An important criterion for judging the soundness of a banking institution is the size and character, not only of its assets portfolio but also, of its contingent liability commitments such as guarantees, letters of credit, etc. As a part of business, banks issue guarantees on behalf of their customers for various purposes. The guarantees executed by banks comprise both performance guarantees and financial guarantees. The guarantees are structured according to the terms of agreement, viz., security, maturity and purpose. With the introduction of risk weights for both on-Balance Sheet and off-Balance Sheet exposures, banks have become more risk sensitive, resulting in structuring of their business exposures in a more prudent manner. Banks should comply with the following guidelines in the conduct of their guarantee business.RBI Master Circular – Guarantees and Co-acceptances
RBI Guidelines relating to conduct of guarantee business
Norms for unsecured advances & guarantees
Until June 17, 2004, banks were required to limit their commitments by way of unsecured guarantees in such a manner that 20 percent of a bank’s outstanding unsecured guarantees plus the total of its outstanding unsecured advances should not exceed 15 percent of its total outstanding advances. In order to provide further flexibility to banks on their loan policies, the above limit on unsecured exposure of banks was withdrawn and banks’ Boards have been given the freedom to fix their own policies on their unsecured exposures. “Unsecured exposure” is defined as an exposure where the realisable value of the security, as assessed by the bank/ approved valuers / Reserve Bank’s inspecting officers, is not more than 10 per cent, ab-initio, of the outstanding exposure. Exposure shall include all funded and non-funded exposures (including underwriting and similar commitments). ‘Security’ will mean tangible security properly charged to the bank and will not include intangible securities like guarantees, letter of comfort, etc.
For determining the amount of unsecured advances for reflecting in schedule 9 of the published balance sheet, the rights, licenses, authorisations, etc., charged to the banks as collateral in respect of projects (including infrastructure projects) financed by them, should not be reckoned as tangible security. Banks, may however, treat annuities under build-operate –transfer (BOT) model in respect of road/highway projects and toll collection rights where there are provisions to compensate the project sponsor if a certain level of traffic is not achieved, as tangible securities, subject to the condition that banks’ right to receive annuities and toll collection rights is legally enforceable and irrevocable.
All exemptions allowed for computation of unsecured advances stand withdrawn.
Precautions for issuing guarantees
Banks should adopt the following precautions while issuing guarantees on behalf of their customers.
(i) As a rule, banks should avoid giving unsecured guarantees in large amounts and for medium and long-term periods. They should avoid undue concentration of such unsecured guarantee commitments to particular groups of customers and/or trades.
(ii) Unsecured guarantees on account of any individual constituent should be limited to a reasonable proportion of the bank’s total unsecured guarantees. Guarantees on behalf of an individual should also bear a reasonable proportion to the constituent’s equity.
(iii) In exceptional cases, banks may give deferred payment guarantees on an unsecured basis for modest amounts to first class customers who have entered into deferred payment arrangements in consonance with Government policy.
(iv) Guarantees executed on behalf of any individual constituent, or a group of constituents, should be subject to the prescribed exposure norms.
(v) It is essential to realise that guarantees contain inherent risks and that it would not be in the bank’s interest or in the public interest, generally, to encourage parties to over-extend their commitments and embark upon enterprises solely relying on the easy availability of guarantee facilities.
Precautions for averting frauds
While issuing guarantees on behalf of customers, the following safeguards should be observed by banks:
(i) At the time of issuing financial guarantees, banks should be satisfied that the customer would be in a position to reimburse the bank in case the bank is required to make payment under the guarantee.
(ii) In the case of performance guarantee, banks should exercise due caution and have sufficient experience with the customer to satisfy themselves that the customer has the necessary experience, capacity and means to perform the obligations under the contract, and is not likely to commit any default.
(iii) Banks should refrain from issuing guarantees on behalf of customers who do not enjoy credit facilities with them. As non-compliance of RBI regulations in this regard is likely to vitiate credit discipline, RBI will consider penalising non-compliant banks. However, BG /LC may be issued by scheduled commercial banks to clients of co-operative banks against counter guarantee of the co-operative bank. In such cases, banks may be guided by the provisions of paragraph 22.214.171.124 of the Master Circular on Loans and Advances-Statutory and Other Restrictions dated July 1, 2014. Further, banks must satisfy themselves that the concerned co-operative banks have sound credit appraisal and monitoring systems as well as robust Know Your Customer (KYC) regime. Before issuing BG/LCs to specific constituents of co-operative banks, they must satisfy themselves that KYC has been done properly in these cases.
