Bank Guarantee and Letter of Credit for MSMEs: Non-Fund-Based Limits Explained
A bank guarantee and a letter of credit are non-fund-based limits: the bank lends its undertaking, not money, and pays only if a defined event happens (default under a contract, or presentation of complying documents). Credit Core Finance arranges these limits for MSMEs as part of working capital mandates from ₹1 crore. Rules on this page are as on 07-Sep-2026. RBI has announced a new export–import framework from 01-Oct-2026; this page will be reviewed on that date.
What a bank guarantee is
Under Section 126 of the Indian Contract Act, 1872 a guarantee is a contract to perform the promise, or discharge the liability, of a third person in case of default. The law names three distinct parties to this contract: the surety, the principal debtor, and the creditor. In banking practice, these legal roles map directly to the transaction. The bank acts as the surety. The MSME securing the facility is the applicant or principal debtor. The buyer, project owner, or government authority holding the undertaking is the beneficiary.
In commercial usage, guarantees split into two primary categories. The first category is financial guarantees, which secure direct monetary obligations. Common examples include guarantees for advance payments or the release of retention money. The second category is performance guarantees, which secure the actual execution of work under a contract. In government tenders, four instruments appear most often: bid security (also called earnest money deposit or EMD), performance security, mobilisation-advance guarantees, and retention-money guarantees.
The regulatory framework governing these facilities is the Reserve Bank of India (Commercial Banks – Credit Facilities) Directions, 2025 (issued 28-Nov-2025, since amended). These Directions establish operational standards for every issuing institution:
- Under paragraph 404: a bank guarantee must be irrevocable and unconditional, containing an explicit mechanism to honour the claim without demur.
- Under paragraph 407: the issuing bank must honour an invoked guarantee according to the terms of the guarantee deed unless restrained by an order of a competent court.
- Under paragraph 406: the tenor and claim period of a guarantee are determined by the bank's own board-approved guarantee policy. There is no universal RBI tenor cap.
- Commercial terminology: terms like financial guarantee or performance guarantee reflect market practice rather than formal regulatory definitions framed by the central bank.
For an MSME applicant, this structure carries serious operational consequences. Because the undertaking is independent and payable without demur, the bank pays the beneficiary first upon invocation and then recovers the funds from you. A commercial dispute between you and the project owner does not halt payment. Unless you obtain an order from a court, the issuing bank is bound to release the funds against a claim made in the form the guarantee requires.
Electronic bank guarantees (e-BG) on the National E-Governance Services Limited (NeSL) platform have been available since Sep-2022. Under this system, the beneficiary views, tracks, and verifies the authenticity of the guarantee directly on the digital platform. RBI regulates electronic guarantees wherever they are issued. An e-BG removes the physical handling and transit of the paper guarantee, though issuance on the NeSL platform is not mandated for every beneficiary.
Guarantees in government tenders: the security ladder (GFR 2017)
Public procurement relies on structured financial securities to protect public funds. The baseline framework sits within the General Financial Rules (GFR) 2017, administered by the Ministry of Finance Department of Expenditure. Tender documents require specific instruments at each stage of bidding and project execution.
Rule 170 governs bid security, also known as EMD, requiring bidders to deposit between 2% and 5% of the estimated contract value to ensure serious bids. Rule 171 governs performance security, which covers non-performance after contract award.
Originally set at 5% to 10% under GFR 2017, performance security was reduced to 3% during COVID under Office Memorandum (OM) F.9/4/2020-PPD dated 12-Nov-2020, extended by OM dated 30-Dec-2021 through 31-Mar-2023. Current procurement security bands were re-established by OM F.1/2/2023-PPD dated 01-Jan-2024.
| Security Type | Rule / Office Memorandum | Current Band | Original 2017 Band |
|---|---|---|---|
| Bid Security (EMD) | GFR 2017 Rule 170 | 2% to 5% of estimated value | 2% to 5% of estimated value |
| Performance Security (Goods, Consultancy, Non-Consultancy Services) | OM F.1/2/2023-PPD (01-Jan-2024) | 3% to 5% of contract value | 5% to 10% of contract value |
| Performance Security (Works Contracts) | OM F.1/2/2023-PPD (01-Jan-2024) | 3% to 10% of contract value | 5% to 10% of contract value |
For execution milestones, contracting authorities follow the Department of Expenditure's Manual for Procurement of Works, 2025. The Works Manual sets retention money generally at 5% of running bills, which can be released against an unconditional bank guarantee or insurance surety bond at prescribed contract stages.
