How non-fund based credit works
Term loans and amounts drawn under cash credit are funded exposures. With a non-fund based (NFB) facility, a bank undertakes to pay a third party if the applicable conditions are met. It does not advance cash to the customer simply by issuing a letter of credit (LC) or bank guarantee (BG). The undertaking is the bank’s own commitment. Check whether the tender or supplier accepts alternatives before including an instrument in the financing plan.
For commercial banks, Chapter XVI of the RBI Credit Facilities Directions requires a credit policy addressing NFB appraisal, limits, security, controls and monitoring. The general rule links issuance to a funded facility with that bank, subject to specified exceptions. Examples include eligible fully secured facilities and cases meeting the requirements for a no-objection certificate from the funded lender or lenders. Confirm the provision and the bank’s approval before assuming a stand-alone line.
Letter of credit versus bank guarantee
| Dimension | Documentary LC | Bank guarantee |
|---|---|---|
| Commercial role | Provides the seller a documentary payment undertaking. | Secures a financial or performance obligation under the deed. |
| Payment trigger | Complying presentation; payment timing depends on sight, deferred-payment or acceptance terms. | A demand satisfying the guarantee’s wording, including time, amount, form and any required statements or documents. |
| Rules | ICC UCP 600 applies when incorporated. Banks deal with documents and assess them against the credit, subject to applicable law. | Apply the guarantee deed, governing law and relevant RBI directions. ICC URDG 758 applies when incorporated, subject to its terms. |
| Documents and structures | Invoice, transport, packing, insurance or inspection documents if required. Structures include domestic, import, sight, usance, revolving and back-to-back credits. | Examples include advance payment, security deposit, bid, performance and defect liability guarantees. Read the tender and actual wording to identify the obligations secured. |
| Exposure turning into a funded debit | If the bank pays but the applicant has not provided funds, the LC may devolve. | If the bank pays a complying demand, reimbursement is governed by the facility and counter-indemnity. |
Estimate an LC limit
Start with the value of procurement that will use LCs. For a steady purchasing run rate, monthly LC procurement times the number of months an LC occupies the line estimates average outstanding exposure. Run a shipment-by-shipment schedule for seasonal orders, overlap and foreign exchange changes. Measure from issuance or the bank’s limit-blocking date to release or settlement, based on the actual terms. Add only time intervals that do not overlap. Usance can start from a shipment, sight, acceptance or other specified date; shipping and clearance may run inside that period.
For example, annual import LC purchases of ₹36 crore give ₹3 crore a month. Assume the line is blocked for 4.5 months: one month for the first interval, half a month for clearance and inspection, and three months from the specified maturity reference event thereafter. If those intervals are consecutive and a 30-day planning month is used, indicative exposure is ₹13.50 crore. If usance starts on shipment, rebuild the calendar rather than adding all three intervals.
Size a guarantee portfolio and the cash it ties up
List outstanding guarantees and projected issues by contract, beneficiary, face amount, issue and expiry dates, claim period and documented release or reduction. Bid, performance and advance guarantees can overlap. Add the live face amounts at each date, reflecting step-downs when effective, then size the line to the peak and a justified contingency. Use contract-specific percentages and defect liability terms. A stock of live contract values should not be multiplied again by years of tenure. An annual flow of new contracts needs an issuance and release schedule.
Financial guarantees secure a monetary obligation, such as repayment of a mobilisation advance. A performance guarantee backs performance under the contract. The bank classifies the exposure by substance for capital purposes. Its regulatory credit conversion factor is distinct from the counterparty risk weight and from the cash margin charged to the customer.
Cash margin, deposit lien, title documents, underlying security, collateral and commission follow the bank’s approval, pricing and facility documents. Check the rate base, minimum fee, charging period, taxes, collateral release and permitted interchange between facilities. A lien-marked fixed deposit ties up liquidity even when interest accrues. Do not assume the bank has a pledge simply because an LC exists, or that an existing security automatically extends to new facilities.
Handle devolvement and invocation
Where UCP 600 is incorporated, the issuing bank is bound to honour a complying presentation under its terms. A buyer’s inability to reimburse it is not itself grounds for refusing such a presentation. The bank may book a funded debit in line with the facility. RBI’s income-recognition and asset-classification directions include outstanding devolved LC or invoked BG debits in the principal operating account for classification even if the bank parks them separately. Apply the governing overdue or out-of-order tests and borrower-level rules; there is no automatic SMA-1 or SMA-2 on the day of devolvement or automatic NPA solely because 30 days elapse.
For a guarantee demand, check the exact deed, demand language, timing and amount. RBI’s directions require commercial banks to honour guarantees invoked in accordance with the deed unless a court has restrained payment. Under the Supreme Court’s approach, including U.P. State Sugar Corporation v. Sumac International Ltd, courts generally decline to restrain a complying demand under an unconditional guarantee except on narrow grounds, such as egregious fraud known to the bank or irretrievable injustice. An ordinary dispute about delays or performance does not suffice. Non-compliance with the guarantee’s own terms is a separate issue.
Seven worked cases
All sanction terms, facts and outcomes below are illustrative.