Ghosh Committee Recommendations
Banks should implement the following recommendations made by the High Level Committee constituted in October 1991 (Chaired by Shri A. Ghosh, the then Dy. Governor of RBI):
(i) In order to prevent unaccounted issue of guarantees, as well as fake guarantees, as suggested by IBA, bank guarantees should be issued in serially numbered security forms.
(ii) Banks should, while forwarding guarantees, caution the beneficiaries that they should, in their own interest, verify the genuineness of the guarantee with the issuing bank.
Internal control systems
Bank guarantees issued for Rs.50,000/- and above should be signed by two officials jointly. A lower cut-off point, depending upon the size and category of branches, may be prescribed by banks, where considered necessary. Such a system will reduce the scope for malpractices/ losses arising from the wrong perception/ judgement or lack of honesty/ integrity on the part of a single signatory. Banks should evolve suitable systems and procedures, keeping in view the spirit of these instructions and allow deviation from the two signatures discipline only in exceptional circumstances. The responsibility for ensuring the adequacy and effectiveness of the systems and procedures for preventing perpetration of frauds and malpractices by their officials would, in such cases, rest on the top managements of the banks. In case, exceptions are made for affixing of only one signature on the instruments, banks should devise a system for subjecting such instruments to special scrutiny by the auditors or inspectors at the time of internal inspection of branches.
Guarantees on behalf of Banks’ Directors
Section 20 of the Banking Regulation Act, 1949 prohibits banks from granting loans or advances to any of their directors or any firm or company in which any of their directors is a partner or guarantor. However, certain facilities which, inter alia, include issue of guarantees, are not regarded as ‘loan and advances’ within the meaning of Section 20 of the Act, ibid. In this regard, it is pertinent to note with particular reference to banks giving guarantees on behalf of their directors, that in the event of the principal debtor committing default in discharging his liability and the bank being called upon to honour its obligation under the guarantee, the relationship between the bank and the director could become one of creditor and debtor. Further, directors would also be able to evade the provisions of Section 20 by borrowing from a third party against the guarantee given by the bank. These types of transactions are likely to defeat the very purpose of Section 20of the Act, if banks do not take appropriate steps to ensure that the liabilities there under do not devolve on them.
In view of the above, banks should, while extending non-fund based facilities such as guarantees, etc. on behalf of their directors and the companies/firms in which the director is interested, ensure that:
i. adequate and effective arrangements have been made to the satisfaction of the bank that the commitments would be met out of their own resources by the party on whose behalf guarantee was issued and
ii. the bank will not be called upon to grant any loan or advance to meet the liability, consequent upon the invocation of the guarantee.
In case, such contingencies arise as at (ii) above, the bank will be deemed to be a party to the violation of the provisions of Section 20 of the Banking Regulation Act, 1949.
Bank Guarantee Scheme of Government of India
The Bank Guarantee Scheme formulated by the Government of India for the issuance of bank guarantees in favour of Central Government Departments, in lieu of security deposits, etc. by contractors, has been modified from time to time. Under the scheme, it is open to Government Departments to accept freely guarantees, etc. from all scheduled commercial banks.
Banks should adopt the Model Form of Bank Guarantee Bond given in Annex 1. The Government of India have advised all the Government departments/ Public Sector Undertakings, etc. to accept bank guarantees in the Model Bond and to ensure that alterations/additions to the clauses whenever considered necessary are not one-sided and are made in agreement with the guaranteeing bank. Banks should mention in the guarantee bonds and their correspondence with the various State Governments, the names of the beneficiary departments and the purposes for which the guarantees are executed. This is necessary to facilitate prompt identification of the guarantees with the concerned departments. In regard to the guarantees furnished by the banks in favour of Government Departments in the name of the President of India, any correspondence thereon should be exchanged with the concerned ministries/ departments and not with the President of India. In respect of guarantees issued in favour of Directorate General of Supplies and Disposal, the following aspects should be kept in view:
i. In order to speed up the process of verification of the genuineness of the bank guarantee, the name, designation and code numbers of the officer/officers signing the guarantees should be incorporated under the signature(s) of officials signing the bank guarantee.