Mobilisation advances may be granted up to 10% of the contract price for specialised or capital-intensive works. These advances are interest-bearing, secured by an unconditional bank guarantee, and released in two separate 5% instalments, with the second release tied to achieving 10% financial progress on the site.
Micro and Small Enterprises receive targeted concessions under the Public Procurement Policy for Micro and Small Enterprises (MSEs) Order, 2012, notified via S.O. 581(E) dated 23-Mar-2012 (effective 01-Apr-2012, with mandatory procurement targets from 01-Apr-2015).
Under this policy, eligible MSEs are exempt from paying bid security (EMD) and tender-document fees. Central government departments and central public sector enterprises (CPSEs) must meet an annual target of 25% procurement from MSEs, which includes sub-targets of 4% from SC/ST-owned enterprises and 3% from women-owned enterprises notified under S.O. 5670(E) dated 09-Nov-2018.
MSEs also benefit from relaxations in prior turnover and prior experience criteria under Ministry of MSME Policy Circular 1(2)(1)/2016-MA dated 10-Mar-2016, provided they satisfy the technical quality specifications of the tender.
Many business owners misread these provisions. There is no general MSE exemption from performance security. When an MSE wins a tender with a government department or CPSE, it must furnish the required performance security within the stipulated timeline. Without a guarantee line, that security has to come out of the enterprise's own cash.
Contractors now have an alternative to traditional bank lines. Insurance surety bonds were introduced via the Insurance Regulatory and Development Authority of India (Surety Insurance Contracts) Guidelines, 2022 (reference IRDAI/NL/GDL/SIC/01/01/2022 dated 03-Jan-2022).
The Department of Expenditure issued OM F.1/1/2022-PPD on 02-Feb-2022, permitting insurance surety bonds as bid security and performance security in central government procurement. IRDAI issued subsequent modifications to these guidelines on 12-Jan-2023 and 16-May-2023.
For the sector view of contractor funding, including running-bill finance alongside guarantee lines, see our page on construction and EPC finance. The largest guarantee line we have closed sat inside a ₹40 crore civil-contractor package, cash credit ₹15 crore with bank guarantees of ₹25 crore; the anonymised case study shows how it was structured.
What a letter of credit is
A letter of credit (LC) is a financial commitment issued by a bank on behalf of a buyer. It constitutes an irrevocable undertaking by the issuing bank to honour a complying presentation of trade documents submitted by the seller. The instrument separates the obligation to pay from the physical goods, resting on document verification.
International and domestic letters of credit operate under standard contract rules codified by the International Chamber of Commerce (ICC). The principal rulebook is the Uniform Customs and Practice for Documentary Credits, ICC Publication 600 (UCP 600), which came into force on 01-Jul-2007. Key articles govern every operational step:
- Articles 2 and 3: establish that every credit is irrevocable, even if the text of the instrument does not expressly say so.
- Article 7: defines the issuing bank's definitive undertaking to pay the beneficiary once a complying presentation is made.
- Article 14: gives the issuing bank a maximum of five banking days following the day of presentation to examine documents and determine compliance.
- Article 16: governs refusal where the documents are discrepant, including the notice the bank must give.
Document examination standards are governed by the International Standard Banking Practice, publication ISBP 821 (2023 edition). Where presentations involve electronic records, transactions follow the eUCP version 2.1, effective from 01-Jul-2019. Standby letters of credit follow International Standby Practices 1998, ICC Publication 590 (ISP98).
Whether an issuing authority or counterparty accepts a standby LC in place of a bank guarantee depends on the terms of that particular transaction.
Commercial contracts employ several variations of credit. Transactions are structured as sight credits (payable upon presentation of complying documents) or usance credits (payable on a determined future date). LCs can also be inland or import, revolving, or back-to-back.
The standard issuance and settlement process follows six sequential steps:
- The buyer and seller execute a commercial sales contract specifying payment via documentary credit.
- The buyer (applicant) applies to its bank to open the letter of credit in favour of the seller.
- The issuing bank creates the credit and transmits it to the seller's bank (advising bank), which advises it to the seller (beneficiary).
- The seller ships the consignment and submits all stipulated shipping, insurance, and commercial documents to its bank.
- The issuing bank examines the presented documents within a maximum of five banking days to verify compliance with UCP 600 and the credit terms.
- The issuing bank honours the presentation by paying the beneficiary at sight or undertaking payment on the maturity date for a usance credit.
A letter of credit protects both sides of a trade transaction. The seller avoids private credit risk because payment relies on a bank undertaking rather than buyer willingness. The buyer gains assurance that payment will release only after transport documents confirm shipping within the agreed schedule. However, technical discrepancies in documents, rather than commercial disputes, are what delay payment under an LC.
