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SECTION 3 – TRADE FINANCE

CHAPTER 3.1 IMPORTANCE OF TRADE FINANCE

Trade finance provides alternative solutions that balance risk and

payment. In this overview, we’ll outline the two broad categories of
trade finance:
Pre-shipment financing to produce or purchase the material and
labour necessary to fulfil the sales order.
Post-shipment financing in order to generate immediate cash while
offering payment terms to buyers.

GENERAL CONSIDERATIONS
The following factors and considerations apply to financing in general:
1. Financing can make the sale
2. Financing Costs
The total cost of finance and its effect on the price and
3. Financing Terms
Costs of finance increases with the length of terms.
4. Risk Management
Credit-worthiness of the buyer is evaluated by banks. Banks/Lenders
are generally concerned with two questions:
• Can the exporter perform?
• Can the Importer pay?

FEATURES OF TRADE FINANCE PERSPECTIVES

• Financing of individual transactions or a series of revolving
transactions.
• Self-liquidating

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• The extent of control and existence of guaranteed payment

mechanisms can make trade finance less risky

WORKING CAPITAL LOANS

Working capital loans are used for pre-shipment financing.
Loan proceeds are commonly used to finance three different areas:
• Labour
• Material
• Inventory

TERM FINANCING FOR FOREIGN BUYERS

Exporting country’s government institutions often back buyer Credit
Programs.
The exporting country’s financial institution lends credit to the foreign
buyer in order allow the foreign importer to pay the exporter
immediately. The payment is usually made directly to the exporter.
Benefit to Exporter: Cash on delivery
Benefit to Importer: Extended credit terms
Benefit to Lender: Guarantees

EXPORT TRADE FINANCE

• Helps to improve cash flow
• Advantageous credit terms to buyer

IMPORT TRADE FINANCE

• Improve cash flow
• Post shipment finance allows selling goods before making
payment
• Offer payment at sight
• Negotiation advantage
• Pre-shipment: Allows pre-payment by clean remittance
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CHAPTER 3.2 PRE-SHIPMENT FINANCE

Granted to exporter as a part of working capital finance to arrange raw

materials, manufacturing, packing, shipment

TYPES OF PRE-SHIPMENT FINANCE

REQUIREMENTS FOR GETTING PACKING CREDIT

1. Ten-digit IEC code

2. Not in caution list of RBI
3. Not in specific list of ECGC
4. Authorisation from DGFT if goods not freely permissible under ftp

Packing credit facility can be provided to an exporter on production of

following evidences to the bank:

1.Application with undertaking shipment of goods and submission of

documents with bank within prescribed time limit

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2.Confirmed and irrevocable order or irrevocable L/C unless it has

been waived
3. Authorisation letter if goods are restricted

Order should contain details of buyer, goods, shipment date, value

and payment date

ELIGIBILITY

1. Order in name of exporter

2. Can also be a third-party manufacture to whom some export
obligations have been outsourced
3. Can be shared between exporter if more than one exporter
involved for the transaction

QUANTUM OF FINANCE
Pre-shipment finance need based finance

Percentage of margin determined on basis of:

• Nature of order
• Nature of commodity
• Capability of exporter to bring in required contribution

STAGES OF PRE-SHIPMENT CREDIT

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Appraisal and Disbursement Follow up of

sanction of of packing Packing Credit
Limits credit advance Advance

Liquidation of
Overdue
Packing Credit
Packing Credit
Advance

1.Appraisal and sanction of Limits

• Specific purpose working capital limit

• All costs before shipment eligible for packing credit
• Bank conducts its due diligence for exporter as well as the buyers
• Reports on foreign buyer can be taken from institutions like ECGC
or international consulting agencies

Factors considered before approval:

- Reputation of exporter
- Whether regulatory requirements fulfilled
- Countries dealt with – whether allowed or not, if restricted
whether authorization to trade received or not

2. Disbursement of packing credit advance

After approval loan is disbursed – disbursement is done if documents
meet the requirements.

Running Account Packing credit – allowed even if export order not

available, normally if goods dealt with are seasonal in nature

Quantum of finance:

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Note: Insurance and freight considered at time of shipment

• Disbursement done in stages

• Payments done to suppliers directly by cheques
• Period of credit is decided by bank based on judgment
• Term of credit–
Maximum 180 days,
Extension of 90 days and
Further extension of 90 days without referring to RBI

Concessional rate of interest is only allowed if advance is adjusted by

submission of export document within 360 days from date of advance

In case of delay, advance will cease to qualify for prescribed rate of

interest for export credit to the exporter ab initio

Particulars checked in documents –

Name of buyer, commodity, quantity, value of goods, shipment date
expected, other terms to be complied with.

3. Follow up of Packing Credit Advance

• Stock statement to be submitted by exporter, for hypothecated
stock
• Frequency of reporting is fixed by bank
• Authorized dealer they can also physically inspect the stock
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4. Liquidation of Packing Credit Advance

• Liquidated with proceeds of relevant shipment
• Repayment can also be done by payments receivable from
government – duty drawback, market development fund
• In case of default (export did not take place) – interest rate
(nominal market rate) and penal rate can also be imposed,
concessional rate allowed to the extent of actual export.
• Can also be adjusted from EEFC funds or local funds.
• Under unavoidable circumstances substitution commodity or
buyer for liquidation is permitted (without reference to RBI)

5. Overdue Packing Credit

• Overdue – not liquidated on due date
• Bank takes steps to realize dues.

