Letters of Credit and Bank Guarantees
No money leaves the bank on day one, but the risk is real. Here is how LC and BG limits are assessed and honoured.
Letters of credit (LCs) and bank guarantees (BGs) are non-fund based facilities. The bank lends its name, not its money, and earns a commission. No cash leaves the bank when it issues one. But if the customer fails to pay or perform, the bank must pay, and the contingent exposure becomes a funded loan overnight.
That is why a credit officer appraises an LC or BG limit as carefully as a cash credit limit. This page covers the types the CCP syllabus lists, the two limit calculations the exam asks for, and RBI's rules on honouring them.
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LC vs Bank Guarantee
What the bank promises
Letter of credit
To pay the seller against documents that comply with the LC
Bank guarantee
To pay the beneficiary if the customer defaults on a payment or a performance
When the bank pays
Letter of credit
In the normal course of trade, on a complying presentation
Bank guarantee
Only if the guarantee is invoked
Typical use
Letter of credit
Buying goods, especially imports
Bank guarantee
Contracts, tenders, deferred payments, security deposits
Who is the bank's customer
Letter of credit
The buyer (applicant)
Bank guarantee
The party whose obligation is guaranteed
| Point | Letter of credit | Bank guarantee |
|---|---|---|
| What the bank promises | To pay the seller against documents that comply with the LC | To pay the beneficiary if the customer defaults on a payment or a performance |
| When the bank pays | In the normal course of trade, on a complying presentation | Only if the guarantee is invoked |
| Typical use | Buying goods, especially imports | Contracts, tenders, deferred payments, security deposits |
| Who is the bank's customer | The buyer (applicant) | The party whose obligation is guaranteed |
Types of Letters of Credit
- Sight LC
- Paid when complying documents are presented.
- Usance (deferred payment) LC
- Paid on a stated future date, so the buyer gets credit for the usance period.
- Confirmed LC
- A second bank adds its own undertaking to pay, on top of the issuing bank's.
- Transferable LC
- The beneficiary can transfer it to another party, only if the LC says it is transferable. Under UCP 600 a transferred credit cannot be transferred again at the second beneficiary's request.
- Revolving LC
- The amount or availability reinstates as the LC specifies, for repeat shipments.
- Back-to-back LC
- A separate, second LC opened on the strength of the first. It is not a transfer.
- Red clause and green clause LC
- Allow an advance to the seller before shipment. A green clause also covers storage and insurance before shipment.
- Standby LC
- Works like a guarantee: paid only if the applicant defaults.
UCP 600 Points the Exam Likes
Under UCP 600, a credit is irrevocable even if it does not say so. Banks deal in documents, not goods, and a nominated, confirming or issuing bank has a maximum of five banking days after presentation to decide whether the documents comply. RBI's master circular adds that payment to overseas suppliers should be released only when documents strictly conform to the LC terms.
Assessing an LC Limit: Worked Example
The LC limit covers every LC open at one time. It equals the average monthly purchase under LC multiplied by the months each LC stays outstanding (lead time + transit time + usance period).
Annual raw material bought under LC
Working
Given
Result
₹36 crore
Average monthly LC purchase
Working
₹36 crore ÷ 12
Result
₹3 crore
Lead time (order to shipment)
Working
Given
Result
15 days
Transit time
Working
Given
Result
15 days
Usance period
Working
Given
Result
2 months
Total period each LC stays open
Working
15 days + 15 days + 2 months
Result
3 months
LC limit
Working
₹3 crore × 3
Result
₹9 crore
| Step | Working | Result |
|---|---|---|
| Annual raw material bought under LC | Given | ₹36 crore |
| Average monthly LC purchase | ₹36 crore ÷ 12 | ₹3 crore |
| Lead time (order to shipment) | Given | 15 days |
| Transit time | Given | 15 days |
| Usance period | Given | 2 months |
| Total period each LC stays open | 15 days + 15 days + 2 months | 3 months |
| LC limit | ₹3 crore × 3 | ₹9 crore |
Non-fund based facility questions. No signup.
Types of Bank Guarantees
- Financial guarantee
- Backs a payment obligation, for example a guarantee in lieu of earnest money or a security deposit.
