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Workability of Documentary Credit

Documentary credit is a payment mechanism used in international trade to ensure timely and secure payment for goods or services. It involves an undertaking by a bank, known as the issuing bank, to pay a specified amount to a beneficiary, usually the seller, upon presentation of complying documents. The workability of a documentary credit depends on the clarity and completeness of its terms and conditions, which should be aligned with the underlying sales contract. Applicant and Beneficiary Details The documentary credit should clearly identify the applicant, who is the buyer or importer, and the beneficiary, who is the seller or exporter. The details should include their full names, addresses, and any other relevant contact information. Documentary Credit Amount and Tolerance The documentary credit should specify the currency and amount of the credit. It may also include a tolerance, which allows for a certain percentage of variation in the amount or quantity of goods shipped. Partial...
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Bank Guarantees: Understanding the Charges and Key Considerations

Introduction

A bank guarantee is a financial instrument issued by a bank on behalf of a customer (applicant) to a third party (beneficiary). It assures the beneficiary that the applicant will fulfill a specific contractual obligation. If the applicant fails to meet their obligation, the beneficiary can claim payment directly from the issuing bank. 

Types of Bank Guarantees

Bank guarantees are issued for various purposes and can take different forms, including:

  • Performance Guarantees: Ensure the fulfillment of contractual obligations, such as construction contracts or supply agreements.   
  • Bid Guarantees: Assure that the applicant will enter into a contract after winning a bid.   
  • Advance Payment Guarantees: Protect the beneficiary in case the applicant fails to deliver goods or services after receiving an advance payment.   
  • Payment Guarantees: Guarantee the payment of a specific sum to the beneficiary under certain conditions.   
  • Customs Guarantees: Used to secure the payment of customs duties or taxes.   

Charge Criteria

Banks do of course charge for this service. The basis of charging is outside the scope of this course, but in broad terms it will depend on:

  • The value of the instrument: Higher guarantee values typically result in higher charges.
  • The validity period of the instrument: Longer validity periods generally incur higher fees.
  • The risk of the beneficiary making a call: Guarantees with higher perceived risk (e.g., those related to complex projects) may have higher charges.
  • The risk of the bank being unable to obtain reimbursement from the applicant: The bank assesses the applicant's creditworthiness and financial stability to determine the risk of non-reimbursement.   

Example

Let's consider a construction project where a bank issues a performance guarantee to the client. The bank will consider factors such as:

  • Contract value: A larger contract value will likely result in a higher guarantee amount and, consequently, higher charges.
  • Project duration: A longer project duration means a longer validity period for the guarantee, leading to increased fees.
  • Contractor's financial stability: If the contractor has a history of financial difficulties, the bank may perceive a higher risk of non-reimbursement and charge accordingly.
  • Project complexity: More complex projects may involve higher risks for the contractor and the bank, potentially leading to increased charges.

Key Considerations

  • Negotiation: Applicants can negotiate guarantee fees with the issuing bank, especially for large or complex transactions.
  • Alternative Solutions: In some cases, alternative security arrangements, such as letters of credit, may be more cost-effective.
  • Transparency: It's crucial for applicants to understand the bank's fee structure and any associated terms and conditions before issuing a guarantee.

This article provides a general overview of bank guarantee charges. The specific fees and charging criteria can vary significantly depending on the bank, the type of guarantee, and the specific circumstances of the transaction.






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