SPECIAL CASES

1.Packing credit to sub supplier

• Packing credit can be shared between Export Order Holder (EOH)
and manufacturer of goods
• Basis of sharing – Disclaimer issued by EOH to the effect that he
has not availed/is not availing any credit facility against the portion
of the order transferred in the name of the manufacturer. Commented [hm1]: I need to understand this point

• Disclaimer may be countersigned by the banker of EOH.

• Sub-supplier’s bank may grant credit based on Inland L/C for goods
to be supplied to EOH issued by banker of EOH
• EOH’s banker will pay sub-supplier’s bank when the goods are
supplied by sub-supplier
Final export responsibility is on exporter, he will be subject to penal
provisions in case of delay.

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Only covers first stage of production cycle Commented [hm2]: What does it mean ??

Running account facility not granted to sub-supplier

Bank ensure that – there’s no double financing or period of credit does
not exceed the actual production cycle

2. Running account facility

• Granting of pre-shipment advance without prior confirmed
orders or L/C
• Provided if exporter has good track record and need for running
account has been proven to satisfaction of bank
• Letter of credit/ export order to be provided within reasonable
time
• Liquidation/ set off of transactions done on FIFO basis

3. Pre-shipment credit in foreign currency

• Objective – Provide credit at internationally competitive rates of
interest. At related rates of interest like LIBOR, EURO LIBOR,
EURIBOR Commented [hm3]: These are not applicable now, make
sure to find the current system and explain that
• Additional window along with existing INR packing credit
• Provided for procurement of raw material – whether from
domestic market or international market
• Bank can quote rates for standard or non-standard period
• Standard periods of are 1, 2, 3, 6 and 12 months
• If non standard rate is quoted, it should be lower than upper
standard rate
• Period of Credit for PCFC
a) Maximum 360 days. Extension subject to same conditions as INR
PC
b) If no export takes place within 360 days – PCFC adjusted at TT
selling rate of concerned currency

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a. In this case, banks can arrange to remit foreign exchange

to repay the loan or line of credit raised abroad and
interest without prior permission of RBI.
c) Banks can determine rate of interest on credits provided in
foreign currency – if extension is for a period less than 180 days.
• Exporter can take credit for order in a foreign currency other
than the currency mentioned on the export order. Risk and cost
of cross currency – borne by exporter
• Banks can provide Running account facility
• Banks must closely monitor use of funds
• Sources of banks for providing credit in foreign currency:
a) Earner Foreign Currency Accounts (EEFC),
b) Resident Foreign Currency Accounts RFC (D)
c) Foreign Currency (Non-Resident) Accounts.
d) Banks can also use balances in Escrow accounts, provided
the limit prescribed for maximum balance under broad
based facility is met
• Bank can borrow from overseas bank for PCFC without prior
approval of RBI
• Banks can also borrow from other banks in India, provided they
do not have any foreign branch
• Spread between borrowing and lending bank is as per bank’s
discretion

4. Packing credit facility for deemed exports

• Deemed exports made under orders secured through
global tenders in free foreign exchange, are eligible for
packing credit facilities.
• Liquidated by foreign currency loan at post-supply stage

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• Maximum period – earlier of 30 days or up to the date of

payment
• Repayment can be made out of balances in EEFC a/c or
rupee sources – to the extent of supplies made
5. Packing credit facility for Consulting services
Physical movement of goods is not involved
Credit can be provided to mobilize resources like technical
personnel and training them

6. Advance against Cheques/Drafts received as advance payment

• Bank may grant export credit at concessional rate till the time of
realization of the proceeds of the cheques or draft
• The proceeds must be against an export order.

LONDON INTERBANK OFFERED RATE (LIBOR)

• Average of rate charged by leading banks in London from other
banks
• Officially referred to as ICE LIBOR – Intercontinental
Exchange Libor
• Responsibility of administration – Intercontinental exchange
• Primary benchmark rate for short-term interest rates
• Commonly referred to LIBOR for US Dollars transactions
• LIBORs also exist for other currencies like Euro, Swiss Franc,
Japanese Yen and Sterling Pounds.
• Rate from 18 banks is taken, out of which upper and lower 4
rates are ignored and average of remaining 10 rates is the LIBOR
• Announced for 7 tenors:
• Overnight, 1 week, 1 month, 2 months, 3 months, 6 months and
12 months LIBOR.

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The most commonly used LIBORs are the 3 months and 6 months
LIBORs.

CHAPTER 3.3 POST-SHIPMENT FINANCE

• ‘Post-shipment Credit’ means any credit after shipment to the date

of realisation of export proceeds.
• It includes any loan against security of any duty drawback allowed
by the Government from time to time.
Features of post-shipment credit
1. Purpose of finance
• Finance export sales receivables till date of realization of proceeds
• Deemed exports - Finance receivables against supplies made to
designated agencies
2. Basis of finance
Provided against evidence of shipment to importer or designated
agencies
3. Form of Finance
• Can be secured or unsecured
• Document of title given to bank, finance is self-liquidating normally
• If there are advances against undrawn balance – it is unsecured
• Mostly finance is funded. If guarantees are issued, the financing is
non-funded

4. Quantum of finance
• 100% of value of goods
• Finance for price difference (where domestic price is more than
export price) is given if such difference is covered by receivables
from government
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• Undrawn balance can also be financed