Import LCs and Trade Credit
When an MSME imports raw materials or capital equipment, documentary credits must align with foreign exchange regulations. The core framework is the RBI Master Direction on External Commercial Borrowings, Trade Credits and Structured Obligations (dated 26-Mar-2019, updated 16-Feb-2026).
Trade credit arrangements, such as suppliers' credit or buyers' credit, provide short-term financing linked to import shipments. The Master Direction fixes clear limits on credit duration.
- For imports of capital goods, trade credit can be extended for up to three years from the date of shipment.
- For non-capital goods, trade credit is capped at up to one year or the operating cycle of the business, whichever is less.
- Under the automatic route, the borrowing limit per import transaction is USD 150 million for oil and gas refining and marketing, airline, and shipping companies.
- For all other corporate and MSME importers, the automatic-route limit is USD 50 million per import transaction.
Payment timelines are regulated separately under the RBI Master Direction on Import of Goods and Services. Remittance for import transactions is generally due within six months from the date of shipment, subject to specific extensions permitted by policy.
Importers must manage usance terms so that maturity falls within these remittance windows.
Regulatory note: Rules on this page are as on 07-Sep-2026. RBI has announced a new export–import framework from 01-Oct-2026; this page will be reviewed on that date.
Bills under LCs, and LC or BG without a Cash Credit Limit
Financing trade bills drawn under letters of credit requires adherence to regulatory directions. Under the RBI 2025 Directions, the underlying commercial trade must be genuine and verified.
- Banks purchase or discount LC bills primarily for their own borrowing constituents who hold sanctioned credit lines.
- A restricted-LC exception exists for a non-constituent beneficiary, provided the discounting proceeds are remitted directly to that beneficiary's regular banker.
- Bill rediscounting is confined to eligible usance bills.
- Banks are prohibited from rediscounting bills arising from services transactions.
A guarantee or LC line does not have to sit with the bank that holds your cash credit. Paragraph 401 of the RBI 2025 Directions (descended from circular DBR.Dir.BC.No.70/13.03.00/2015-16 dated 07-Jan-2016) allows a bank to extend non-fund-based facilities to a borrower that holds no fund-based credit facility with it.
The issuing bank performs normal credit appraisal, due diligence, KYC checks, and credit-information reporting under its own board-approved policy.
What this means for an MSME: You can maintain your day-to-day cash credit account at one institution while securing a dedicated bank guarantee or letter of credit limit from another bank, subject to that bank's credit assessment and internal policy.
What the Bank Sets by Policy, and What We Prepare
The Reserve Bank of India does not mandate standard commission rates, cash-margin percentages, collateral coverage ratios, or maximum tenors for non-fund-based limits.
The 2025 Directions instruct each commercial bank to establish an internal board-approved policy governing exposure limits, security standards, eligible tenors, commission schedules, and risk controls.
Because regulatory rules leave pricing and margins open, every proposal is packaged and negotiated on its own file.
Credit Core Finance structures the credit application file with complete documentation before submission:
- Contract, work order, tender document, or purchase order: The document requiring the guarantee, along with the beneficiary's prescribed format. The bank issues on a format it has reviewed; open-ended liability clauses in the beneficiary's format need to be settled before issuance.
- Letter of credit documents: The proforma invoice or sales contract, accompanied by the Importer-Exporter Code and import licences for foreign purchases. Missing codes or unverified commercial terms stall document vetting.
- Existing BG and LC register: A detailed register of all existing bank guarantees and letters of credit, listing sanctioned amounts, outstanding balances, and expiry dates. Undisclosed contingent liabilities distort exposure assessments.
- Financial statements and bank statements: Latest audited financials and updated bank statements across all active accounts. Incomplete financial statements prevent the credit manager from verifying operating cash flows.
- GST returns: Filed GST returns. Turnover reported in GST filings that fails to match the banking turnover causes delays during underwriting.
- Existing sanction letters: Copies of existing sanction letters. Outdated sanction terms conceal current encumbrances on company assets.
GST on Guarantees and LCs
Non-fund-based banking facilities incur indirect taxes on service fees. Under the Goods and Services Tax framework, bank guarantee commissions and letter of credit processing charges attract GST at 18% under financial services (Heading 9971).
Notification 12/2017-Central Tax (Rate), Sl. No. 27(a) exempts transactions where consideration is represented by way of interest or discount. Because guarantee commissions and LC charges represent fee-based income rather than interest, they do not qualify for this exemption.
