Banks must protect their business of handing out guarantees
Transport and Highways Minister Nitin Gadakari has sarcastically commented that the insurance regulator IRDAI did a ‘deep study’ for three years on a proposal of allowing ‘surety bonds’ by insurance companies. He was taking a dig at the IRDAI, while launching the country’s first surety bond specially designed for highway projects by Bajaj Allianz insurance company.
He said that he got the idea from former SBI chairman Rajnish Kumar on the following lines: “He told me that there is a concept of surety bond in other countries in place of bank guarantees. I took it up with our finance minister. I would thank IRDAI for their deep study for three years before giving the approval. I thank those who expeditiously approved it in three years. It is better late than never.”
When banking circles are wondering how a lucrative business from their portfolio is allowed to be taken out, it is strange that the proposal has emanated from the Government and the banking regulator Reserve Bank of India has not objected to such a proposal.
Areas of operation of insurance companies and banking companies are well demarcated. Insurance companies are supposed to do the business of insurance, which means that they are entering into a contract of indemnity.
Section 124 of Indian Contract Act 1872 defines Contract of indemnity as “a contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person”. Issue of surety bond does not fit into the business of contract of indemnity.
The issue of surety bond belongs to the category of contract of guarantee. Section 126 of Indian Contract Act 1872 defines Contract of guarantee as a contract to perform the promise, or discharge the liability, of a third person in case of his default.
Since the inception of the banking system in India, issuing bank guarantees has been the domain of banks. Though the definition of guarantee provides for ‘performing the promise’ banks issue guarantees to discharge the liability and also to pay at agreed terms when the promise is not performed by their clients.
When any guarantee is issued, no outflow of funds are involved. It is a ‘non-fund based’ business. But the moment the bank is called upon to pay on the basis of guarantee on the failure of its client, it has to discharge the liability and it becomes a fund-based one. Whenever such an eventuality happens, banks pay under the head ‘Defaulted Guarantees’ and banks have to ultimately recover the amount like any other loan recovery. The RBI has also stipulated various other guidelines for issue of guarantee by banks—(1) It should be for a definite period and definite amount; (2) Maximum period can be 10 years; (3) Claim period should be mentioned; (4) Ceilings for unsecured guarantees; (5) Cannot be repayment of deposits by finance companies, etc.; (6) Provision for confirmation from higher authorities.
In January 2022, IRDAI issued ‘Surety Insurance Contracts’ guidelines 2022. While the guidelines cover essential features, types of surety contracts, underwriting requirements, etc., it is silent on how the insurance company will recover the defaulted guarantees. It does not contain any stipulation of counter guarantee or collateral security.
When there is strict regulation by the RBI that invoked guarantee should be paid immediately, there does not seem to be any such instruction from IRDAI. Banks do pay for the invoked guarantees immediately so as to keep the trust of the people on the guarantees issued by them.
It is time for the Indian Banks Association and the RBI to retain the business of guarantee with the banks.
(The author is a retired banker)
