Estimation of Working Capital 289Standby Letter of Credit These credits are generally used as a substitute for performance guarantee or for
securing secured loans.
Effectiveness of L/C as an Assured Payment Mechanism An L/C deals only with documents. If the documents
are submitted exactly as per the L/C terms, the L/C opening bank is duly bound to make the payment.
Payment of L/C Liability The payment for the L/C on the due date is the responsibility of the customer and
has to take place through his own sources. However, in case the customer is unable to arrange for the pay-
ment on the crystallization date, the L/C is deemed as ‘devolved’. The bank has to payoff the L/C amount
and recovers the same from the customer.
(c) Bank Guarantee
A contract of guarantee is a contract to perform the promise or discharge the liability of a third person in case
of his default. There are three parties to a contract of guarantee. The person who guarantees the performance
of a promise or the liability of a third person is called the guarantor (surety). The person, on whose behalf
the guarantee is given is the principal debtor, and the person to whom the guarantee is given is called
the creditor.
The obligation of the surety, under a guarantee issued, arises when there is a default to perform the
promise by the person on whose behalf the guarantee is given. The liability of a surety runs parallel to the
liability of a principal debtor towards the creditor. On failure of the principal debtor to perform the obligation
under the contract, the liability of the surety with respect to the guarantee starts. The bank may be called to
perform its obligation under a bank guarantee issued by it the moment the customer, on whose behalf the
guarantee is given, defaults. Therefore, though bank guarantees are non-fund credit supports initially, the
probability of their turning into fund-based credit is high.
In order to ensure that the guarantee executed by the banker does not remain in force for an indefinite
period, it is stipulated that the guarantee would remain in force for the period specified therein, on the expiry
of which no claims would be entertained by the banker.
Types of Bank Guarantees
Bank guarantees, issued by the banks, are principally of three types:
Financial Guarantee Under this type of guarantee, the bank undertakes only the financial liability. The
bank undertakes to pay the beneficiary of the guarantee, an amount not exceeding the sum stated, on default
of promise by the customer. These are guarantees issued in respect of purely monetary obligations.
Performance Guarantee The bank guarantees that the customer, on whose behalf the guarantee is given,
will perform the contract undertaken. If the customer fails on performing the same, the banker shall make
good the loss caused to the beneficiary, by limiting him financially to a sum not exceeding the amount
undertaken in the guarantee.
The important difference between the financial and performance guarantees lies in the additional factor.
That is, performance by the customer guaranteed by the banker in case of the latter. The commonality
between the two is that both result ultimately in financial liability only.