In this article we will discuss about:- 1. Meaning of Bank Guarantee 2. Nature of Bank Guarantees 3. Quantitative Assessment.
Meaning of Bank Guarantee:
Issuance of bank guarantee is another form of non-fund based business for commercial banks. There are three parties involved, i.e., the applicant (customer), the beneficiary (in whose favour the guarantee is issued) and the bank. Guarantees are normally issued by banks to enable their customers to participate in tenders, auction, etc., where the bank’s customer is required to submit bank guarantee for a minimum stipulated amount, in lieu of security deposits/earnest money deposit, etc.
When the customer obtains advance payment from the principal who floated the tender, the latter asks for providing bank guarantee covering the amount of advance. Similarly, there may be other occasions when the customer is required to provide bank guarantees to other parties with whom he has business dealings.
However, bank guarantees cannot be issued promising refund of any loan or deposits taken by the customer from other banks or financial institutions. A bank cannot guarantee the repayment of a loan granted by another bank.
Nature of Bank Guarantees:
Financial Guarantee:
Any bank guarantee which has a bearing on the cash flow position of the applicant is a financial guarantee.
It may be explained in the following manner:
The applicant is engaged in the activities of civil construction and has to participate in various tenders floated by government departments. The terms of the tender provide that those who want to participate in the tender have to provide a deposit of a certain amount with the tenderer (principal) or, in lieu of the deposit, a bank guarantee for a similar amount should be provided to the principal.
The terms further state that the successful bidders can avail of advance payment of 20% of the tender value against production of bank guarantee. In both the situations, the cash flow position of the civil contractor (customer) is impacted. By providing a bank guarantee, the customer does not have to part with funds which, otherwise, he was required to deposit with the principal.
This had a positive impact on his funds position. In the second situation, the customer (contractor) received a certain amount (20% of the tender value) as advance money against producing a bank guarantee, which also had a positive impact on his fund position.
Quantitative Assessment of Bank Guarantee Limit:
A simple method to assess the quantum of bank guarantee requirement against earnest money deposits and for release of bills, etc. is given below:
ABC & Co. manufactures aluminium shots to feed into the blast furnace of an integrated steel plant (Mother Plant). The steel plant invites tenders for its periodical requirements of aluminium shots from suppliers. ABC & Co. usually submits 20 tenders to the mother plant during a year for supplying shots aggregating Rs 10 million. At any point of time, 10 tender deposits are outstanding. Besides, 10 tenders for a total supply worth Rs 5 million are likely to be accepted.
Tender deposit is 10% of the value of the tender, whereas the security deposit is 8% of the value of supplies (accepted tender amount). The steel plant usually retains 2% of all supplies made during the year from the bill amounts as retention money. All the deposits, whether made against submission of tenders, acceptance of tenders or funds retained against submission of bills, are returned after one year. We need to assess a limit for the BG requirements of ABC & Co.
Assessment:
(i) No. of tenders likely to be submitted by ABC & Co. = 20
(ii) At any point of time, 10 tenders are outstanding. Therefore, funds blocked in tender deposits
= 10 x Rs 500,000 x 10% = Rs 500,000
(iii) Tenders usually accepted during a year = 10. Therefore, security deposit blocked in tenders accepted = 10 x Rs 500,000 x 8% = Rs 400,000
(iv) Aggregate value of supplies made = Rs 5 million. Therefore, retention money from bills
= Rs 5 million x 2% = Rs 100,000
(v) All the deposits, whether relating to tenders or against submission of bills, are returned after one year. Bank guarantees issued against the above liabilities would thus remain in the books of the bank for at least one year.
(vi) Therefore, the total bank guarantee limit = Rs (500,000 + 400,000 + 100,000) = Rs 1 million
If, however, the management of the steel plant revises its policy regarding the retention period of these deposits, the bank guarantee limit will also undergo a change.
A specimen Bank Guarantee is reproduced below:
