't require immediate access to a large sum of money.

3. **Risk Management**: Lenders can better manage their risk exposure with non-fund facilities. They can
offer credit lines without immediately exposing themselves to the risk of default, as funds are only disbursed
when the borrower actually uses them.

4. **Relationship Building**: Offering non-fund facilities can help lenders build stronger relationships with
their clients. By providing flexible financing options tailored to the specific needs of the borrower, lenders can
demonstrate their commitment to supporting the growth and success of their clients' businesses.

5. **Working Capital Management**: Non-fund facilities are particularly useful for managing working capital
needs. Businesses can use these facilities to bridge temporary gaps in cash flow, finance inventory purchases,
or cover short-term expenses without having to tie up their own capital.

6. **Reduced Administrative Burden**: Compared to traditional loan facilities, non-fund facilities often
involve less paperwork and administrative hassle. Once the facility is set up, borrowers can easily access funds
without going through the lengthy approval process required for each drawdown.

7. **Potential Tax Benefits**: Depending on the jurisdiction and the specific nature of the facility, there may
be potential tax benefits associated with non-fund facilities. For example, interest payments on certain types of
non-fund facilities may be tax-deductible for the borrower.
Overall, non-fund facilities offer a flexible and cost-effective financing solution for businesses, providing them
with access to the funds they need while allowing lenders to manage their risk exposure more effectively.

Non-fund based (NFB) facilities encompass a range of financial instruments that provide financing without
the actual disbursal of funds. Here are various types of NFB facilities commonly offered by financial
institutions:

1. **Letter of Credit (LC)**: A letter of credit is a guarantee issued by a bank on behalf of a buyer that ensures
payment to the seller for goods or services, provided the seller meets certain conditions outlined in the LC.

2. **Bank Guarantees (BG)**: Bank guarantees are promises by a bank to assume liability for the performance
of a particular obligation, typically issued in favor of a beneficiary in case of non-performance by the principal
party.

3. **Standby Letter of Credit (SBLC)**: Similar to an LC, a standby letter of credit serves as a guarantee of
payment to a beneficiary in case the applicant defaults on their obligations. SBLCs are often used in
international trade or construction contracts.

4. **Performance Guarantees**: Performance guarantees are issued by banks to ensure that a contractor or
supplier fulfills their contractual obligations. If the contractor fails to perform as per the contract terms, the
bank will compensate the beneficiary.

5. **Bid Bonds**: Bid bonds are issued by banks to guarantee that a bidder will honor their bid and enter into
a contract if awarded. If the bidder fails to do so, the bank pays compensation to the project owner.

6. **Advance Payment Guarantees**: These guarantees are issued to ensure repayment if the beneficiary fails
to fulfill its obligations after receiving an advance payment from the applicant.

7. **Retention Money Guarantees**: Retention money guarantees assure payment of retention money to the
contractor upon satisfactory completion of work as per the terms of the contract.

8. **Financial Guarantees**: Financial guarantees are provided to ensure the repayment of financial liabilities,
such as loans or bonds, in case the borrower defaults.

9. **Credit Enhancement Facilities**: These facilities are designed to improve the creditworthiness of a
borrower, often by providing a guarantee or collateral, thereby enabling them to access financing on better
terms.
10. **Credit Insurance**: While not directly provided by banks, credit insurance policies protect lenders against
the risk of non-payment by borrowers, providing coverage for losses resulting from default.

These NFB facilities play crucial roles in facilitating trade, mitigating risks, and supporting various business
activities by providing alternative forms of financial support beyond traditional loans and credit lines.
Various types of Letter of Credits

Letter of Credits (LCs) are widely used in international trade to facilitate transactions by providing a payment
guarantee between the buyer and seller. Here are various types of LCs commonly utilized:

1. **Commercial Letter of Credit**: This is the most common type of LC used in international trade. It serves
as a guarantee of payment from the buyer's bank to the seller upon presentation of compliant documents proving
the shipment of goods or completion of services.

2. **Standby Letter of Credit (SBLC)**: Unlike commercial LCs, SBLCs primarily serve as a secondary
payment mechanism. They act as a guarantee of payment to the beneficiary (seller) in case the applicant (buyer)
fails to fulfill their contractual obligations. SBLCs are often used in construction projects, lease agreements, or
to secure performance in financial transactions.