1. Domestic LC for steel procurement
Annual LC purchases of ₹48 crore give ₹4 crore a month. Assume the bank blocks the line for 120 days, comprising 30 days of transit and inspection followed by 90 days of usance, with no overlap. Using a 30-day planning month, indicative exposure is ₹16 crore. At an assumed 15% cash margin on the full ₹16 crore exposure, the required lien-marked deposit is ₹2.40 crore.
2. EPC contractor’s concurrent guarantees
Assume ₹100 crore of live bids at 2%, ₹180 crore of active contracts at 5%, and a ₹60 crore new package with a 10% advance. Their respective guarantees are ₹2 crore, ₹9 crore and ₹6 crore. If they all overlap at full face value, the peak is ₹17 crore. At a 10% margin, that peak ties up ₹1.70 crore. Model six-month bid validity and three years of construction plus one year of defect liability for the performance guarantee only as the assumed contract terms, including actual claim and release dates.
3. Fund an LC shortfall
An import LC for ₹2.20 crore matures on 15 November 2026. Applying an available ₹35 lakh cash balance leaves ₹1.85 crore to fund. After ₹90 lakh from internal accruals, the uncovered amount is ₹95 lakh. If the bank approves a working capital demand loan for that balance and the debit is cleared 12 calendar days after maturity, clearance is on 27 November. This illustration assumes the stated dates; it does not establish the applicable classification, charges or reporting outcome.
4. A disputed performance guarantee demand
A metro contractor reports that a project is 98% complete. The employer demands ₹4.50 crore under an unconditional performance guarantee, although the contractor has letters documenting employer-side delays. Check the guarantee and demand immediately, preserve evidence and arrange liquidity. If there is an applicable arbitration agreement, counsel can assess whether to seek interim measures under section 9 of the Arbitration and Conciliation Act, 1996. The delay letters alone do not establish fraud or irretrievable injustice, and no injunction is assumed.
5. Interchange between cash credit and LC limits
A bank sanctions ₹10 crore of cash credit and ₹5 crore of LC capacity, with written authority to transfer up to ₹3 crore of available headroom between the two. Moving ₹3 crore to LCs gives ₹8 crore of LC capacity and leaves ₹7 crore of cash credit capacity within the ₹15 crore total. Test outstanding drawings, drawing power, security and margin conditions before treating the headroom as available.
6. Lien-marked deposit and commission
For a ₹10 crore guarantee issued for a full year, assume a ₹1.50 crore fixed deposit and 1.2% annual commission on face value. Margin is 15% and commission is ₹12 lakh before taxes; if recognised evenly over a one-year service period, the expense is ₹1 lakh a month. Apply the applicable accounting standards to classification and any directly attributable costs. Under Schedule III, disclose the balance held as margin money or security separately. Its balance sheet line and current or non-current classification depend on the applicable division, deposit terms, maturity and restrictions; do not treat a restricted deposit as freely available cash. Assess contingent liability disclosure on the underlying facts and recognise deposit interest on the applicable basis.
7. Consortium renewal workpapers
For a three-bank consortium with ₹25 crore in funded and ₹35 crore in NFB facilities, build a schedule showing a combined ₹60 crore of gross sanctioned facilities before any shared caps. Reconcile each lender’s outstanding issuances, commitments, expiry dates, margins and charges to its statements. Link the procurement and guarantee schedules to the Credit Monitoring Arrangement (CMA) data the lenders request. A workbook or financial platform can support the work, but the underlying records and lender terms still need review.
Frequently asked questions
What distinguishes the two facilities?
A funded drawing makes money available to the borrower. An LC or BG creates a payment undertaking to a third party; reimbursement can subsequently become a funded exposure.
How do I estimate the LC requirement?
Estimate monthly LC purchases times non-overlapping months of line use, then verify the peak with a dated schedule. This is a planning model, not a statutory formula.
What happens if the company cannot reimburse an LC?
The bank may pay under the credit and seek reimbursement or book a funded debit. Classification and charges follow applicable RBI directions and facility terms.
How do financial and performance guarantees differ?
They secure different obligations. Classify them by substance and read the deed for payment conditions; margin and commission are separate issues.
Can a court restrain payment under an unconditional BG?
The courts ordinarily do not restrain an invocation made in accordance with the guarantee. The exceptions are narrow. Check first whether the demand meets the deed.
What should the finance model show?
Keep a dated schedule of live and projected commitments, release terms, blocked cash, peak exposure and the liquidity required if a bank must pay.
Sources
- RBI Commercial Banks – Credit Facilities Directions, 2025, Chapter XVI
- RBI Commercial Banks – Income Recognition, Asset Classification and Provisioning Directions, 2025
- ICC UCP 600, Articles 1, 4, 5 and 7
- ICC URDG 758, Articles 1 and 5
- Indian Contract Act, 1872, sections 126–128
- Arbitration and Conciliation Act, 1996, section 9
- Supreme Court, 2025 INSC 640, paragraphs 11–13, discussing Sumac International and enforcement of bank guarantees
- Companies Act, 2013, Schedule III