• Banks can also stipulate margin requirements
5. Period of Finance
• Depends on the payment terms offered by exporter to overseas
buyer
• Currently period of export proceeds realization and repatriation is
9 months
• In case of demand bills period of advance is Normal transit period
by FEDAI
• In case of Usance bill, credit period can be maximum 365 days from
date of shipment, bank should closely monitor need to extent limit
to 365 days
• ‘Normal transit period’ or NTP means the average period normally
involved from the date of discount till the receipt of bill as
prescribed by FEDAI from time to time.
• At present, NTP specified by FEDAI is 25 days.
• In case of deferred payment exports requiring prior approval of the
Authorized dealer, RBI or Exim Bank, post-shipment finance can be
extended at non- concessional rates up to the approved period.
Financing for various types of export
1. Physical exports
Provided to actual exporter – in whose name documents are
transferred.
2. Deemed Exports
Financed to the supplier of goods of designated agencies
3. Capital goods and project exports
Finance is sometimes is in name of overseas buyer
Disbursement of money is directly made to the exporter
4. Buyer’s credit
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In case of capital goods and project exports – credit is sometimes

extended directly to foreign buyer
Financial institution in exporting country extends loan to foreign buyer
to finance purchase from exporting country and enable buyer to make
payment to supplier.
5. Supplier’s credit
Finance extended by suppliers to buyers in their own name is referred Commented [hm4]: Mtlb??

to as supplier’s credit.
Exporter extend credit to buyer to finance buyer’s purchase

TYPES OF POST SHIPMENT FINANCE

1. Export Bills Purchased/Discounted (DP & DA Bills)
• Export Bills (Non-L/C Bills) drawn in terms of contract/ order may
be discounted or purchased by the banks.
• Proper limit has to be sanctioned to the exporter for purchase of
export bill facility.
• It involves financing against DP bills, whereas Export Bills
Discounted entails financing against DA bills, where the risk of non-
payment is higher.
• If the export is not covered under L/C, risk of non-payment may
arise. The risk is more pronounced in case of Documents under
Acceptance.

2. Export Bills Negotiated (Bills under L/C)

• Letter of credit is a secure mode of transaction due to the
guarantee by issuing bank so the risk of non-payment is also lower
in this transaction.
• Risk is reduced further by guarantee of confirming bank
• Terms must be carefully examined before negotiating the L/C
• Banks face two major risks in this case:

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a) Risk of non-performance by the exporter, or not following the

terms and conditions in which case the issuing bank would not
honour the LC.
b) Documentary risk:
Discrepancy in the documents can lead to refusal to honour
Negotiating bank and lending bank must thoroughly scrutinize
terms and conditions of LC and documents submitted.

3. Advance Against Export Bills Sent on Collection Basis

• Bills are sent on collection basis when:
a) Exporter fully utilized his L/C
b) There are discrepancies in bill drawn under L/C
c) Exporter himself sent bill on collection, anticipating the
strengthening of foreign currency
• Banks may allow advance against these collection bills to an
exporter.
• Concessional rates of interest can be charged for this advance
• Period of interest:
a) DP Bills: Until the transit period
b) Usance Bills: Transit period plus usance period
• ELIGIBLE TRANSIT PERIOD: Commences from the date of tendering
of the export documents at the bank’s branch for collection and
not from the date of advance.

4. Advance Against Export on Consignment Basis

• Goods are exported on consignment basis at the risk of the
exporter.
• Eventual remittance of sale proceeds is made by agent/consignee.
• The overseas branch/correspondent of the bank is instructed to
deliver the documents against trust receipt.

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• Export on consignment basis may result in misuse in the matter of

repatriation of export proceeds.
• The rate of interest to be charged by banks on post-shipment credit
should be similar to normal export transactions.
• In this case, even if extended period beyond 365 days is allowed by
RBI, prescribed rate will be charged by bank only up to notional due
date (subject to maximum of 365 days)

5. Advance against Undrawn Balance on Exports

• It is customary to leave a certain amount as undrawn balance for
buyers to make adjustments are made by buyer for differences
ascertained after arrival and inspection of goods.
• Authorized Dealers (Banks) can handle such Bills provided the
undrawn balance is in conformity with the normal level of balance
left undrawn in the particular line of export trade.
• Payment of undrawn balance is contingent in nature. Banks may
consider granting advances against undrawn balances based on
their commercial judgment and the track record of the buyer
• The exporter has to give an undertaking that he shall surrender or
account for the balance of the proceeds within a period prescribed
for Realization.

6. Advance Against Receivables from Government

• Exporter get support/ incentive from government to cover the cost
differences in international market price and domestic cost of
production of goods
• The Government of India and other agencies provide support to the
exporters under the Export Promotion Scheme in the form of
refund of Excise and Customs duty, known as Duty Drawback.

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• These advances being in the nature of unsecured advances cannot

be granted in isolation. These are granted only if other types of
export finance are also extended to the exporter by the same
bank.
• These advances are liquidated out of the settlement of claims
lodged by the exporters. The bank should be authorized to receive
the claim amount directly from the concerned government
authorities.

CRYSTALLIZATION OF OVERDUE EXPORT BILLS

• If the export bill discounted is not realized on due date
Demand Bills – Normal Transit period
Usance Bills – Notional due date
• To avoid Exchange risk and swap costs – Exporter’s foreign
exchange liability is converted into rupee liability.
• TT selling rate is used for conversion of liability to INR

Rediscounting of Export Bills Abroad Scheme (EBR)

• Available in all convertible currencies in addition to the existing

post financing options
• The scheme mainly covers export bills up to 180 days from date of
shipment (inclusive of normal transit period and grace period, if any
applicable).
• ADs rediscount the export bills in overseas market by way of Line
of Credit or Banker's Acceptance Facility or any other similar
facility.
• Rediscount rates: Rates linked to international interest rates at
post-shipment stage.

