Bank Guarantee & Letter of Credit for MSMEs: A Practical Guide (2026)
You win a ₹2 crore order from an OEM in Chakan, and the purchase order says “Performance Bank Guarantee of 10% to be submitted before release of advance.” Or your raw-material supplier abroad will ship only against a Letter of Credit. This is where many growing MSMEs get stuck: not because the business is weak, but because nobody explained how these two instruments actually work.
This guide covers what bank guarantees (BG) and letters of credit (LC) are, which type you need, how much margin and collateral banks ask for, what they cost (including Maharashtra's new stamp duty rules from July 2026), and how banks sanction BG and LC limits alongside your Cash Credit.
Key takeaways
- BG and LC are non-fund based limits. The bank lends its promise, not cash. Money moves only if something goes wrong (BG) or when documents are presented (LC).
- Banks usually ask for a cash margin (typically 10–25%) plus collateral, but CGTMSE covers non-fund based facilities too, so collateral-free BG/LC limits are possible for eligible micro and small units.
- Micro and Small Enterprises are exempt from bid security (EMD) in central government tenders under GFR Rule 170.
- From 22 July 2026, Maharashtra charges stamp duty on bank guarantees under a new Article 34A, with only ₹500 for guarantees given to government bodies for public works/procurement.
- Plan your LC limit together with your CC limit. An unpaid LC bill gets debited to your CC and can push it into overdrawn status.
01Fund-based vs non-fund based: the basic idea
Your Cash Credit, Overdraft and term loan are fund-based. The bank pays out money and charges interest on it. A bank guarantee or letter of credit is non-fund based. The bank gives a written promise to a third party on your behalf. No money leaves the bank on day one, so you pay a commission instead of interest.
The promise only turns into a cash payout in specific situations: when a guarantee is invoked, or when an LC is drawn against compliant documents. At that point the bank pays and immediately recovers the amount from you, usually by debiting your CC account. That's why banks assess BG/LC limits as seriously as a loan: a non-fund limit is a contingent loan.
02How a bank guarantee works
A bank guarantee has three parties. You (the applicant) have a contract with a beneficiary, such as a buyer, a PSU, a government department or a landlord. The beneficiary wants comfort that you'll perform or pay. Your bank issues a guarantee promising to pay the beneficiary up to a fixed amount if you don't.
One point that surprises many business owners: a bank guarantee is an independent, on-demand promise. If the beneficiary makes a claim within the terms of the guarantee, the bank generally pays without deciding who is right in your commercial dispute. Your remedy is against the beneficiary under your contract, not against the bank. So read the BG format your buyer asks for before you accept the order, especially the invocation clause, validity and claim period.
In India, banks issue guarantees under the Reserve Bank of India's Master Circular on Guarantees and Co-acceptances (latest updated 1 April 2025), along with each bank's own credit policy.
03Types of bank guarantee you'll actually meet
Broadly, guarantees are either financial (they guarantee a payment) or performance (they guarantee that you'll do what the contract says). Here are the ones MSMEs see most often:
Government tenders: two MSE benefits most suppliers miss
- No EMD for Micro and Small Enterprises. Under Rule 170 of the General Financial Rules (GFR) 2017, MSEs as defined in the MSE Procurement Policy are exempt from bid security in central government tenders. Instead, you sign a Bid Security Declaration. On GeM, this exemption applies to manufacturers of goods and service providers for services (not traders), and you must upload proof such as your Udyam certificate.
- Surety bonds are an alternative to a BG. Since February 2022, GFR allows performance and bid security to be given as an insurance surety bond, which doesn't block your bank limits. Ask whether your tender accepts it.
04Validity period vs claim period: where hidden cost sits
Every BG has two dates. The validity (expiry) date is the period the guarantee covers. The claim period is extra time after expiry during which the beneficiary can still lodge a claim for something that happened during validity. Banks charge commission and hold your margin for the full validity plus claim period.