3. **Revocable Letter of Credit**: A revocable LC can be amended or canceled by the issuing bank without
prior notice to the beneficiary. However, revocable LCs are rarely used in international trade due to the
uncertainty they introduce for the beneficiary.

4. **Irrevocable Letter of Credit**: An irrevocable LC cannot be amended or canceled without the consent of
all parties involved, including the beneficiary. Irrevocable LCs provide more security for the seller, as they
guarantee payment as long as the seller meets the terms and conditions outlined in the LC.

5. **Confirmed Letter of Credit**: A confirmed LC involves a second bank (the confirming bank) adding its
confirmation to the LC, guaranteeing payment to the beneficiary even if the issuing bank defaults. Confirmed
LCs are often used when the seller is concerned about the creditworthiness of the buyer's bank or the political
or economic stability of the buyer's country.

6. **Transferable Letter of Credit**: A transferable LC allows the beneficiary to transfer all or part of the credit
to one or more secondary beneficiaries. Transferable LCs are commonly used when the intermediary party,
such as a trading company, does not have the financial capacity to fulfill the transaction themselves.

7. **Back-to-Back Letter of Credit**: In a back-to-back LC arrangement, the seller receives an LC from the
buyer and then uses it as collateral to obtain another LC to pay their own supplier. This arrangement is
commonly used in cases where the intermediary does not have the necessary funds or creditworthiness to
directly finance the transaction.
8. **Red Clause Letter of Credit**: A red clause LC includes a special clause allowing the seller to receive an
advance payment (known as a "red clause advance") from the issuing bank upon presentation of certain
documents, such as a shipping certificate. This advance is typically deducted from the final payment under the
LC.

Each type of LC has its own specific characteristics and is used in different situations depending on the needs
and preferences of the parties involved in the transaction.

Assessment of Letter of credit

Assessing Letter of Credit (LC) limits involves a thorough evaluation of various factors to determine the
appropriate level of credit exposure that a bank or financial institution is willing to extend to its customers.
Here's an overview of how LC limits are typically assessed:

1. **Creditworthiness of the Applicant**: The primary consideration is the creditworthiness of the applicant
(buyer), including their financial strength, payment history, and overall credit risk. Banks may analyze the
applicant's financial statements, credit reports, and payment behavior to assess their ability to fulfill their
obligations under the LC.

2. **Nature of the Transaction**: The type of transaction being financed through the LC is crucial. Factors
such as the industry involved, the countries of import and export, and the stability of the political and economic
environment can influence the risk associated with the transaction.

3. **Amount of the LC**: The proposed amount of the LC is an essential factor in determining the credit limit.
Banks may consider the size of the transaction relative to the applicant's financial capacity and the bank's risk
appetite.

4. **Collateral or Security**: Depending on the risk profile of the applicant and the transaction, banks may
require collateral or other forms of security to mitigate credit risk. Collateral could include cash deposits,
marketable securities, real estate, or guarantees from creditworthy third parties.

5. **Historical Relationship**: The history of the relationship between the bank and the applicant is relevant.
A long-standing relationship characterized by timely payments and responsible financial behavior may result
in a higher credit limit for the applicant.

6. **Industry and Market Analysis**: Banks may conduct industry and market analyses to assess the risks
associated with specific sectors or geographic regions. Factors such as market volatility, regulatory
environment, and competitive landscape can impact the credit risk of the transaction.

7. **Legal and Regulatory Considerations**: Banks must comply with legal and regulatory requirements when
extending credit facilities, including restrictions on exposure limits and prudential guidelines set by regulatory
authorities.
8. **Risk Management Policies**: Banks have internal risk management policies and procedures governing
the assessment and approval of credit limits. These policies outline the criteria for evaluating credit risk, setting
exposure limits, and monitoring credit exposures over time.

9. **Market Conditions**: External market conditions, such as interest rates, exchange rates, and liquidity
conditions, can influence the bank's assessment of credit risk and the overall risk appetite for extending credit
facilities.

10. **Documentation and Due Diligence**: Comprehensive documentation and due diligence are essential in
assessing LC limits. Banks require accurate and complete information about the applicant, the underlying
transaction, and any associated risks to make informed credit decisions.