Tax liabilities also arise when corporate entities issue cross-guarantees.
Under CGST Rule 28(2), inserted by Notification 52/2023-Central Tax dated 26-Oct-2023, a corporate guarantee provided by an entity for a related business is valued for GST at 1% per annum of the guaranteed amount or the actual consideration charged, whichever is higher.
This provision was amended via Notification 12/2024-Central Tax on 10-Jul-2024, operative from 26-Oct-2023, and clarified under Circular 225/19/2024-GST dated 11-Jul-2024.
Director's personal guarantee: A director's personal guarantee furnished to a lending institution is treated separately under Circular 204/16/2023-GST dated 27-Oct-2023.
When a BG or LC Line Fits, and When It Does Not
Non-fund-based credit lines fit contractors bidding on projects issued by central government departments and CPSEs.
They fit industrial suppliers fulfilling purchase orders that demand performance security or advance payment guarantees.
An LC line fits manufacturing units purchasing domestic raw materials on deferred terms or importing components under usance trade credit.
It also serves active exporters whose international buyers require confirmed payment mechanisms.
When a Non-Fund-Based Facility Does Not Fit
- There is no verifiable underlying commercial trade or contract.
- An applicant attempts to use a bank guarantee to secure fund-based loans from another lending institution.
- The arrangement is designed to cover inter-corporate deposits or unsecured obligations between related parties.
- The beneficiary demands an open-ended guarantee format that conflicts with banking policies.
Credit Core Finance approach: We read the tender or contract first and tell you which instrument fits — bank guarantee, surety bond or letter of credit — before any application is made.
How Credit Core Finance Works on a Non-Fund-Based Mandate
Credit Core Finance sits between your tax consultant and the bank's credit desk: the file is appraised the way a credit manager will read it before it is submitted.
- We evaluate contract terms and identify the actual requirement for the proposed non-fund-based facility.
- We match non-fund-based limits against the business's working capital cycle and expected transaction flows.
- We structure credit proposals across a panel of 90+ lenders spanning nationalised, private and MNC channels.
- We prepare the credit application file and supporting documentation before submission to the appropriate lender.
There is no upfront or advance fee to start work.
Fraud warning: Anyone asking you for an advance fee to arrange a loan is not acting for Credit Core Finance. Clients have faced such frauds, and we ask you to check with us before paying anyone.
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Talk to us: +91 89563 34991 | creditcore.finance | Office: Koregaon Park, Pune.
Bank guarantee and LC limits are among the working capital products we arrange. Explore our MSME loan services for the full list of financing solutions.
Frequently Asked Questions
What is the difference between a bank guarantee and a letter of credit?
A bank guarantee is an independent undertaking where the issuing bank agrees to pay the beneficiary if the applicant defaults on a contractual or financial obligation. A letter of credit is a payment mechanism where the issuing bank commits to honour complying presentations of trade documents submitted by the seller, regardless of whether a default has occurred.
Are MSEs exempt from EMD and performance security in government tenders?
Eligible Micro and Small Enterprises are exempt from paying earnest money deposits (EMD or bid security) and tender-document fees under the Public Procurement Policy for MSEs Order, 2012. However, there is no general exemption for MSEs from furnishing performance security upon contract award.
What is the current performance security percentage under GFR 2017?
Under Department of Expenditure OM F.1/2/2023-PPD dated 01-Jan-2024, performance security is currently set between 3% and 5% of contract value for goods, consultancy, and non-consultancy services, and between 3% and 10% for works contracts. The original 2017 band was 5% to 10%.
Can an insurance surety bond replace a bank guarantee?
Yes. Under Department of Expenditure OM F.1/1/2022-PPD dated 02-Feb-2022, insurance surety bonds issued in accordance with IRDAI guidelines are accepted as bid security and performance security in central government procurement.
Can I get a bank guarantee or LC without a cash credit limit at that bank?
Yes. Under paragraph 401 of the RBI 2025 Directions, banks can sanction non-fund-based facilities to borrowers who do not maintain a fund-based credit facility with them, subject to the bank's board-approved credit policy, due diligence, and KYC compliance.
Is GST charged on bank guarantee commission and LC charges?
Yes. Bank guarantee commission and letter of credit charges attract GST at 18% under financial services (Heading 9971). The GST exemption for interest and discount does not apply to separate service fees or commissions.
What documents does Credit Core Finance need for a BG or LC file?
Credit Core Finance collects the underlying contract, tender document, or proforma invoice; the prescribed guarantee format; an updated register of existing BG and LC limits; audited financial statements; bank statements; filed GST returns; and current sanction letters.