Working capital crisis: Can surety bonds free MSMEs from the hassle of costly bank guarantees?

Credit and financing for MSMEs: MSME experts have hailed the government’s decision to allow surety bonds to substitute for bank guarantees in public procurement as a major measure that could benefit MSMEs, as thousands of small units make up a significant portion of government service providers , public sector units, ministries, etc. . Finance Minister Nirmala Sitharaman’s announcement should help MSMEs, as bank guarantees usually eat away at their working capital, as well as the need for guarantees and margin money to secure these guarantees as part of a procurement process public procurement.

For the uninitiated, government projects usually include clauses that MSME vendors must provide a bank guarantee for a certain percentage of the order value. The guarantee is invoked by the government department to recover or realize the amount in the event of the seller’s default or inability to perform the contract or complete the project. In order to obtain a bank guarantee, the seller is required to pay a large security deposit as well as collateral and margin money which strains the working capital left to the seller and reduces the seller’s ability to undertake several projects or orders simultaneously.

A surety bond is essentially a mechanism that provides public buyers with assurances from surety providers (insurance companies) that the latter would indemnify if the seller breaches the contract.

According to experts, the cost of a bank guarantee usually ranges between 5 and 15% for MSMEs. This includes approximately 2 percent of the collateral amount and approximately 10 percent of the collateral margin money in the form of fixed deposit (FD). Apart from this collateral guarantee covering the entire amount of the guarantee is also required. In some cases, an FD equivalent to the amount of the guarantee is requested. In comparison, the cost of unsecured bonds should be cheaper than bank guarantees.

“Bank guarantees are very expensive for MSMEs, while surety bonds, which should be cheaper, are likely to reduce the cost of doing business. If bonds were more expensive, it would not make sense to opt for them. The government’s idea seems to be to reduce costs for MSMEs. In addition, surety bonds may be unsecured and are likely to be in effect for the life of the project and not require periodic renewal. Therefore, this would mean that the cost you will pay for surety bonds should be less than the surety fee you pay to the bank. Nevertheless, we will have to look into more details beforehand to come to a conclusion,” Sunil Badala, Partner and Country Head – BFSI and Tax, KPMG India told Financial Express Online.

Also read: Budget 2022: 8 MSME-related announcements made by FM Sitharaman and here’s what the experts have to say

According to Finance Minister Nirmala Sitharaman’s budget speech: In order to reduce indirect costs for suppliers and contractors, the use of surety bonds as a substitute for bank guarantee will be made acceptable in public procurement.

At present, the central government has mandated public sector units, government departments, ministries and others to procure at least 25% of their annual purchases from micro and small enterprises. According to public procurement policy monitoring portal MSME Sambandh, annual government procurement, collectively by all departments and PSUs, has been over 25% over the past few years. For example, total purchases from small businesses were 26% in FY19, 30% in FY20, 28% in FY21, and 32% in the current fiscal year so far. Of the purchases worth Rs 93,776 crore made by the government in FY22 so far, Rs 30,493 worth of purchases were made from 1.38 lakh micro and small businesses.

Given that government purchases have been above the target annual limit, the acceptability of surety bonds would likely help companies with limited assets or zero collateral and deep pockets obtain expensive bank guarantees.

“Although details are awaited, there will certainly be a cost of the bonds also in terms of premium. However, it is expected that this would not take away precious little working capital from existing businesses. Typically, until now only well-to-do MSMEs who had cash or assets as collateral could afford bank guarantees to sell assets to the government, but now even those without a lot of capital can access government orders through bonds based on possible metrics such as past trade performance. , experience, etc However, one would have to see how enthusiastic the insurance companies are about this, how much premium they will charge and how much risk they would take. For MSMEs, the government is the biggest buyer,” Rajiv Chawla, Chairman of the Integrated Association of Micro, Small and Medium Enterprises of India (IamSMEofIndia) told Financial Express Online.

Comments from IRDAI, banks and insurance companies were not immediately available for this story.

Finance Minister Sitharaman in her speech noted that the IRDAI had provided the framework for the issuance of bonds by insurance companies. According to the IRDAI website, on January 3, 2022, the IRDAI (Surety Insurance Contracts) Guidelines 2022 were released to “regulate and develop surety insurance business”. The guidelines will come into effect from April 1, 2022. IRDAI has also authorized all general insurance companies to engage in surety insurance business. Insurers can offer six types of bonds: prepayment bond, bid bond, contract bond, customs and court bond, performance bond and holdback.

“This approach can also help insurance companies expand their business scope,” KR Sekar, President, BCIC and Partner, Deloitte Touche Tohmatsu India LLP told Financial Express Online. Badala echoed, “Insurance companies should also make money from this process. In the future, this could lead to healthy competition between banks and insurance companies and an option for MSMEs to choose from.

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On the other hand, the replacement of bank guarantees by bonds could require a modification of public contracts, in particular for small PSUs. “The more sophisticated power supplies like ONGC probably won’t need a boost. Perhaps the credit guarantee scheme could be extended to issue bonds for MSMEs. Insurance companies will certainly be willing to issue such bonds, but they will surely be as selective as banks,” said Sujjain Talwar, Partner, Economic Laws Practice at Financial Express Online.

According to IRDAI guidelines, the premium charged for all surety insurance policies taken out during a financial year, including all payments due in subsequent years for these policies, must not exceed 10% of the total of this year’s gross written premiums, subject to a maximum of Rs 500 crore. Insurance companies can also work with banks or other financial institutions such as non-bank financial companies (NBFCs) to share risk information, technical expertise to monitor projects, cash flow, among others aspects. However, the guidelines note that such surety insurance contracts must be offered to infrastructure projects. Therefore, details regarding their applicability to public procurement remain to be determined.

“The success of this measure will depend on improving MSMEs’ access to these insurance products. It will also require proactive efforts from insurance companies and the IRDA,” Shravan Shetty, managing director of management consultancy Primus Partners, told Financial Express Online.