By considering these factors in combination, banks can assess LC limits in a manner that balances the need to
support trade finance activities with prudent risk management practices.

Bills purchase or discounting under a Letter of Credit (LC) is a financing arrangement where the beneficiary
(seller/exporter) of the LC receives immediate cash payment from a bank or financial institution by selling or
discounting the LC proceeds. Here's how it typically works:

1. **Issuance of the LC**: The buyer (importer) arranges for the issuance of an LC in favor of the seller
(beneficiary) to guarantee payment for goods or services to be provided. The LC outlines the terms and
conditions under which payment will be made, including the documents required for payment.

2. **Presentation of Documents**: Upon shipment of the goods or completion of services, the seller presents
the required documents (such as invoices, bills of lading, certificates of origin) to the nominated bank (advising
bank or confirming bank) in accordance with the terms of the LC.

3. **Processing by the Bank**: The bank examines the documents presented by the seller to ensure they comply
with the requirements of the LC. If the documents are in order, the bank forwards them to the issuing bank
(buyer's bank) for payment or acceptance.

4. **Bills Purchase/Discounting**: Instead of waiting for payment under the LC's terms (which might involve
a deferred payment), the seller can choose to discount or sell the LC proceeds to a bank or financial institution.
The bank pays the seller the discounted value of the LC, deducting a fee or discount based on the time value of
money and the perceived credit risk.

5. **Transfer of Risk**: By discounting the LC proceeds, the seller transfers the credit risk associated with the
buyer to the bank or financial institution. The bank assumes responsibility for collecting payment from the
buyer upon maturity of the LC.
6. **Settlement**: The bank holds the documents as security and presents them to the issuing bank for payment
or acceptance at maturity. Upon payment or acceptance, the bank recoups the full value of the LC and any fees
or charges incurred from the seller.

Bills purchase or discounting under LC provides several benefits to the seller, including immediate access to
cash flow, improved liquidity, and mitigation of credit risk. However, it also involves costs in the form of
discount fees charged by the bank and potential risks associated with non-payment or non-acceptance by the
buyer. Therefore, sellers should carefully evaluate the terms and conditions of the LC and consider the cost-
benefit analysis before opting for bills purchase or discounting.

Loan commitments and unfunded lines of credit are financial arrangements provided by lenders to
borrowers, typically in the form of credit facilities. Here are their characteristics:

1. **Loan Commitments**:

- **Definition**: A loan commitment is a binding agreement between a lender and a borrower where the
lender commits to extend credit to the borrower up to a specified amount and under specific terms and
conditions.

- **Characteristics**:

- **Binding Agreement**: Once the loan commitment is made, the lender is legally obligated to provide the
agreed-upon credit facility to the borrower upon request, subject to the terms and conditions outlined in the
agreement.

- **Fixed Terms**: Loan commitments typically specify the terms of the credit facility, including the loan
amount, interest rate, repayment schedule, and any other conditions or covenants.

- **Drawdown Period**: The loan commitment may have a drawdown period during which the borrower
can access the funds. Once the drawdown period expires, the commitment may be terminated or extended,
depending on the agreement.

- **Fees and Charges**: Lenders may charge commitment fees to compensate for the risk and administrative
costs associated with providing the loan commitment, regardless of whether the borrower draws down the funds.

- **Usage Flexibility**: Borrowers have the flexibility to draw down funds as needed within the specified
limits and timeframe, allowing them to manage their cash flow and liquidity more effectively.
 - **Risk Management**: Loan commitments allow lenders to manage their credit exposure by providing a
predetermined framework for extending credit to borrowers while mitigating the risk of unexpected funding
requests.

Unfunded Lines of Credit

- **Definition**: An unfunded line of credit is a pre-approved credit facility extended by a lender to a

borrower, allowing the borrower to access funds up to a certain limit as needed. Unlike a loan commitment, an
unfunded line of credit does not involve an immediate disbursement of funds.

- **Characteristics**:

- **Pre-Approval**: The lender pre-approves a specific credit limit for the borrower, but no funds are
disbursed initially. The borrower can access funds as needed, up to the approved limit, by drawing checks,
making electronic transfers, or using a credit card linked to the line of credit.

