29 May 2023

Prudential Regulations Banks – Guarantees

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Introduction:

The prudential regulations R-7 issued by the State Bank of Pakistan (SBP) play a crucial role in governing the issuance of banks and Development Financial Institutions (DFIs) guarantees.

These regulations provide a framework for ensuring the soundness, security, and proper risk management associated with guarantees, performance bonds, and counter-guarantees.

By establishing guidelines on collateral, rating requirements, evaluation procedures, and reporting obligations, the SBP aims to safeguard the interests of all stakeholders involved in guarantee transactions.

The prudential regulations R-7 serve as a cornerstone for promoting transparency, reliability, and confidence in the guarantee mechanisms within the financial sector, ultimately contributing to the stability and growth of the economy.

Regulation – R-7 Guarantees

Security of Guarantees

Banks and Development Financial Institutions (DFIs) must ensure complete security for all guarantees they issue.

However, certain exceptions are mentioned in Annexure-IV where banks/DFIs can waive up to 50% of the security requirement at their discretion.

In such cases, banks/DFIs must still hold a minimum of 20% of the guaranteed amount in liquid assets as security.

Annexure IV : Eligible Cases for Relaxation under Regulation R-7

The following cases qualify for relaxation under Regulation R-7:

i) Bid bonds issued on behalf of local consultancy firms/contractors bidding for international contracts or tenders where payments are in foreign exchange.

ii) Performance bonds issued on behalf of local construction companies/contractors bidding for international tenders. The bank/DFI’s liability will be based on reducing balance, considering certified progressive billing and payments received.

iii) Guarantees issued on behalf of local construction companies/contractors bidding for international tenders regarding mobilization advance.

a) The guarantees should include a clause stipulating that the mobilization advance and other contract proceeds will be routed through the contractor’s account with the guaranteeing bank/DFI.

b) The construction company/contractor must sign an agreement with the bank/DFI, ensuring that cash proceeds from the mobilization advance will be released based on the bank/DFI’s satisfaction with the contract’s progress.

iv) Banks/DFIs may determine the type and amount of security when issuing guarantees to cotton exporters, as per F.E. Circular No.77 dated December 4, 1988.

v) Performance bonds, bid bonds, and guarantees issued for mobilization advances on behalf of manufacturers of engineering goods. The term “engineering goods” has the same meaning as defined in the State Bank of Pakistan’s scheme for financing locally manufactured machinery. However, this condition may not apply to guarantees issued by international banks.

Explanation

Performance Bonds

Performance bonds are financial guarantees issued by a bank or financial institution on behalf of a contractor or supplier. They are typically used in construction projects or large contracts to ensure that the contractor fulfills their obligations as outlined in the contract. If the contractor fails to complete the project or meet the agreed-upon terms, the bond serves as compensation for the project owner to cover any financial losses or damages incurred.

Bid Bonds

Bid bonds, also known as tender bonds, are a type of guarantee provided by a bank or financial institution on behalf of a bidder participating in a competitive bidding process.

They demonstrate the bidder’s commitment and financial capability to carry out the project or contract if their bid is accepted. Bid bonds serve as a form of assurance for the project owner that the selected bidder will enter into a contract and provide the necessary performance bond or other required guarantees.

Guarantees

Guarantees, in a financial context, are commitments made by banks or financial institutions to be liable for the payment or fulfillment of a specific obligation if the party responsible for the obligation fails to meet their commitment. Guarantees can take various forms depending on the nature of the obligation. They are commonly used in international trade, construction projects, and other commercial transactions to provide assurance and mitigate financial risks for the parties involved.

Guarantees for Pakistani Firms / Companies

Banks and Development Financial Institutions (DFIs) have the authority to issue guarantees on behalf of Pakistani firms and companies operating within Pakistan.

These guarantees can be issued based on the back-to-back or counter-guarantees provided by banks/DFIs that hold a minimum ‘A’ rating or its equivalent from a credit rating agency approved by the State Bank of Pakistan.

Furthermore, it is acceptable for a foreign bank or Development Financial Institution (DFI) to offer a counter-guarantee if it meets certain criteria.

The counter-guarantee must be provided by a foreign bank/DFI that holds a minimum rating of ‘A’ or its equivalent on a reputable global or national rating scale.

These ratings can be determined by well-known credit ratings agencies such as Standard & Poor, Moody’s, Fitch, Japan Credit Rating Agency (JCRA), or a local credit rating agency in the country where the foreign bank/DFI is located.

However, the guarantee-issuing bank in Pakistan must be comfortable with and agree to accept the counter-guarantee from the foreign bank.

Explanation

Counter-guarantee

A counter-guarantee is a form of guarantee provided by one bank or financial institution to another bank or financial institution as a means of supporting or securing a primary guarantee. It acts as a secondary layer of protection in the event that the party initially responsible for fulfilling the obligation fails to do so.

In the context of international trade or financial transactions, when a bank or financial institution issues a guarantee on behalf of its client, it may seek a counter-guarantee from another bank or financial institution to mitigate its own risk. The counter-guarantee serves as a promise from the second bank or financial institution to cover the obligations outlined in the primary guarantee if the original guarantor is unable to fulfill them.

Counter Guarantees

Additionally, Banks and Development Financial Institutions (DFIs) can issue guarantees and performance bonds to residents of Pakistan based on the counter guarantees provided by banks ranked within the top 1000 globally based on Balance Sheet size.

To facilitate this, Banks/DFIs must have a Board-approved policy with internal limits for accepting such counter guarantees, considering their own risk appetite and the risk profile of the counter-guarantee issuing bank. Banks/DFIs should also establish a mechanism to monitor these limits.

Evaluation of Counter Guarantees

Banks/DFIs must ensure a thorough evaluation of the counter-guarantees received and exercise caution when issuing their own guarantees based on such counter-guarantees.

Reporting to SBP if payments not received

If payments are not received within 20 working days when guarantees from overseas banks are invoked, Banks/DFIs should report the matter to the State Bank of Pakistan (SBP) and provide information on the steps being taken to recover the outstanding amount under the guarantee.

Security for back-to-back L/Cs

For back-to-back letters of credit issued by Banks/DFIs for export-oriented goods and services, they have the freedom to determine security arrangements at their own discretion.

However, this is subject to the condition that the original letter of credit has been established by branches of the guarantee issuing bank or a bank with a minimum ‘A’ rating by Standard & Poor, Moody’s, Fitch, or Japan Credit Rating Agency (JCRA).

Expiry Date of Guarantees and Open Guarantees

Guarantees should specify a specific amount, expiry date, and claim lodgment date. However, Banks/DFIs are permitted to issue open-ended guarantees without clearance from the State Bank of Pakistan in favor of government departments, corporations/autonomous bodies owned or controlled by the government, and guarantees required by the courts.

To issue such guarantees, Banks/DFIs must secure their interests through sufficient collateral or other acceptable arrangements.

Explanation

Back-to-back letters of credit (LCs)

Back-to-back letters of credit (LCs) are a financial arrangement commonly used in international trade transactions. In this setup, two separate LCs are established by different banks to facilitate a chain of payments between various parties involved in the transaction.

Here’s how back-to-back LCs work:

1. The buyer (importer) initiates the process by applying to their local bank for an LC, known as the “original LC” or “master LC.” This LC serves as the primary instrument for purchasing goods or services from a foreign supplier.

2. The buyer’s bank issues the original LC in favor of the foreign supplier. This document assures the supplier that payment will be made once the required documents are presented in compliance with the terms and conditions outlined in the LC.

3. The foreign supplier, in some cases, may require additional payment guarantees. To secure this, they approach their own bank, known as the advising bank, and request a second LC called the “back-to-back LC” or “secondary LC.”

4. The advising bank issues the back-to-back LC in favor of a third party, which can be a subcontractor or supplier. This third party will provide the goods or services required by the foreign supplier to fulfill the obligations specified in the original LC.

The involvement of a third party, such as a subcontractor or supplier, in a back-to-back LC is necessary when the foreign supplier requires additional goods or services to fulfill the obligations specified in the original LC.

5. The back-to-back LC utilizes the original LC as collateral. The advising bank’s commitment to payment is dependent on receiving funds from the buyer’s bank under the original LC.

6. With the back-to-back LC in place, the third party can proceed with the delivery of goods or provision of services to the foreign supplier, ensuring the requirements of the original LC are met.

7. Once the foreign supplier receives payment from the buyer’s bank under the original LC, they can utilize these funds to fulfill their payment obligation to the third party under the back-to-back LC. This completes the transaction chain, ensuring all parties involved receive the necessary payments.

Overall, back-to-back LCs enable complex international trade transactions by providing a secure framework for payments and involving multiple parties in the process. It ensures that goods and services are delivered as agreed upon and provides financial protection for all stakeholders.

SBP Prudential Regulations Link