Strategic Management and Corporate Finance · Raising of Funds - Non Fund Based

Credit Rating and Assessment of Non-Fund Based Limits

Updated 11 October 2026 · Fact-checked

Non-fund based limits are bank guarantees and letters of credit where the bank lends its name, not cash. The bank assesses your business, finances and credit rating, sets a limit, takes margin and security, charges commission, and monitors usage. A better rating usually means a larger limit, lower margin and lower commission.

Understand Credit Rating and Assessment of Non-Fund Based Limits

A non-fund based limit is a facility where the bank does not pay out money on day one. It gives a promise instead. A letter of credit (LC) promises payment to your supplier. A bank guarantee (BG) promises payment to a beneficiary if you default. The bank has only a contingent liability. If you fail to perform or pay, the liability becomes real and the bank must pay out of its own funds.

Because the risk is real, the bank assesses you as carefully as for a loan. It looks at your business, management, financial strength, past conduct with banks and the purpose of the facility. It asks one question: if the bank has to pay, can you reimburse it?

The bank then sets a limit, which is the maximum outstanding amount at any time. It decides the margin, which is the part of the amount you deposit or fund yourself. It decides the commission and the security. Weaker borrowers get higher margin, more security and higher commission. Stronger borrowers get relief on all three.

A credit rating is an independent opinion from a rating agency on your ability to repay on time. Banks use it as an input. It supports the limit decision, the pricing and the margin. It does not replace the bank's own appraisal. Ratings are reviewed at least once a year, and a downgrade can lead the bank to reprice, ask for more margin or cut the limit.

After sanction, the bank monitors the account. It tracks LCs devolving into loans, invoked guarantees, expiry dates of guarantees, and whether the purchased goods or the contract are progressing as planned. Devolvement of an LC or invocation of a guarantee is an early warning sign.

Key rules to remember

Margin money: Margin = Margin % × Amount of LC or BG; This is the amount you must fund. The bank's net exposure is the amount minus the margin.
Net bank exposure: Net exposure = Amount of LC or BG − Margin money; Use this when asked how much risk the bank actually carries.
Guarantee commission: Commission = Amount × Rate % p.a. × Period in years; Commission is usually charged on the full guarantee amount, not on the net exposure. Take the period as the question states.
Limit sizing for LCs: LC limit ≈ Monthly purchases through LC × (Usance period + Transit and processing time in months); A working rule used in practice. The bank may adjust it. State this as an approach, not a fixed regulation.
Rating and terms (principle): Better rating → lower margin, lower commission, easier limit; A general principle. Exact terms are the bank's own decision.

How to solve Credit Rating and Assessment of Non-Fund Based Limits questions

Use this method for any question on assessing or managing non-fund based limits.

1Identify the facility: LC or BG. Note whether it is for supply of goods, performance of a contract, payment of dues or financial purpose.
2State why the bank carries risk: the liability is contingent and turns real on default or invocation.
3List what the bank assesses: management, business, financials, conduct, purpose and the credit rating.
4Explain how the limit is fixed: the need, the cycle or contract value and the borrower's capacity.
5Cover pricing, margin and security: commission, cash margin, collateral and rating-linked relief.
6If numbers are given, compute margin, net exposure and commission clearly with units and period.
7Explain monitoring: expiry, devolvement, invocation, renewal and rating review.
8Close with a one-line conclusion tied to the facts in the question.

Quickest way: Five-point answer frame: Need, Risk, Rating, Terms, Watch

When to use it: Use it for theory questions with little time, such as short notes or a 5 to 8 mark question.

Need: say what the facility is for and how the limit is sized.
Risk: say the liability is contingent and can become funded.
Rating: say what the rating changes in limit, margin and commission.
Terms: give margin, commission and security in one line each.
Watch: give monitoring points like expiry, devolvement and invocation.