- **Interest Accrual**: Interest is typically charged only on the amount of funds actually drawn down by
the borrower, not on the total approved limit. This provides flexibility and cost savings for the borrower.

- **Revolving Nature**: Unfunded lines of credit are often revolving facilities, meaning that as the borrower
repays the drawn funds, the credit becomes available for future use without the need for reapplication.

- **Collateral Requirements**: Depending on the creditworthiness of the borrower and the amount of the
line of credit, the lender may require collateral to secure the unfunded line of credit.

- **Risk Management**: From the lender's perspective, unfunded lines of credit allow for more efficient
risk management, as funds are only disbursed when the borrower actually needs them, reducing the lender's
exposure to credit risk.

- **Flexible Repayment**: Borrowers have the flexibility to repay the drawn funds on their own timeline,
subject to the terms and conditions of the line of credit agreement.

In summary, loan commitments and unfunded lines of credit provide borrowers with access to credit facilities
for managing their financial needs, with each option offering unique features and benefits tailored to the
borrower's requirements and preferences.
Bank Guarantees

Bank guarantees are financial instruments issued by banks to provide assurance or security for various types of
transactions.
1. **Performance Guarantee**:

- **Definition**: A performance guarantee, also known as a performance bond, is a type of bank guarantee
issued by a bank on behalf of a contractor or supplier to assure the counterparty (typically the project owner or
buyer) that the contractor or supplier will fulfill their contractual obligations according to the terms and
conditions of the contract.

- **Purpose**: Performance guarantees are commonly used in construction contracts, service agreements,
and other commercial arrangements to protect the interests of the counterparty in case the contractor fails to
perform as agreed.

- **Payment Trigger**: If the contractor fails to meet its obligations under the contract, the beneficiary of the
guarantee can make a claim on the bank for compensation, typically up to the amount specified in the guarantee.

2. **Financial Guarantees**:

- **Definition**: Financial guarantees are commitments made by a bank to ensure the repayment of financial
liabilities (such as loans, bonds, or other debt instruments) issued by a borrower.

- **Purpose**: Financial guarantees provide assurance to lenders or investors that they will receive payment
of principal and interest on the debt instrument in the event of default by the borrower.

- **Scope**: Financial guarantees can cover a wide range of financial obligations, including corporate loans,
project finance, municipal bonds, and trade finance transactions.

- **Risk Mitigation**: By providing a financial guarantee, the bank assumes the credit risk associated with
the underlying debt instrument, thereby enhancing the creditworthiness of the borrower and improving access
to financing at favorable terms.

3. **Deferred Payment Guarantees**:

- **Definition**: A deferred payment guarantee is a type of bank guarantee issued to a seller/exporter to

assure payment for goods or services sold on deferred payment terms to the buyer/importer.

- **Purpose**: Deferred payment guarantees help mitigate the credit risk for the seller by providing assurance
of payment at a future date, typically after a specified period of credit granted to the buyer.
 - **Payment Obligation**: If the buyer fails to make payment as per the agreed-upon terms, the beneficiary
of the guarantee (seller) can make a claim on the bank for payment, subject to the conditions specified in the
guarantee.

Each type of bank guarantee serves a specific purpose and provides financial protection or assurance to parties
involved in commercial transactions, lending, or investment activities. These guarantees play a crucial role in
facilitating trade, supporting project finance, and managing credit risk in the financial system.
Performance and financial guarantees are two broad categories of bank guarantees, each serving different
purposes within commercial transactions. Within these categories, various types of guarantees exist, tailored to
specific needs and circumstances. Here's a breakdown:

Performance Guarantees

1. **Bid Bond**: Provides assurance to a project owner that a bidder will honor their bid and enter into a
contract if awarded. If the bidder fails to do so, the bond compensates the project owner for the difference
between the bid amount and the next acceptable bid.

2. **Advance Payment Guarantee**: Assures the repayment of an advance payment made by the buyer to the
seller in a transaction. If the seller fails to fulfill its obligations, the guarantee ensures the repayment of the
advance payment to the buyer.

3. **Performance Bond**: Similar to bid bonds, these bonds ensure that the contractor or supplier performs the
contractual obligations outlined in a construction or service contract. If the contractor defaults, the bond
compensates the project owner for any losses incurred due to the non-performance.