ii. The beneficiary of the bank guarantee should also be advised to invariably obtain the confirmation of the concerned banks about the genuineness of the guarantee issued by them as a measure of safety.
iii. The initial period of the bank guarantee issued by banks as a means of security in Directorate General of Supplies and Disposal contract administration would be for a period of six months beyond the original delivery period. Banks may incorporate a suitable clause in their bank guarantee, providing automatic extension of the validity period of the guarantee by 6 months, and also obtain suitable undertaking from the customer at the time of issuing the guarantee to avoid any possible complication later.
iv. A clause would be incorporated by Directorate General of Supplies and Disposal (DGS&D) in the tender forms of Directorate General of Supplies and Disposal 229 (Instruction to the tenderers) to the effect that whenever a firm fails to supply the stores within the delivery period of the contract wherein bank guarantee has been furnished, the request for extension for delivery period will automatically be taken as an agreement for getting the bank guarantee extended. Banks should make similar provisions in the bank guarantees for automatic extension of the guarantee period.
v. The Public Notice issued by the Customs Department stipulates, inter alia, that all bank guarantees furnished by an importer should contain a self-renewal clause inbuilt in the guarantee itself. As the stipulation in the Public Notice issued by the Customs Department is akin to the notice in the tender form floated by the DGS&D, the provision for automatic extension of the guarantee period in the bank guarantees issued to DGS&D, as at sub-paragraph (iv) above, should also be made applicable to bank guarantees issued favouring the Customs Houses.
vi. The bank guarantee, as a means of security in the Directorate General of Supplies and Disposal contract administration and extension letters thereof, would be on non-judicial stamp paper.
Guarantees on behalf of Share and Stock Brokers/ Commodity Brokers
Banks may issue guarantees on behalf of share and stock brokers in favour of stock exchanges in lieu of security deposit to the extent it is acceptable in the form of bank guarantee as laid down by stock exchanges. Banks may also issue guarantees in lieu of margin requirements as per stock exchange regulations. Banks have been advised that they should obtain a minimum margin of 50 percent while issuing such guarantees. A minimum cash margin of 25 per cent (within the above margin of 50 per cent) should be maintained in respect of such guarantees issued by banks. The above minimum margin of 50 percent and minimum cash margin requirement of 25 percent (within the margin of 50 percent) will also apply to guarantees issued by banks on behalf of commodity brokers in favour of the national level commodity exchanges, viz., National Commodity & Derivatives Exchange (NCDEX), Multi Commodity Exchange of India Limited (MCX) and National Multi-Commodity Exchange of India Limited (NMCEIL), in lieu of margin requirements as per the commodity exchange regulations. Banks should assess the requirement of each applicant and observe usual and necessary safeguards including the exposure ceilings.
Irrevocable Payment Commitments – Financial Guarantees
Banks issuing Irrevocable Payment Commitment (IPCs) to various Stock Exchange on behalf of Mutual Funds and FIIs are advised to adopt the following risk mitigation measures:
Only those custodian banks would be permitted to issue IPCs who have a clause in the Agreement with their clients which gives them an inalienable right over the securities to be received as payout in any settlement. However, in cases where transactions are pre-funded i.e. there are clear INR funds in the customer’s account and, in case of FX deals, the bank’s nostro account has been credited before the issuance of the IPC by custodian banks, the requirement of the clause of inalienable right over the security to be received as payout in the agreement with the clients will not be insisted upon.
As regards calculation of CME the instruction are indicated in circular DBOD.Dir.BC.68/13.03.00/2011-12 dated December 27, 2011 on Banks’ Exposure to Capital Market- Issue of Irrevocable Payment Commitments (IPCs). The same is also incorporated in para 2.3.5 of our Master Circular on ‘Exposure Norms’ dated July 1, 2015.
