Why This Business Is No Longer A Guarantee For Banks

Once a mainstay on balance sheets of top lenders, the business of issuing bank guarantees is losing its sheen.

The demand for bank guarantees has been coming down, forcing lenders to look at other avenues to boost fee income, four bankers said on the condition of anonymity. Incremental issuance of bank guarantees have dropped 30-40% by value since January, the bankers quoted above said.

A bank guarantee is essentially a contingent liability taken by a lender, on behalf of its borrowers. If the borrower is not able to deliver on a contractual payment within time, the guarantee-issuing bank makes good on this payment.

These guarantees have a wide array of applications, including in infrastructure projects, purchase of stressed assets and mergers and acquisitions. However, guarantees given in the course of bidding and executing government contracts make up a large chunk of this business.

There is no clear estimate of the quantum of bank guarantees outstanding. However, the scale of the business can be judged from the books of large banks. For instance, State Bank of India had issued guarantees worth Rs 1.67 lakh crore in FY22 on behalf of constituents in India, according to its annual report. HDFC Bank Ltd. reported guarantees worth Rs 83,391 crore last fiscal. In case of ICICI Bank, the guarantees issued stood at Rs 81,528 crore in FY21. The latest annual report for ICICI Bank is not available yet.

A change in the environment for telecom and infrastructure firms is a key reason for the drop in demand for bank guarantees.

Last year, infrastructure companies and telecom firms had met with the government and argued that the requirement for bank guarantees was inflating costs, the first two bankers quoted above said.

Against the guarantees, banks collect a fee from their borrowers.

In case of performance guarantees, where the bank backs a company's ability to execute a project, the fee ranges between 1% and 1.5% of the value of the guarantees. In case of financial guarantees, where the bank backs a project's future cash flow estimates, the fee may be higher at 2-2.5%.

The fee may be lower if the borrower is well rated, or if there is considerable competition among lenders, the first of the four bankers quoted above said.

In October 2021, the government announced that telecom companies are only required to submit bank guarantees worth 20% of their statutory dues instead of 80% before. Earlier this year, the Department of Telecom also returned Rs 23,000 crore worth of bank guarantees to Vodafone Idea Ltd. and Bharti Airtel Ltd., reducing outstanding guarantees.

These measures have hit the fee income earned from guarantees issued to telecom companies, the bankers quoted above said.

Similarly, for long-term infrastructure contracts such as roads engineering, procurement and construction projects, the government has lowered the requirement for guarantees. The National Highway Authority of India has allowed bidders to submit bank guarantees worth 3% of the contract value, compared with the previous requirement of 5-10%.

In addition, from April 1, engineering, procurement and construction contractors are allowed to submit surety bonds along with their bids instead of bank guarantees. However, surety bonds are still only picking up, as general insurance companies have not begun issuing such bonds in large quantities, the bankers said.

Suneet Maheshwari, founder and managing partner of Udvik Infrastructure Advisors, said there is a need for proper risk assessment before asking for a bank guarantee to be issued.

"There has to be actuarial process (by the government) where the actual risk of non-completion or bad quality is calculated before asking a guarantee or an earnest money. So the government's move to reduce the requirement of such guarantees may help in streamlining the process," Maheshwari said.

While demand for bank guarantees is currently low, it could pick up if a new infrastructure cycle kicks in.

There are levels of issuance of bank guarantees, an official at State Bank of India said on the condition of anonymity. The first stage is a bid bond used by a company bidding for a project, this is followed by earnest money deposit, then advance deposit and finally retention. For this business to pick up again, infrastructure companies have to bid for more projects, which will happen as the capex cycle turns, he said.

Moreover, as the availability of surety bonds is still limited, EPC companies and other infrastructure firms will end up coming to banks for guarantees to support their bids, the first two bankers said.

In the meantime, banks are shifting focus to other segments of the non-fund based business, such as letters of credit to boost income.

According to the third banker quoted above, a senior official from SBI, with the commodity prices going up this year, the demand for LCs from importers and exporters has risen.

However, an LC is issued for a shorter period of time and lower value contracts. So even if the issuance of these letters rises, the fee income will not completely compensate for the losses from the guarantee business, the SBI official said.

To maintain growth in fee income, banks will look at pushing up retail fee income from their forex businesses this year, he said.

"Bank guarantees as a business are part of the overall working capital limits banks calculate for a borrower," said Jindal Haria, director, India Ratings & Research. "Considering the macroeconomic conditions we are in and the higher level of inflation, we should see higher working capital utilisation by companies, which may compensate for any lack in fee income from bank guarantees."