Many banks insist on a minimum 12-month claim period, citing Exception 3 to Section 28 of the Indian Contract Act. In Larsen & Toubro Ltd v. Punjab National Bank (2021), the Delhi High Court held that this exception does not force banks to keep a minimum one-year claim period, so a shorter claim period agreed in the contract is legally valid. In practice, it is still your bank's policy and the beneficiary's format that decide, so negotiate the claim period at the PO stage, not at the bank counter.
05How a letter of credit works
A bank guarantee says “we'll pay if our customer fails.” A letter of credit says “we'll pay when the seller presents the right documents.” It is a payment instrument, used mainly when you buy raw material or machinery (import or inland), or when your buyer pays you through one.
Most LCs are issued subject to the ICC's UCP 600 rules. Three of those rules matter in daily practice:
- Documents, not goods. The LC is separate from your purchase contract. The bank checks only whether the documents comply, not the quality of the material.
- Five banking days. Each bank in the chain gets a maximum of five banking days after presentation to decide whether documents comply. If it finds discrepancies, it must give one refusal notice listing all of them.
- 21-day presentation window. Where original transport documents are required, they must be presented within 21 calendar days of shipment (unless the LC says otherwise), and always before the LC expires.
Types of LC worth knowing
| Type | What it means | When MSMEs use it |
|---|---|---|
| Sight LC | Payment as soon as compliant documents are presented | Supplier wants immediate payment |
| Usance LC | Payment on a future date, e.g. 60/90/120 days after shipment or acceptance | You get credit from the supplier, backed by your bank |
| Inland LC | Buyer and seller both in India (often via SFMS) | Steel, chemicals, components bought from large Indian mills/distributors |
| Import (foreign) LC | Overseas seller, usually via SWIFT | Imported raw material, CNC machines, spares |
| Confirmed LC | A second bank adds its own payment promise | Exporters receiving an LC from a weaker or high-risk country bank |
| Revolving LC | Reinstates automatically for repeated shipments | Regular monthly purchases from the same supplier |
If you're the exporter or seller
- An LC from a reputed bank makes it easier to get pre-shipment (packing) credit and to discount the bills after dispatch, often at better rates than open-account invoices.
- Discrepancies are the number one reason payments get delayed. Watch for mismatched descriptions between invoice and LC, late presentation, missing signatures or stamps, expired LC, and wrong consignee or port details.
- Check the LC the day it's advised. Ask for amendments before shipment, not after.
06Bank guarantee vs letter of credit: side by side
| Point | Bank Guarantee (BG) | Letter of Credit (LC) |
|---|---|---|
| Purpose | Security if you fail to perform or pay | Mechanism to make a payment |
| Bank pays when | Beneficiary invokes it (default) | Seller presents compliant documents |
| Expected to be used? | No. Ideally it expires unused | Yes. Payment is the normal outcome |
| Typical user (MSME) | Supplier to OEMs, PSUs, govt, EPC contractors | Buyer of raw material/machinery; exporter receiving payment |
| Main rules | Contract Act, RBI master circular, BG wording | UCP 600, ISBP, LC terms |
| Cost basis | Commission % p.a. on BG amount for full period incl. claim period | Opening commission + usance commission for credit period |
07Margin, collateral & CGTMSE
Because a BG or LC can turn into a loan overnight, banks secure it in two layers:
- Cash margin. A portion of the BG/LC amount kept with the bank, usually as a lien-marked fixed deposit that continues to earn interest. In our experience with lenders, 10–25% is the common range for regular customers. New borrowers, weaker ratings, or BGs with long tenure can face higher margins, sometimes even 100%.
- Collateral and counter-guarantee. The remaining exposure is covered by property, stock and book debts already charged to the bank, plus your counter-guarantee (a promise to reimburse the bank).