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• Spread between Borrowing and Lending is left to the discretion of

the bank concerned.
• Rediscounting on without-recourse basis: The credit limits of the
exporter are restored immediately.
• ADs can use following sources to extend post-shipment credit in
foreign currency:
a) Exchange Earner's Foreign Currency accounts (EEFC),
b) Resident Foreign Currency Account and
c) Foreign Currency (non-resident) Account schemes
• Rediscounting facilities can be taken from abroad without prior
permission from the RBI, subject to compliance of guidelines.

OPTIONS FOR THE EXPORTER

1. Pre-shipment credit and post-shipment credit in Rupees.
2. Pre-shipment in Rupees and post-shipment under export bill
rediscounting in foreign currency, EBR.
3. Pre-shipment in Foreign Currency (PCFC) and post-shipment under
export bill rediscounting in foreign currency, under EBR.
Exporter can choose currency for credit based on premium/ discount
factor and the risk exposure.

CHAPTER 3.4 FORFAITING AND FACTORING

Hardlabor Industries utilized appropriate pre-shipment and post-

shipment financing options and has been able to fulfil its first and
subsequent exports orders very profitably.
Hardlabor Industries has grown organically and now has a good
reputation in the international market. A substantial portion of
Hardlabor Industries' income now is generated from overseas buyers.
Trust Money Bank has been Hardlabor Industries' partner in growth
and has provided it with appropriate Trade Finance instruments at
various stages of its growth lifecycle.
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With many international customers procuring its goods at regular

intervals, Hardlabor Industries is now exploring more financial options
in order to streamline its cash flows and enhance liquidity.
Again, Mr. Serve well meets up with Mr. Smarts, and over a cup of
Coffee, they discuss how Trust Money Bank can step into make things
even simpler for for Hardlabor Industries. Forfaiting and Factoring
services are discussed in detail.

BRIEF HISTORY
Factoring has a long and rich tradition, dating back 4,000 years to the
days of Hammurabi. Hammurabi was the king of Mesopotamia, which
gets credit as the
"cradle of civilization." In addition to many other things, the
Mesopotamians first developed writing, put structure into business
code and government regulation, and came up with the concept of
factoring.
The first widespread, documented use of factoring occurred in the
American colonies before the revolution. During this time, cotton, furs
and timber were shipped from the colonies. Merchant bankers in
London and other parts of Europe advanced funds to the colonists for
these raw materials, before they reached the continent. This enabled
the colonists to continue to harvest their new land, free from the
burden of waiting to be paid by their European customers.
These were not banking relationships, as they exist today. If the
colonists had been forced to use modern banking services in
eighteenth century England, the process would have been much
slower. The banks would have waited to collect from the European
buyers of the raw materials before paying the seller of these goods.
This was not practical for anyone involved. So, just as today, the
"factors" of colonial times made advances against the accounts
receivable of clients.
With the advent of the Industrial Revolution, factoring became more
focused on the issue of credit, although the basic premise remained
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the same. By assisting clients in determining the creditworthiness of

their customers and setting credit limits, factors could actually
guarantee payment for approved customers. This is known as
factoring without recourse (or non-recourse factoring) and is quite
common in business today.
Today, factors exist in all shapes and sizes: as divisions of large
financial institutions or, in larger numbers, as individually owned and
operated entrepreneurial endeavors.

Forfaiting and factoring

Forfaiting and factoring are similar services that serve to provide
better cash flows and risk mitigation to the seller. It may be mentioned
that factoring is for short-term receivables (under 90 days) and is more
related to receivables against commodity sales. Forfaiting can be for
receivables against which payments are due over a longer term, over
90 days and even to 5 years. The difference in the risk profiles of the
receivables is the fundamental difference between factoring and
forfaiting, which has implications for the cost of services.
Both factoring and forfaiting are like bill discounting, but bill
discounting is more domestic-related and usually falls within the
working capital limit set by the bank for the customer.

FORFAITING
Forfaiting is a mechanism of financing exports :
• By discounting export receivables.
• Evidenced by bills of exchange or promissory notes.
• Without recourse to the seller (such as the exporter).
• Carrying medium to long-term maturities.
• On a fixed rate basis (discount).
• Up to 100% of the contract value.

In a forfaiting transaction, the exporter surrenders his rights to claim

for payment on goods delivered to an importer, in return for
immediate cash payment from a forfaiting agency. As a result, an
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exporter can convert a credit sale into a cash sale, with no recourse
either to him or his banker.

FORFAITING - OPERATING PROCEDURE

1. Exporter initiates negotiations with prospective overseas buyer,

finalizes the contract and the importer opens an LC through his Bank
in favour of the seller (exporter).
2. Exporter Ships the goods as per the sched Are agreed with the
buyer.
3. The exporter draws a series of bills of exchange and sends them
along with the shipping documents, to his banker for presentation to
importer for acceptance through latter's bank. Bank returns avalised
and accepted bills of exchange to his client (the exporter).
4. Exporter informs the Importers Bank about assignment of proceeds
of transaction to the Forfaiting bank.
5. Exporter endorses avalised Bill of Exchange (BOE) with the words
"Without recourse" and forwards them to the Forfaiting Agency (FA)
through his bank.
6. The FA effects payments of discounted value after verifying the
Aval's signature and other particulars.
7. Exporter's Bank credits Exporter's a/c.
8. On maturity of BOE/Promissory notes, the Forfaiting Agency
presents the instruments to the Aval (Importer's Bank) for payment.