4. **Retention Money Guarantee**: Ensures the repayment of retention money held by the project owner until
satisfactory completion of the project. If the contractor fails to meet contractual obligations, the guarantee
compensates the project owner for any losses.

Financial Guarantees

1. **Loan Guarantee**: Provides assurance to lenders that a borrower will fulfill its financial obligations under
a loan agreement. If the borrower defaults, the guarantee ensures repayment of the outstanding loan amount to
the lender.

2. **Debt Service Guarantee**: Guarantees repayment of principal and interest on debt securities issued by a
borrower. This type of guarantee enhances the creditworthiness of the issuer and may lower borrowing costs.

3. **Trade Finance Guarantee**: Assures payment to exporters or financial institutions for trade-related
transactions, such as letters of credit or trade finance facilities. This type of guarantee facilitates international
trade by mitigating risks associated with cross-border transactions.
4. **Payment Guarantees**: Ensures payment to beneficiaries in various financial transactions, such as lease
agreements, deferred payment arrangements, or installment sales contracts. If the buyer defaults, the guarantee
compensates the seller for the unpaid amount.

5. **Credit Enhancement Guarantees**: Enhances the credit quality of debt instruments, such as bonds or loans,
by providing a guarantee of repayment to investors or lenders. This type of guarantee may be issued by a
government agency or financial institution to support projects with lower credit ratings.

Assessing bank guarantees limit and understanding the period of claim under the guarantee involves a thorough
evaluation of various factors to ensure that the bank can meet its obligations effectively. Here's a breakdown:

Assessment of Bank Guarantees Limit

1. **Creditworthiness of the Applicant**: The bank assesses the creditworthiness of the applicant (usually the
beneficiary of the guarantee) to determine their ability to fulfill their obligations under the underlying
transaction. This includes reviewing financial statements, credit history, and overall financial stability.

2. **Nature and Terms of the Guarantee**: The bank evaluates the specific terms and conditions of the
guarantee, including the amount, purpose, duration, and any special provisions or requirements. Guarantees
with higher risks or longer durations may require more stringent assessment criteria.

3. **Collateral and Security**: Depending on the risk profile of the applicant and the amount of the guarantee,
the bank may require collateral or other forms of security to mitigate credit risk. Collateral could include cash
deposits, marketable securities, or guarantees from creditworthy third parties.

4. **Legal and Regulatory Requirements**: The bank ensures compliance with legal and regulatory
requirements governing the issuance of guarantees, including restrictions on exposure limits, capital adequacy,
and prudential guidelines set by regulatory authorities.

5. **Risk Management Policies**: The bank follows internal risk management policies and procedures
governing the assessment and approval of guarantees. These policies outline the criteria for evaluating credit
risk, setting exposure limits, and monitoring credit exposures over time.

Period of Claim under Guarantee

1. **Claim Conditions**: The period during which a claim can be made under the guarantee depends on the
specific conditions outlined in the guarantee agreement. This typically includes conditions related to the
occurrence of an event triggering the guarantee, such as non-performance or default by the applicant.
2. **Notification Requirements**: The beneficiary of the guarantee is usually required to notify the bank
promptly upon the occurrence of the triggering event. Failure to notify the bank within the specified timeframe
may affect the validity of the claim under the guarantee.

3. **Documentation and Verification**: The bank may require the beneficiary to submit documentary evidence
and supporting documentation to substantiate the claim under the guarantee. This could include invoices,
contracts, shipping documents, and other relevant information.

4. **Review and Approval Process**: Upon receipt of the claim, the bank conducts a review to assess its
validity and compliance with the terms of the guarantee. This may involve verification of the documents,
evaluation of the circumstances leading to the claim, and approval by authorized personnel.

5. **Payment or Settlement**: If the claim is found to be valid and meets the conditions of the guarantee, the
bank makes payment to the beneficiary according to the terms of the guarantee agreement. Payment may be
made in cash, through the issuance of a letter of credit, or by other means specified in the agreement.

Understanding the assessment process and the period of claim under the guarantee is essential for both the bank
and the beneficiary to ensure smooth and efficient handling of guarantee transactions while managing credit
risk effectively.