CGTMSE: collateral-free BG and LC limits
Many owners think CGTMSE is only for term loans and CC. It isn't. The scheme covers both fund-based and non-fund based facilities, including bank guarantees and letters of credit, extended to eligible micro and small enterprises without collateral or third-party guarantee. The ceiling under the scheme for banks is ₹10 crore per borrower. The bank pays an annual guarantee fee, which is usually passed on to you.
Two practical points: the bank must agree to put the NFB limit under CGTMSE at sanction, and you still pay any cash margin the bank's policy requires. CGTMSE replaces collateral, not margin.
08How banks sanction BG and LC limits alongside your CC
BG and LC limits are usually sanctioned as part of your working capital package, assessed with your CMA data at the same time as the CC limit. Sometimes they're carved out as a sub-limit of CC (interchangeable). The bank sizes each limit from your actual business need, not a round number.
LC limit: the standard formula
BG limit: based on your order book
For BGs, the bank looks at guarantees already outstanding, the orders and tenders you expect in the next 12 months, the BG percentage each of those requires, and your track record of BGs being returned without invocation. A clean history of BGs that expired unused is one of the strongest arguments for a larger limit.
Why LC and CC must be planned together
When a usance LC falls due, the bank pays the supplier and debits your account. If you haven't kept funds ready, the amount is usually debited to your CC account. This is called devolvement. If your CC has no headroom, the account goes overdrawn, and repeated irregularity can hurt your account classification. The material bought under LC also becomes stock that supports your CC drawing power, so the two limits feed each other.
09What it costs, including Maharashtra stamp duty from July 2026
Bank commission
Commission is charged as a percentage per annum on the BG/LC amount, usually collected upfront. Published card rates vary widely. For example, some public sector banks list inland BG commission around 2.5–3% p.a., while some private banks list about 1.8% p.a. with a minimum charge. Actual pricing for a good account is often negotiated lower, and BGs backed by 100% cash margin are usually priced at a concession. Add GST, SWIFT/SFMS and documentation charges on top.
Stamp duty: Maharashtra's new Article 34A
The Maharashtra Stamp (Fourth Amendment) Act, 2026, effective from 22 July 2026, added a dedicated Article 34A for bank and financial guarantees. Earlier, these were charged as security bonds, and every renewal paid the full duty again. The new rates:
| Guarantee | Stamp duty |
|---|---|
| Up to ₹5 lakh | 0.1% of guaranteed amount, minimum ₹500 |
| Above ₹5 lakh | 0.3% of guaranteed amount, maximum ₹20 lakh |
| In favour of a Government corporation, local authority or statutory body for public works / public procurement | ₹500 flat |
| Renewal / extension without increase in amount | 0.25%, maximum ₹25,000 |
| Letter of guarantee (other cases) | ₹500 |
The Act doesn't define “bank guarantee” or “financial guarantee”, and commentators have flagged open questions on how some instruments, such as pure performance guarantees, will be classified. Confirm the applicable entry with your bank before issue.
Worked example: ₹50 lakh PBG to a private OEM
Illustrative only. Commission rate, GST and other charges vary by bank and borrower profile.
Electronic BGs (e-BG)
More beneficiaries now accept, or insist on, e-BGs issued through NeSL (National e-Governance Services Ltd). Maharashtra's MSEDCL, for example, accepts performance guarantees only as e-BGs via the NeSL portal. Since September 2025, NeSL has also been permitted to collect Maharashtra stamp duty on such documents. e-BGs are faster to issue, can't be forged, and the beneficiary can verify them instantly. Ask your bank whether it is integrated.
10Documents checklist & common mistakes
Documents banks usually ask for
- KYC of business and promoters, Udyam registration, GST certificate
- Last 2–3 years' audited financials and ITRs, plus current-year provisional figures
- 12 months' bank statements and GST returns
- CMA data / projections covering the BG and LC requirement
- For BG: purchase order or tender document, the beneficiary's BG format, and a list of BGs outstanding
- For LC: proforma invoice or contract, supplier details, IEC (for imports), and the purchase plan for the year
- Collateral documents, if not covered under CGTMSE
Six mistakes we see MSMEs make
- Accepting the buyer's BG format without reading it. Unconditional invocation clauses and long claim periods are negotiable before you sign the PO, not after.