DOCUMENTARY REQUIREMENT
In case of Indian exporters availing Forfaiting facility, the forfaiting
transaction is to be reflected in the following three documents
associated with an export trans-action, in the manner suggested
below-

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• Invoice: Forfaiting discount, commitment fees, etc. need not be

shown separately, instead, these could be built into the FOB price,
stated on the invoice.
• Shipping Bill and GR form: Details of the forfaiting costs are to be
included along with the other details, such as FOB price, commission
insurance, normally included in the "Analysis of Export Value" on the
Shipping Bill. The claim for duty drawback if any is to be certified only
with reference to the FOB value of the exports stated on the shipping
bill.

Benefits to Exporter
• 100 per cent financing - Without recourse and not occupying
exporter's credit line. That is to say once the exporter obtains the
financed fund, he will be exempt from the responsibility to repay the
debt.
• Improved cash flow - Receivables become current cash inflow and it
is beneficial to the exporter to improve financial status and liquidity
position so as to further improve the Credit rating.
• Reduced administration cost - By using forraiting, the exporter will
be spared from the management of the receivables. The relative costs,
as a re-sult, are reduced greatly.
• Advanced tax refund - Through forfaiting, the exporter can make the
verification of export and get tax refund in advance just after
financing.
• Risk reduction - Forfaiting business enables the exporter to transfer
various risks resulted from deferred payment, such as interest-rate
risk, currency risk, credit risk and political risk to the forfaiting bank.
• Increased trade opportunity - With forfaiting, the exporter is able to
grant credit to his buyer freely, and thus, be more competitive in the
market.

FEE TYPE DESCRIPTION

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Commitment Fee
This is payable to the forfaiting Agency for his commitment to execute
a specific forfaiting transaction at a firm discount rate within a
specified time. It ranges between 0.5% to 1.5% per annum of the
unutilized amount to be forfaited and is charged for the period
between the date the commitment is given by the forfaiter and the
date the discounting takes place or until the validity of the forfaiting
contract, whichever is earlier.

Discount Fee
This is the interest cost payable by the exporter for the entire period
of credit involved and is deducted by the forfaiter from the amount
paid to the exporter against the avalised promissory notes or bills of
exchange.

Benefit to Bank
Forfaiting services provide the bank with the following benefits :
• Banks can provide an innovative product range to clients, enabling
the client to avail 100% finance, as against 80-85% in case of other
discounting products.
• Banks gain fee-based income.
• Lower credit administration and credit follow up.

FACTORING
Factoring is a continuing arrangement between a financial institution
(the Factor) and a business concern (the client), selling goods or
services to trade customers. The Factor purchases the client's book
debts (account receivables) either with or without recourse to the
client.
The purchase of book debts or receivables is central to the functioning
of factor-ing. The supplier submits invoices arising from contracts of
sale of goods to the Factor.

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The Factor performs at least two of the following services:

• Financing for the seller, by way of advance payments.
• Maintenance of accounts relating to the account receivables.
• Collection of account receivables.
• Credit protection against default in payment by the buyer.
The buyer is informed in writing that all payment of receivables should
be made to the Factor.

Different Models of Factoring

Export Factoring can be done based on two distinct models :
1. Two-factor system
2. Direct factoring

(1) A two-factor system

It essentially involves an export factor in the country of the seller
(exporter) and its correspondent factor (import factor) in the country
of the debtor (importer).
The correspondent factor typically performs a mutually agreed set of
services for the export factor. It could be any one or both the below
mentioned services:
A. Credit Guarantee Protection: The import factor undertakes to pay
the export factor in the event the importer fails to pay by a specified
period after due date. The import factor sets up limits on buyers
present in that country and the export factor discounts invoices for its
customers based on these limits. The credit guarantee protection
covers insolvency/protracted default of buyer. However it does not
cover trade disputes.
B. Collection Services: The import factor undertakes to follow up with
debtors for payment and in cases where payment is not forthcoming
they would be in a position to detect early indications as they would
be based in the same location and would be familiar with local
business intelligence as well as practices.
The factoring quotes given by various import factors would differ
depending on their location and comfort regarding the overseas
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buyer. In this situation, the export factor would need to monitor its
correspondent relations with various import factors across the globe.
Also, the possibility of undertaking any factoring business by the
export factor would be depend on the response of the import factors
for each transaction.
(2) Direct Factoring with credit insurance and tie up with a global
collection agency
Factoring can also be offered by availing credit insurance for the entire
factoring portfolio. Credit insurance will cover insolvency/protracted
default by the buyer as well as country risk but it would not cover
trade disputes. The credit insurer will set up limits on overseas buyers
and based on these limits export bills would be discounted
Thereafter, details of the invoice would be passed on to the collection
agency that will follow up for payment with the overseas buyer. In
case the overseas buyer does not respond, the collection agent can
monitor potential default cases, so that credit insurer can be informed
in advance.
Using services of a collection agency could reduce significantly the
delays and to some extent the uncertainty in payments from overseas
buyers.

Comparison of Model I & Model II

Advantages Disadvantages

Model I (Two-factor 1. Greater 1. Relatively

System) geographical expensive
coverage possible 2. Varying standards
with tying up with a of service of import
large number of factors
import factors 3. Response time
2.The credit risk on 4. Need to deal with
the overseas buyer is many correspondent

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assumed by the factors

import factor 5.Trade disputes are
not covered

Model II (Direct 1. Comparatively 1. export factor

Factoring with Credit low-cost option would be subject to
Insurance) 2. The export factor uninsured first losses
would retain 2. Trade disputes are
complete control not covered
over the customer
3. Faster response
time
4. Greater flexibility
with export factor in
decision marking

Benefits of Factoring
• Turnover linked finance - So as an exporter, you can finance a higher
level of sales than before and plan growth more effectively.
• Flexible cash flow - To finance working capital requirements and
improve profitability.
• No collateral/security - So availing the financing is comparatively
easier.
• More time for core business - Since sales ledger management and
collections are handled by the Factor.
• Credit protection - Reduces the incidence of bad debts.
• Pre-assessments - So buyers creditworthiness is checked
beforehand.
• Regular MIS reports - MIS reports from Factors reduce the time
spent on reconciliation of outstanding.