- Performance guarantee
- Backs completion of a contract as agreed: bid bonds, advance payment, contract performance, retention money and warranty-period guarantees.
- Deferred payment guarantee (DPG)
- Guarantees instalments a buyer of capital goods, such as machinery, pays over time to the supplier.
Assessing a BG Limit: Worked Example
BGs outstanding as per the last audited balance sheet
Working
Given
Amount
₹5 crore
Add: new BGs needed in the coming year
Working
From the order book and tenders planned
Amount
₹8 crore
Less: BGs expiring or cancelled during the year
Working
From the BG register
Amount
₹3 crore
BG limit required
Working
5 + 8 − 3
Amount
₹10 crore
| Step | Working | Amount |
|---|---|---|
| BGs outstanding as per the last audited balance sheet | Given | ₹5 crore |
| Add: new BGs needed in the coming year | From the order book and tenders planned | ₹8 crore |
| Less: BGs expiring or cancelled during the year | From the BG register | ₹3 crore |
| BG limit required | 5 + 8 − 3 | ₹10 crore |
What a Banker Checks Before Issuing a Guarantee
- check_circleIs the need linked to the customer's normal business, and is it one-time or recurring?
- check_circleIs it financial or performance? RBI asks for due caution on performance guarantees: the bank must be sure the customer has the experience, capacity and means to perform.
- check_circleCan the customer reimburse the bank if the guarantee is invoked?
- check_circleHow has the customer handled earlier guarantees, and how much is already outstanding?
- check_circleWhat margin and collateral does the bank's policy require?
RBI Rules on Guarantees
| Rule | What it says |
|---|---|
| Maturity | No guarantee should normally exceed 10 years. Banks may go beyond 10 years for long project loans, under a Board-approved policy. |
| Non-constituents | Banks should generally give non-fund facilities only to customers who enjoy credit facilities with them. Customers with no fund-based facility from any bank in India can get them under a Board policy, with the same appraisal. |
| Invocation | An invoked guarantee must be paid without delay and demur, unless a court order restrains the bank. |
| Broker guarantees | Guarantees for stock or commodity brokers to exchanges need at least 50% margin, of which at least 25% must be cash. |
| Unsecured exposure | An exposure is unsecured if the realisable value of tangible security is not more than 10% of it. Guarantees are not counted as security. |
New RBI Directions From 1 April 2026
RBI's Non-Fund Based Credit Facilities Directions, 2025 apply to new and renewed facilities from 1 April 2026. Under them, tenor and claim period are matters for the bank's policy and the guarantee deed, not a fixed universal rule, and guarantees are to be irrevocable and unconditional. Learn the master circular rules above and know where the Directions differ. IIBF's cut-off for exams from September 2026 to February 2027 is guidelines issued up to 30 June 2026.
Co-acceptance of Bills
When a bank co-accepts a bill, it promises the seller it will pay if the buyer does not. RBI's safeguards:
- check_circleCo-accept only genuine trade bills, and confirm the goods have reached the buyer's stock.
- check_circleNever co-accept accommodation bills drawn by group concerns on each other.
- check_circleExtend co-acceptance limits only to customers who enjoy other limits with the bank.
- check_circleKeep records so the commitment for each customer and each branch is readily known.
FAQs
How is an LC limit calculated?expand_more
Average monthly purchases under LC multiplied by the months each LC stays open: lead time plus transit time plus usance period. Purchases of ₹3 crore a month over a 3-month cycle need a ₹9 crore limit.
What is the maximum period of a bank guarantee?expand_more
Under RBI's master circular, normally 10 years, with longer guarantees allowed under a Board policy for long project loans. The 2025 Directions, from 1 April 2026, leave tenor to the bank's policy.
What is the difference between a financial and a performance guarantee?expand_more
A financial guarantee backs a payment obligation. A performance guarantee backs completion of a contract as agreed, such as a bid bond or an advance payment guarantee.
Can a bank refuse to pay an invoked guarantee because of a dispute?expand_more
Generally no. RBI says invoked guarantees must be paid without delay and demur unless a court restrains the bank. Disputes are pursued separately.
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