Common mistakes in Credit Rating and Assessment of Non-Fund Based Limits

Treating non-fund based limits as risk-free for the bank.
No cash leaves the bank at the start, so the exposure looks nil.
Fix: Write that the liability is contingent and becomes a funded one on devolvement or invocation.
Saying the credit rating replaces the bank's appraisal.
Students overstate the role of the rating agency.
Fix: Say the rating is one input. The bank still does its own assessment of cash flows, security and conduct.
Charging commission on net exposure.
Students confuse commission with the bank's risk after margin.
Fix: Compute commission on the full guarantee or LC amount unless the question says otherwise.
Mixing up margin and limit.
Both words relate to the amount of the facility.
Fix: Limit is the maximum the bank allows. Margin is the share you fund yourself.
Ignoring monitoring after sanction.
Answers stop at assessment and pricing.
Fix: Add a short paragraph on expiry tracking, devolvement, invocation, renewal and rating review.
Giving fixed margin percentages as if they were rules.
Textbook examples use round numbers like 10% or 25%.
Fix: Say margins vary with the borrower's rating, security and nature of the facility. Use the figure given in the question.

Worked examples

Example 1

Sunrise Textiles Ltd obtains a performance bank guarantee of ₹80,00,000 for 18 months from its bank. The bank takes 25% cash margin and charges commission of 1.5% p.a. on the guarantee amount. Calculate the margin money, the bank's net exposure and the total commission.

Show the solution

Margin money = 25% × ₹80,00,000 = ₹20,00,000.
Net exposure = ₹80,00,000 − ₹20,00,000 = ₹60,00,000.
Period = 18 months = 1.5 years.
Commission = ₹80,00,000 × 1.5% × 1.5 = ₹1,80,000.
Commission is on the full guarantee amount, not on the net exposure.

Answer: Margin money is ₹20,00,000, net exposure is ₹60,00,000 and total commission is ₹1,80,000.

Example 2

Explain the role of a credit rating when a bank assesses a company's request for a non-fund based limit. Also state what the bank does after sanction.

Show the solution

Provision: a bank guarantee or LC creates a contingent liability, so the bank must assess repayment capacity before sanction.
Analysis: the bank studies management, business, financials, past conduct and purpose. The credit rating is an independent view on timely repayment and supports this study.
Effect of a good rating: the bank may give a larger limit, ask for lower margin and charge lower commission.
Effect of a weak rating: the bank may ask for higher margin, more collateral and higher commission, or restrict the limit.
Limit of the rating: it does not replace the bank's own appraisal.
After sanction: the bank monitors expiry dates, LC devolvement, guarantee invocation and utilisation against the sanctioned limit.
The bank reviews the rating at renewal. A downgrade can lead to repricing, more margin or a lower limit.
Conclusion: the rating guides pricing and limit, while appraisal and monitoring control the actual risk.

Answer: The credit rating is an input to limit, margin and pricing decisions but not a substitute for the bank's appraisal. After sanction, the bank monitors usage, expiry, devolvement and invocation, and reviews terms when the rating changes.

Exam tips

Start every answer by saying the liability is contingent. It earns the first mark and frames the rest.
Show margin, net exposure and commission as separate lines in numerical answers.
Use the three levers together: limit, margin and commission. Link each to the rating.
Add a monitoring paragraph. Many answers lose marks by stopping at sanction.
Tie your conclusion to the company or facts in the case, not generic words.

Practice questions from Raising of Funds - Non Fund Based

Credit Rating and Assessment of Non-Fund Based Limits: frequently asked questions

How do banks assess non-fund based limits?

They study the borrower's management, business, financial position, past conduct and the purpose of the LC or guarantee. They also consider the credit rating, security offered and the borrower's ability to reimburse if the bank has to pay. Then they fix the limit, margin and commission.

What is the role of credit rating in LC and bank guarantee limits?

The rating is an independent opinion on timely repayment. It supports decisions on the size of the limit, margin and commission. A better rating usually gives easier terms, but the bank still does its own appraisal.

What is margin money for a letter of credit or bank guarantee?

Margin money is the part of the LC or guarantee amount that you fund, often as a cash deposit. It reduces the bank's net exposure. Its percentage depends on your rating, security and the nature of the facility.

Is commission charged on the margin-adjusted amount?

Normally commission is charged on the full amount of the guarantee or LC, for the period it is outstanding. Read the question carefully, and use the basis it gives.