- Applying for a BG the week it's due. A fresh NFB limit can take weeks to sanction. Get the limit in place before you bid.
- Not tracking expiry and return. Expired BGs that aren't formally returned or cancelled can keep your limit and margin blocked. Collect the original or a written discharge.
- Choosing usance shorter than your cash cycle. The LC then devolves on your CC every month.
- Paying EMD when you're exempt. Eligible MSEs can use a Bid Security Declaration in central government tenders.
- Ignoring CGTMSE for NFB limits. If you lack collateral, ask for the BG/LC limit to be covered under CGTMSE.
FAQFrequently asked questions
Can I get a bank guarantee without collateral?
Yes, in two ways. Micro and small enterprises can get BG limits covered under CGTMSE, which replaces collateral up to the scheme ceiling of ₹10 crore. Alternatively, a BG can be issued against 100% cash margin (an FD), which needs no other security but locks up your cash.
Can an NBFC issue a bank guarantee for me?
Beneficiaries generally ask for a guarantee from a scheduled commercial bank, and government tenders usually specify a commercial bank. Some banks can issue a BG backed by a counter-guarantee or margin arranged elsewhere, but check the tender or PO wording first.
How long does it take to get a BG or LC?
If you already have a sanctioned NFB limit, an individual BG or LC can often be issued within a few working days once the format is agreed. A new limit is assessed like a working capital loan and takes longer, so apply before you need it.
What happens if my BG is invoked wrongly?
The bank will usually pay if the claim is within the BG terms, because a BG is independent of your contract dispute. Courts intervene to stop invocation only in narrow cases such as established fraud or special equities. Your main protection is clear BG wording and good documentation of your performance.
Is stamp duty payable on renewal of a BG in Maharashtra?
Yes, but it's now much lower. Since 22 July 2026, renewal or extension without increasing the amount attracts 0.25% of the guaranteed amount, capped at ₹25,000, instead of the full duty again.
Do I need an LC limit if my supplier gives me open credit?
Not necessarily. But an LC can help you get longer credit periods or better prices from large mills and overseas suppliers, because their payment risk shifts from you to your bank.
Need a BG or LC limit for your next order?
We assess your order book and purchase cycle, size the right NFB limit, and structure margin, collateral or CGTMSE cover with the right lender. We don't sell loans. We structure funding.
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Disclaimer: This article is for general information only and is not legal, tax or financial advice. Fincentrix is a consultancy and loan facilitator, not a lender. Commission rates, margins and charges shown are indicative and vary by bank, borrower profile and instrument. Regulations, scheme limits and stamp duty rates can change; verify current terms with your bank, the tendering authority or a professional advisor before acting.
Sources
- Reserve Bank of India, Master Circular – Guarantees and Co-acceptances, RBI/2025-26/12, 1 April 2025
- Ministry of Finance, General Financial Rules 2017, Rule 170 (bid security) and Rule 171 (performance security); DoE OMs of Nov 2020 and Feb 2022
- CGTMSE scheme guidelines and bank FAQs on fund and non-fund based coverage
- Maharashtra Stamp (Fourth Amendment) Act, 2026, Article 34A; analysis by Vinod Kothari Consultants (Aug 2026) and Acuity Law (Sept 2026)
- ICC Uniform Customs and Practice for Documentary Credits (UCP 600), Articles 4, 14 and 16
- Delhi High Court, Larsen & Toubro Ltd v. Punjab National Bank, W.P.(C) 7677/2019, 28 July 2021
- Published trade finance charge schedules of Central Bank of India, HDFC Bank and AU Small Finance Bank
- MSEDCL e-BG format via NeSL; Registration & Stamps Dept., Pune order of 19 Sept 2025 on NeSL stamp duty