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There is a risk that the party might fail or refuse to fulfill his or her obligations that have been entered into whether at the local or international level. To reduce this risk bank guarantees are largely used worldwide as a reliable solution and to provide protection against the other financial losses that occur to the other party.
A guarantee from a bank whereby the bank makes a promise to fulfill the obligations of debtors if the debtor fails to fulfill it. Therefore, it is a kind of mechanism where a third party provides for compensation, does due diligence, and takes responsibility on behalf of the debtor.
Today, bank guarantees are a general part of the business environment and are required for various business transactions.
BANK GUARANTEE OVERVIEW
Bank guarantees are the contracts of guarantees which promise an amount of money to a beneficiary in case the applicant of bank guarantee is unable to meet his/her obligations as contracted. Their primary purpose is to ensure the buyer or seller from loss or damage that could happen because of the non-performance by the other party in a contract.
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TYPES OF BANK GUARANTEE
There are different types of Bank Guarantees which are discussed in the following paras and each one of the mentioned guarantees is used for a specific type of transaction:
- PERFORMANCE GUARANTEE
This type of guarantee is used as collateral in transactions that involve a buyer & a seller. It gets invoked in case the buyer incurs costs (buys from the market) because the seller did not or was unable to deliver goods or services as it was promised or contracted. To invoke a performance guarantee, the beneficiary is required to declare in writing that the seller did not fulfill his or her contractual obligations properly or on time.
A Performance Guarantee, in simple terms, is a promise by the contractor to fulfill the project that is being undertaken. To further explain this type of guarantee, it can be expressed as a document that legally confirms that the contractor will actually complete the contract that is being undertaken.
It could be issued by a bank or an insurance company to an employer on behalf of the contractor as a guarantee that the full and due performance of the works will be delivered by the contractor as per the agreement.
They increase or instill a sense of confidence in the employer that their projected deadlines will be met & the contracts will get complete within the specified time.
To explain in simple words, in case the contractor fails to complete the assigned work as per the specifications of the contract, the client will receive his/her guaranteed compensation for any monetary losses that will occur up to the performance bond’s contracted amount.
Benefits Performance guarantee: This type of guarantee provides confidence to the Employer/Principal that the contracting party will complete its work which makes them more attractive in the process of tendering.
- FINANCIAL GUARANTEE
An undertaking taken by a bank, termed as a guarantor, in which it takes responsibility for the financial obligation of another company i.e if the company fails (default in payment to lender or investor) to meet its responsibility or application the bank will compensate for the loss.
A bank usually provides this type of guarantee when two related parties are involved. Examples, holding companies and subsidiary companies.
These types of guarantees are generally provided by insurance companies to support large corporations in making payments to the lenders. This type of guarantee also increases the credit rating of the borrowing company.
We can understand this in simple language by taking an example. Suppose, LMN Ltd. has promised to back the loan given to Sure Ltd. (which is a subsidiary company of LMN Ltd.). In the given case, to back the loan given to Sure Ltd., LMN Ltd. Will be required to pledge some of its assets that can cover the whole that is given to Sure Ltd. as security for if the Sure Ltd. actually makes default in the repayment to final lender, then, the amount will be recovered from LMN Ltd.
Understanding Financial Guarantee
These guarantees are offered in the form of bonds which provide guarantees at the corporate level. These are sanctioned by a financial firm or an insurer.
In order to attract investors, many of the insurance firms are tailoring different financial products which can be utilized by the issues of debt.
Both interest and principal amounts that are to be paid by the borrower are guaranteed to investors or lenders.
This way, it provides a breather to the investors because they get surety that if the actual borrower makes the default, then the guarantor will repay the contractual liability of the borrower instead.
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DEFERRED PAYMENT GUARANTEE (DPG)
It is a guarantee which is usually used in case one party in a transaction has undertaken to pay a fixed amount at corresponding future dates. In cases where the debtor refuses to pay or becomes incapable to pay, then to claim the money the deferred payment guarantee is invoked.
In this kind of guarantee, the guarantor usually proposes to repay the guaranteed amount (installments) that has been deferred or postponed.
It is used for the purpose of purchasing goods of capital nature i.e machinery of heavy amounts and where the seller is offering credit to the buyer and the bank of buyer guarantees to pay the purchase price in case the buyer makes default.
This acceptance by the buyer’s bank is in the nature of co-acceptance, where, the guarantee is given for the due amount (the total consideration of the contract of sale/supply of machinery) as mentioned in the drafts (DPGs).
The seller of machinery can get Finance from his bank against these co-accepted bills. It’s not like other guarantees, instead of deferred payment guarantees, the bank makes a payment on duly accepted bills and after that, the installments are recovered from the borrower for which the guarantee has been made.
A proper procedure has been ascribed to assess the term loan to set the DPG limit. To assess DPG limit, projection under the operating statement, break-even point (BEP), DSCR, etc. are considered. The projections also examine the profitability as well as cash flows of the project so as to ensure that the borrower will generate enough funds to pay back its commitments.
As per the guidelines of the Reserve Bank of India (RBI) in relation to deferred payment guarantees made on behalf of borrowers with the main purpose to acquire or buy capital assets, it should be ensured that the total credit facilities that have been provided including the proposed DPG limit remain in the prescribed exposure limits.
HOW TO GET BANK GUARANTEE IN INDIA
Indian banks issue or provide the services of bank guarantee by charging a fee which is known as a guarantee fee. Before it provides a guarantee, the bankers are required to undertake due diligence of the BG applicant and in some cases also ask for the collateral securities.
The application for a bank guarantee should be accompanied by the following mentioned documents:
- Request Letter;
- Duly stamped Counter Indemnity cum Memorandum that proposes to create a charge over the fixed deposit (FD)
- Text of Bank Guarantee.
- Board Resolutions approving the decision to take Bank guarantees (in case of Pvt. Ltd. Company/Ltd. Company)
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ADVANTAGES OF BANK GUARANTEES
To the applicant:
Helps in regular business: small businesses can avail loans or conduct their business which would otherwise be difficult in view of the potential risk of default by the counterparty. This way it helps in the growth of business as well as an entrepreneurial activity.
Low Service Fee: A low guarantee fee is charged for providing Bank guarantees, as low as 1% of the transaction amount.
To the beneficiary (to whom the guarantee is being provided):
Due Diligence: Beneficiary can contract with the counterparty by knowing the fact that due diligence has been done.
Creditworthiness: Guarantee given by the bank adds up to the creditworthiness of both the parties i.e applicant and beneficiary.
Risk Reduction: Risk is reduced as the bank has assured that they will pay up if the applicant defaults on the payment.
Confidence: Bank guarantees increase confidence in the transaction (if it is successful).
Disadvantages of Bank Guarantees
Even though Bank guarantees offer many advantages, they also have some unfavorable parts as mentioned below:
Additional Unnecessary layer: Having a bank involved in the transaction can drag the process of transaction time and also sometimes creates an unnecessary complex layer.
Collateral: When the transaction involved contains a high value or is risky, the bank might also need assurance from the applicant. It can demand that this should be in the form of collateral.
A bank guarantee is only invoked when the applicant makes defaults on its obligation & then the bank will need to step into the transaction. This doesn’t mean that a delayed payment can trigger a bank guarantee.
This way one, especially small businesses who can’t really afford to take big or high risks, can use bank guarantees at their disposal.
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