Guidelines relating to obtaining of personal guarantees of directors and other managerial personnel of borrowing concerns
Personal guarantees of directors
Banks should take personal guarantees of directors for the credit facilities, etc. granted to corporates, public or private, only when absolutely warranted after a careful examination of the circumstances of the case and not as a matter of course. In order to identify the circumstances under which the guarantee may or may not be considered necessary, banks should be guided by the following broad considerations:
A. Where guarantees need not be considered necessary
i. Ordinarily, in the case of public limited companies, when the lending institutions are satisfied about the management, its stake in the concern, economic viability of the proposal and the financial position and capacity for cash generation, no personal guarantee need be insisted upon. In fact, in the case of widely owned public limited companies, which may be rated as first class and satisfying the above conditions, guarantees may not be necessary even if the advances are unsecured. Also, in the case of companies, whether private or public, which are under professional management, guarantees may not be insisted upon from persons who are connected with the management solely by virtue of their professional/technical qualifications and not consequent upon any significant shareholding in the company concerned.
ii. Where the lending institutions are not so convinced about the aspects of loan proposals mentioned above, they should seek to stipulate conditions to make the proposals acceptable without such guarantees. In some cases, more stringent forms of financial discipline like restrictions on distribution of dividends, further expansion, aggregate borrowings, creation of further charge on assets and stipulation of maintenance of minimum net working capital may be necessary. Also, the parity between owned funds and capital investment and the overall debt-equity ratio may have to be taken into account.
B. Where guarantees may be considered helpful
i. Personal guarantees of directors may be helpful in respect of companies, whether private or public, where shares are held closely by a person or connected persons or a group (not being professionals or Government), irrespective of other factors, such as financial condition, security available, etc. The exception being in respect of companies where, by court or statutory order, the management of the company is vested in a person or persons, whether called directors or by any other name, who are not required to be elected by the shareholders. Where personal guarantee is considered necessary, the guarantee should preferably be that of the principal members of the group holding shares in the borrowing company rather than that of the director/managerial personnel functioning as director or in any managerial capacity.
ii. Even if a company is not closely held, there may be justification for a personal guarantee of directors to ensure continuity of management. Thus, a lending institution could make a loan to a company whose management is considered good. Subsequently, a different group could acquire control of the company, which could lead the lending institution to have well-founded fears that the management has changed for the worse and that the funds lent to the company are in jeopardy. One way by which lending institutions could protect themselves in such circumstances is to obtain guarantees of the directors and thus ensure either the continuity of the management or that the changes in management take place with their knowledge. Even where personal guarantees are waived, it may be necessary to obtain an undertaking from the borrowing company that no change in the management would be made without the consent of the lending institution. Similarly, during the formative stages of a company, it may be in the interest of the company, as well as the lending institution, to obtain guarantees to ensure continuity of management.
iii. Personal guarantees of directors may be helpful with regard to public limited companies other than those which may be rated as first class, where the advance is on an unsecured basis.
iv. There may be public limited companies, whose financial position and/or capacity for cash generation is not satisfactory even though the relevant advances are secured. In such cases, personal guarantees are useful.
v. Cases where there is likely to be considerable delay in the creation of a charge on assets, guarantee may be taken, where deemed necessary, to cover the interim period between the disbursement of loan and the creation of the charge on assets.
vi. The guarantee of parent companies may be obtained in the case of subsidiaries whose own financial condition is not considered satisfactory.
vii. Personal guarantees are relevant where the balance sheet or financial statement of a company discloses interlocking of funds between the company and other concerns owned or managed by a group.
C. Worth of the guarantors, payment of guarantee commission, etc
Where personal guarantees of directors are warranted, they should bear reasonable proportion to the estimated worth of the person. The system of obtaining guarantees should not be used by the directors and other managerial personnel as a source of income from the company. Banks should obtain an undertaking from the borrowing company as well as the guarantors that no consideration whether by way of commission, brokerage fees or any other form, would be paid by the former or received by the latter, directly or indirectly. This requirement should be incorporated in the bank’s terms and conditions for sanctioning of credit limits. During the periodic inspections, the bank’s inspectors should verify that this stipulation has been complied with. There may, however, be exceptional cases where payment of remuneration may be permitted e.g. where assisted concerns are not doing well and the existing guarantors are no longer connected with the management but continuance of their guarantees is considered essential because the new management’s guarantee is either not available or is found inadequate and payment of remuneration to guarantors by way of guarantee commission is allowed.
