Sometimes you might come across a situation where your client asks you to provide a financial guarantee from a third party. A bank guarantee can be of huge help in such circumstances.
Let us take the example of a company XYZ, who bags a project from, the Department of Telecommunication (DoT) to build 200 network transmission towers. Companies from all over the world would have applied against an RFP (request for proposal) raised by DoT. The selection would be made on the basis of lowest cost and track record as submitted in the proposal form.
However, the DoT has limited ability to assess all participating companies for financial stability and credit worthiness. Therefore to ensure that the project is done satisfactorily and on time, DoT asks for XYZ to furnish a guarantee given by one or more banks. In banking nomenclature, the company XYZ is an applicant, its bank is the issuing bank and the DoT is the beneficiary. Usually, the bank guarantee is for a specified amount, which is a percentage of the total money required for the contract.
Obviously, the bank will not just issue such guarantee without doing its own due diligence as they are at risk too, in case the client defaults. This amount is called a limit and the bank will issue guarantee provided the company has not exceeded its overall limit for bank guarantees. If DoT is not satisfied with the performance of the contract at a later date, it can invoke the bank guarantee. In this situation, the bank will have to immediately release the amount of the bank guarantee to the DoT.
While there are similarities between a bank guarantee and a letter of credit, they’re actually quite different. Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction doesn’t go as planned.
A letter of credit is an obligation taken on by a bank to make a payment once certain criteria are met. Once these terms are completed and confirmed, the bank will transfer the funds. This ensures the payment will be made as long as the services are performed.
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 nonperformance 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.
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 instruments are designed to reduce the risk taken by each party.
Banks usually have a Bank Guarantee / Letter of Credit Module in the Core Banking System they may be using for automation, but a CBS is limited to the process of issuing the instrument for the host bank. There are four major different parties involved in any Trade Finance product like BG or LC.
Hence, the Tracking and Management process becomes very critical, because there are a lot of interaction points between the concerned parties. Furthermore, there is a blackout period when the bills and goods are in transit, and at that time, nobody in the loop is aware of the status.
The Bank Guarantee document and Customer Details are to be captured from the KYC already completed by the verification process in the Core Banking System. The movement of the documents takes place manually and although the banks have the physical documents and other credentials of the customers, they have no clue of the corresponding bank and the party at the other end, with whom the bank does not have any direct interaction.
The solution Amper has come up with is a web-based wrapper application, which takes the LC/BG data from the core banking solution via CIB (corporate Internet Banking) and allows the concerned parties to interact, submit documents and credentials, and provide a real-time status update. This solution is called Connect Plus.
Connect Plus is a unique product. It is an automation and management suite for Banks’ Trade Finance services. Connect Plus has a unique platform that enables our customers to view images of trade finance documents such as Bank Guarantees, Letters of Credit and Bills through Corporate Internet Banking.