The Essence of Margins for Non Fund Based Working Capital Limits

Corporates require different kinds of non fund based facilities from the Working Capital Lenders mainly in the form of Letter of Credit and Bank Guarantees. Depending on the business activity of the corporate, their requirement on nature (Inland LC, Foreign LC, EMD BG, Retention BG, Performance BG, Financial BG, SBLC, etc.)  of these non fund limits may vary.

The WC lenders at the time of assessment of the limits assess the requirement of these NFB limits by the corporate and accordingly sanction limits. Although these limits are secured by the security provided by the corporate (generally first pari passu charge on the current assets and second pari passu charge on the fixed assets), the lenders follow a practice of stipulating margin based on the utilization of these limits. This margin is stipulated in the form of cash margin (float in the current account) or Fixed Deposit Receipt (FDR) margin. The margin is generally stipulated as a percentage of the limit utilization and ranges generally between 0% to 25% e.i. if the requirement for LC is INR 50 million and margin is 5% then the corporate has to provide margin in the form of FDR equivalent to INR 2.5 million.

These margins stipulation more depend on how better satisfactory track record, years of banking, and Current Ratio corporate has been maintaining with the lender. Generally, with the increasing years of satisfactory track record, financial performance and maintaining better Current Ratio than stipulated, the margin is brought down.

The question arises when the fund based limits are released by the lender relying on the security offered, then what is the need for additional cash margin for the non fund based limits?

It needs to be observed here how the crystallization of non fund limits happens, specially in the context of LCs. When an LC matures, the Cash Credit (CC) account of the borrower is debited and LC is liquidated. In case the CC is fully drawn, then the borrower is required to credit the required funds in the CC account from its other bank/facilities accounts. In case borrower, is not able to bring the required funds, LC has to be devolved i.e. the lender has to make the payment from its own funds. In this situation, the non funds based exposure converts in to the fund based exposure.

This is the point where the cash margin provided by the borrower/corporate becomes helpful to the lender. The lender uses these margins for crystallization of the LCs for devolvement. Now, if we go to the mechanics of the transaction working, one can simply analyze from where this margin money would have been brought/arranged by the corporate. Of-course, these margins are created by the borrower by using the fund based limits extended by the lender. Therefore, these were not the funds of the borrower but the funds of the lender only. 
This is true when the Current Ratio goes below stipulated norm [i.e. 100 divided by (100 - margin on Current Asset which is generally 25%)] i.e 1.33 times (generally stipulated). The margin mechanism ensured reduction in fund based limit utilization (i.e. actually limiting transfer of funds outside the lender bank) by conserving the limit for crystallization of future LC payments. Therefore, the margin structure explains the views of the lender, how much fund based limit utilization it would like borrower to conserve for meeting its future non fund based limits liquidation. A borrower with small non fund based facility may not face difficulty in crystallization of its non fund based obligation, however, for a borrower with larger limits, it could be a major issue if the fund based limits are fully utilized. In case of sudden market difficulties (similar of depreciation of INR seen in the past), the cash flow of the borrower may be hugely affected and it may be short of cash.

Since, providing margin affects the borrower by increasing its transaction cost (it utilizes fund based limit say at interest rate of 13.50% for creation of FDR, gets interest on FDR say at the rate of 9%, also pays LC commission, and may be also forgoing cash discounts in case of Usance period allowed by the supplier), it forces borrower to bargain for better terms from its suppliers or try to avoid non fund based transaction by maximizing the fund based utilization. It encourages borrower to better manage its cash flows resulting in low utilization of non fund based limits.