D. Personal guarantees in the case of sick units
As the personal guarantees of promoters/ directors generally instill greater accountability and responsibility on their part and prompt the managements to conduct the running of the assisted units on sound and healthy lines and to ensure financial discipline, banks, may in their discretion, obtain guarantees from directors (excluding the nominee directors) and other managerial personnel in their individual capacities. In case, for any reasons, a guarantee is not considered expedient by the bank at the time of sanctioning the advance, an undertaking should be obtained from the individual directors and a covenant should invariably be incorporated in the loan agreement that in case the borrowing unit show cash losses or adverse current ratio or diversion of fund, the directors would be under an obligation to execute guarantees in their individual capacities, if required by the bank. Banks may also obtain guarantees at their discretion from the parent/holding company when credit facilities are extended to borrowing units in the same Group.
Guarantees of State Government
The guidelines laid down in paragraph 2.2.9 above, for taking personal guarantees of directors and other managerial personnel, should also be followed in respect of proposal of State Government undertakings/projects and guarantees may not be insisted upon unless absolutely warranted. In other words, banks could obtain guarantees of State Governments on merits and only in circumstances absolutely necessary after thorough examination of the circumstances of each case, and not as matter of course.
A large proportion of guarantees is in favour of all-India financial institutions like NABARD, NCDC, HUDCO, LIC, etc., which are owned by the Central Government. Since in the Indian federal context, there is an implicit underwriting of States’ borrowings by the Centre, such guarantees amount to the Centre guaranteeing itself. The Group therefore, recommends that Acts/policies of these central financial institutions should be amended/rationalized so that guarantees are not routinely insisted upon while extending loans. The need for having such guarantees should be examined and even done away with. It is essential that the lending institution should undertake due diligence and examine the commercial viability of the project instead of relying on the security of government guarantee. Insistence on viability of projects and generation of adequate repayment capacity will push through reforms in the area of levying user charges and removal of subsidies apart from ensuring financial stability. Where guarantee is taken as credit enhancement, it should be reflected in reduction of lending rate.
Consequent to the announcement in the Monetary and Credit policy for the year 2002-03 to dispense with automatic debit mechanism, the Group recommends that the automatic debit mechanism in case of repayments to NABARD both under the RIDF and outside the RIDF should be discontinued and put on the same footing as any other off-market borrowing of the State Government from financial institutions.
While working out the methodology for assessing the fiscal risk of guarantees other than those which can be considered as direct liability, fiscal risk can be measured as follows. Projects/ activities need to be classified as high risk, medium risk, low risk and very low risk and assigned appropriate risk weights. The assessment of risk will be done at the State level. For making such assessment, States can make use of credit rating of bonds sans guarantee. These ratings can then be used for assigning devolvement probability which could then be applied to the underlying liabilities for which guarantees have been extended to arrive at the debt service obligation plus guarantee devolvement obligation representing the annual fiscal burden of debt plus guarantees.
Guarantees for Export Advance
(i) Guarantees are permitted in respect of debt or other liability incurred by an exporter on account of exports from India. It is therefore intended to facilitate execution of export contracts by an exporter and not for other purposes. In terms of extant instructions banks have also been advised that guarantees contain inherent risks, and that it would not be in the banks’ interest or in the public interest generally to encourage parties to over-extend their commitments and embark upon enterprises solely relying on the easy availability of guarantee facilities. Banks should, therefore, be careful while extending guarantees against export advances so as to ensure that no violation of FEMA regulations takes place and banks are not exposed to various risks. It will be important for the banks to carry out due diligence and verify the track record of such exporters to assess their ability to execute such export orders.
(ii) Further, banks should also ensure that the export advances received by the exporters are in compliance with the regulations/ directions issued under the Foreign Exchange Management Act, 1999.
(iii) It is reiterated that export performance guarantees, where permitted to be issued, shall strictly be in the nature of performance guarantee and shall not contain any clauses which may in effect allow such performance guarantees to be utilized as financial guarantees/Standby Letters of Credits.