Factoring: Operating procedure

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For the factoring operations, the pre-requisite is the establishment of

a factoring relationship between the client and the factor. On the basis
of credit evaluation, the factor fixes limits for individual customers of
the client indicating the extent to which, and the period for which the
Factor is prepared to accept the client's receivables for such
customers:
1. The client (seller) sells the goods to the customer (buyer) and
invoices him in the usual way - inscribing a notification to the effect
that the debt due on the invoice is assigned to and must be pal to the
Factor.
2. The client offers the assigned invoices to the Factor under cover of
a schedule of offer accompanied by copies of invoices and receipted
delivery challans.
3. The Factor provides immediate prepayment up to 80% of the value
of the assigned invoices and notifies the customer sending a
statement of account.
4. Factor follows up with the customer and sends him the statement.
5. The Customer makes the payment to the Factor.
6. When the customer makes the payment for the invoice, the Factor
will pay the balance 20% of the invoice value.

The prominent features of the arrangement are :

1. The drawings in the client's account will be regulated on the basis
of the drawing eligibility available from time to time, against the debts
so purchased by the Factor, less the amount of retention money.
2. The client will be free to draw funds at any time up to the drawing
eligibility, which will be adjusted for: (a) new debts factored (b)
factored debts collected (c) charges debited.
3. The Factor will send age-wise statements of accounts to the client
at the agreed periodicity.

FEE TYPE DESCRIPTION

Finance Charge

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Finance charge is computed on the pre-payment outstanding in

exporter's account at monthly intervals.

Service Fee
Service charge is a nominal charge levied at monthly intervals to cover
the cost of services viz. collection, sales ledger management and
periodical MIS reports. It ranges from 0.1% to 0.3% on the total value
of invoices factored/collected by the Bank.

BILL DISCOUNTING VS. FACTORING

A comparison table between the two instruments is as under:
Table

Bill Discounting Factoring

1.Individual transaction 1. whole turnover basis. This also
gives the client the liberty to
draw desired finance only.
2. Each bill has to be individually 2. A one time notification is taken
accepted by the drawee which from the customer at the
takes time commencement of the facility
3. Stamp duty is charged on 3. No stamp duty is charged on
certain usance bills together with the invoice. No charge other than
bank charges it proves very the usual finance and service
expensive charge.
4. More paper work is involved 4.no such paper work is involved
5. Grace period for payment is 5. Grace period is far more
usually 3 days generous.
6. Original documents like MTR , 6. Original copies of such
RR bills of lading are to be documents are necessary
submitted
7. Charges are normally upfront 7. No upfront charges. Finance
charges are levied on only the
amount of money withdrawn.

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CHAPTER 3.5 BANK GUARANTEES

• Guarantees are given by bank on behalf of its customer regarding

specific performance/ obligation by the customer to the other
party.
• The guarantees ensure payment to the party with whom the bank's
customer is doing business.

Under a bank guarantee/surety bond arrangement:

• The bank acts as guarantor of a claim or obligation in lieu of the
debtor.
• The bank cannot be held liable in the event that the debtor fails to
"perform".
• The banks obligation is limited to its pledge to pay a maximum
specified amount on fulfilment of the terms of the commitment.
• Bank guarantee bond issued if the customer has been granted a
line of credit and collateral may also be required.

Difference in LC and BG
• LC is ‘positive action’ instrument i.e. Payment released when all
conditions are met.
• BG is ‘non-performance’ instrument i.e. Payment released when
terms are not complied with.

TYPES OF BANK GUARANTEES

In principle, there are two types of guarantees:

DIRECT GUARANTEE

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Client instructs the bank to issue a guarantee directly in favour of the

beneficiary.

INDIRECT GUARANTEE
• A second bank – usually a foreign bank (located in beneficiary’s
country) is involved in this case
• The second bank is requested by the initiating bank to issue a
guarantee in return for the beneficiary's counter- liability and
counter-guarantee.
• The initiating bank will cover the guaranteeing (foreign) bank
against the risk of any losses from claim made under the guarantee.
• It formally pledges to pay the amounts claimed under the
guarantee upon first demand by the guaranteeing bank.

Depending on the purpose of the Guarantee, the Bank Guarantees

may be classified as under:

1. Tender Bond
• Also known as a bid bond.
• Purpose: To prevent a company from submitting a tender, winning
the contract and then declining to accept it on the grounds that
the deal is no longer lucrative.
• Offer buyers security against dubious or unqualified bids.
• They are often mandatory for public invitations to tender.

2. Performance Bond

• Also known as a performance guarantee.

• Purpose: Security for any costs incurred by the bond beneficiary on
non-performance of:

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a) Contractually agreed service

b) Contractual deadline.

3. Credit Guarantee
• Borrowers are often required to provide collateral for a credit line
or a loan.
• A third party may also provide collateral.
• A bank guarantee is one of the options creditors have to ensure
that a loan will be repaid. (On the condition that the lending and
guaranteeing banks are not identical)

4. Payment Guarantee
• Purpose: Security against default in payment for the goods to be
delivered
• A written declaration to this effect is generally sufficient to
redeem payment from the guaranteeing bank.
• This instrument can be used instead of a letter of credit if, for
example, the buyer does not require or demand proof of delivery
by means of the usual original delivery documents.

5. Confirmed Payment Order

Irrevocable obligation:
• On the part of the bank;
• To pay a specified sum;
• At a specified time;
• To the beneficiary (creditor);
• On behalf of the customer.

6. Advance Payment Guarantee

• Purpose: To ensure that supplier uses the advance payment only
for the purpose stated in the contract between buyer and supplier

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• An advance payment provides the supplier with funds to purchase

equipment or components, for example, or to make other
preparations.
• Contain a reduction clause that automatically reduces the amount
in proportion to the value of the (partial) delivery.
• Effective from: The advance payment guarantee should only
become effective once the advance payment has been received.

7. Mobilization Advance Guarantee

• When projects are awarded to companies, they require release of
some amount in advance to mobilize resources.
• Such amounts are released against Bank guarantee known as
Mobilization Advance Guarantee.
• Set off: As the contract is executed, the advance is set off by
progressive payments and the amount of the guarantee also
decreases over time.

8. B/L Letter of Indemnity

• This is also called a Letter of Indemnity.
• Issue: Individual bill of lading or the full set can go missing or be
held up in the mail.
• Carriers may be liable for damages if they deliver the consignment
before receiving the original bill of lading.
• A bank guarantee in the carrier's favour for 100-200% of the value
of the goods enables them to deliver the goods to the consignee
without presentation of the original documents.

9. Rental Guarantee
• This is a guarantee of payment under a rental contract.

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• The guarantee is either limited to rental payments only, or includes

all payments due under the rental contract.

10. Credit Card Guarantee

• Credit card companies will not issue a high value credit card
without a bank guarantee.
• Such kind of guarantee extended by a Bank is known as a Credit
Card Guarantee.

CLAIM (GUARANTEE UTILIZATION)

If the beneficiary under the guarantee considers that the supplier has
violated the supplier's contractual obligations, the former may utilize
the guarantee.
Claims must be made during the period of validity and strictly in
accordance with the guarantee conditions.

GENERAL GUIDELINES

Guidelines for ADs and EXIM banks to furnish guarantees without

prior approval of RBI.
Safeguards before issuing Guarantees:
1. Customer’s ability to reimburse amount paid under guarantee
2. In the case of Performance Guarantees: Ensure that customer has
experience, capacity and means to perform obligations
3. Existing credit lines issued to customer
4. Term of Guarantee – normally less than 10 years recommended.
To issues longer duration guarantees, impact on Asset liability
management need to be considered by banks
5. To enable banks to formulate their own policy related to
unsecured exposures, restriction to issue unsecured guarantee up to
following extent is removed.
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Maximum unsecured exposure – Not more than 15% of Total

outstanding advances
Where, Unsecured exposure =
20% of unsecured advances + Other unsecured advances
Unsecured Exposure: Exposure where the realizable value of the
security is not more than 10%
Exposure: Includes all funded and non-funded exposures (including
underwriting and similar commitments).
Security:
• Tangible security properly charged to the bank and will not include
intangible securities like guarantees, comfort letters, etc.
• Collateral securities charged to banks in respect of projects
financed are not considered as tangible security.
• Annuities under BOT (Build-operate-transfer) Model can be treated
as tangible securities, subject to conditions that banks' right to receive
annuities and toll collection rights is legally enforceable and
irrevocable.

UNIFORM RULES FOR DEMAND GUARANTEES (URDG)

Framework developed by ICC for:
• Harmonizing international trading practices
• Set of contractual rules for independent guarantee agreements.
Prior to 2010, URDG 458 was used, which has been revised to URDG
758.

URDG 758
The Uniform Rules for Demand Guarantees, 2010 Revision,
International Chamber of Commerce Publication No. 758 (the
"URDG"), became effective on July 1, 2010.

• Designed to unify independent guarantee practice, set of rules for

demand guarantees and counter-guarantees
• URDG 758 is not "law"
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• Sets out the roles and responsibilities of all parties

• Reflects "best practice" in the guarantee business.
• It comprises 35 articles
• It is not mandatory for Banks in India to issue guarantees in terms
of URDG 758.
• Due the global importance of ICC guidelines, Indian Banks need to
formulate own policies abiding by 758 terms

In terms of FEDAI directions, guarantees issued under URDG 758

would be subject to the following conditions:

• Provisions of FEMA 1999 and rules, regulations, circulars etc.

issued thereunder should be complied
• Comply with extant law/provisions of Indian Contract Act.
• Banks are required to include a suitable clause indicating that the
guarantee/counter-guarantee issued under URDG 758 is subject to
Indian Laws.

STANDBY LETTER OF CREDIT

• Used where assuming guarantees is restricted
• Commonly used by US banks
SIMILARITIES WITH THE GUARANTEE
• Abstract in nature, i.e. legally separated from the underlying
transaction
• The documents stipulated in the claim must be submitted within
the specified period.
• These documents act as a proof of non-performance by either
party
• The standby basically fulfils the same purpose as a guarantee
• It is payable upon first demand and without objections or defences
on the basis of the underlying transaction.
• It is up to the beneficiary to decide whether a standby may be
given.

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AREA OF APPLICATION
• Used in import-export business
• Primarily with the Americas and frequently in the Far East

PURPOSE
To secure any claims by the obligee on the obligor due to non-
contractual delivery or performance by the agreed date or credit
repayment on the due date.

SPECIAL FEATURES
• A standby can be confirmed immediately, provided the standby
conditions permit.
• Deferment of the country and credit risk
• The Standby Letters of Credit (LCs) are issued subject to:
a) Uniform customs and Practices for Documentary Credits (UCPDC)
Publication No. 600 or
b) International Standby Practices (ISP 98)
issued by International Chamber of Commerce.

CO-ACCEPTANCE OF BILLS
• Non-fund-based import finance.
• Bill of Exchange drawn by an exporter on the importer is co-
accepted by a Bank.
• Bank undertakes to make payment to the exporter even if the
importer fails to make payment on due date.
• The co-acceptance acts as a guarantee for the exporter

BENEFITS TO CUSTOMER
• Cheaper as compared to opening Import Letter of Credit (LC)
• Commission is applicable after shipment, unlike from date of
opening in case of LC
• Used only when the goods are shipped by exporter and documents
are received at the counters of the importer's Bank.

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• It is a means of non-recourse finance for the exporter, thereby

strengthening the importer's bargaining power.

BENEFITS TO BANK
• Additional Avenue for fee income.
• An addition to product, which can be used by the Bank to attract
new clients.
• Encourage customers to use credit: Customers, who do not use
their LC limits with the Bank, can be encouraged to make use of the
Co-acceptance facility, which is cheaper.
PROCESS FLOW
• Sanctioning of Co-Acceptance Limit by signing of one-time co-
acceptance Facility Agreement.
• Receipt of import documents including a Bill of Exchange by the
Co-accepting bank.
• A presentation memo generated and sent to the customer
(importer) for acceptance.
• After receiving Acceptance Letter and a request letter from the
customer (importer), Bank will co-accept the bill of exchange.
• Notification of Co-acceptance: Through a SWIFT message sent to
his bank.
• From here on, the process flow will be same as that of an Import
Bill under LC.

CHAPTER 3.6 DOMESTIC TRADE FINANCE

• Similar to the trade finance business on an international level.

• Regulatory framework is much simpler.
• Customs clearance is not required
• Remittances do not need to be reported to Forex regulatory
bodies.
• Export/import licenses are not required and export quota
restrictions do not limit growth.
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• Confidence is higher because both parties operate in same legal

and administrative framework.

Modes of transactions are also similar to International Trade. These

include:

Clean Payments
• Open a/c transactions
• Advance payments

Documentary Collections
• Delivery against payment
• Delivery against acceptance

Documentary Credit
Note:
Clean payments and documentary collections are used more often.
Most of the Trade finance options available in international trade are
also available in domestic trade.
Financing options relevant in domestic trade:

CHANNEL FINANCING

• Forward and backward linkages in a business organization play a

significant role in the success or failure of the business entity.
• Channel financing relates to ensuring that integrated financial and
commercial solution is available to the entire chain of supply and
distribution, that could ensure the health of the firm, financed by
the bank.

How channel financing is different from conventional lending?

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• In conventional lending, the financing banks are generally not

concerned as to how the suppliers of the firm and dealers of the
products of firm, are financing their activity.
• In the channel financing the financing bank may have to find ways
and means as to how the suppliers and buyers (dealers of the
product) can be financed through various instruments/facilities.
• Hence, the channel financing adds value to the transaction for all
the parties concerned.

Methodology:
• Reduce dependence on bank finance by outsourcing major part of
working capital.
Example:
a) Drawee Bill Financing
Credit to pay off suppliers not required, because supplier gets finance
in his own name on material supplied.
b) Factoring of receivables/ Finance against book debts
Credit period/ term can be allowed to dealer with this finance,
because firm gets the cash immediately for goods supplied.
• Principle Customer – the dealing firm, suggest names of suppliers
and customers to bank.
• Bank assesses – creditworthiness and standing of suppliers/dealers
and then makes decision.

BENEFITS TO PARTIES INVOLVED:

a) Financed Concern
i)Pre and Post sale working capital requirement – Scaled down.
ii) Concentrate more on their competence area of production and
marketing of products

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iii) Save time and costs involved in arranging creditors and monitoring
recovery.

b) Supplier and Dealers/buyers

i)Receive the payment promptly
ii) Improve Liquidity position and save cost
iii) Reduce counterparty risks

c) Gains to banks from channel financing:

i)Increased customer base
ii) Effective due diligence
iii) Smoothness of lending activity and loan origination process
iv) Ensure better credit discipline
v) Better observation of credit exposure by diversification of risk
between supplier, manufacturer and dealer
vi) Convenient tool for asset portfolio management

WHY BANKS SHOULD ADOPT CHANNEL FINANCING:

i)Suggested for implementation in various forms by various

committees in India
a) Receivable financing by Tandon Committee,
b) Drawee bills financing by Chore Committee
c) Through factoring by Kalyana-Sundaram Committee

ii) Opens up manifold opportunities due to which the banks can make
conscious efforts at popularizing this credit delivery mechanism.

VENDOR FINANCING

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• Vendor financing is a loan arrangement that takes place between

a company and a vendor that supplies a large amount of product to
the company.
• This arrangement is different from extending a credit line
• Vendor financing used commonly where there is a strong working
relationship between the customer and the vendor.

• Vendors can leverage their relationship with reputed companies by

sourcing low-cost bill discounting line of credit.
• Vendor Financing is a product to extend working capital finance to
vendors having business relationships with large corporates in
India.
• Herein the bank undertakes to discount bills drawn by the
supplier/vendor and accepted by the corporate.

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