Working capital crisis: Can surety bonds assure MSMEs freedom from hassle of expensive bank guarantees

Credit and Finance for MSMEs: According to the budget speech by the finance minister Nirmala Sitharaman: To reduce indirect cost for suppliers and work-contractors, the use of surety bonds as a substitute for bank guarantee will be made acceptable in government procurements.

Credit and Finance for MSMEs: MSME experts have hailed the government’s decision to allow surety bonds substitute for bank guarantees in government procurement as a major move that is likely to benefit MSMEs since lakhs of small units form a major chunk of suppliers to government departments, public sector units, ministries and more. The announcement by Finance Minister Nirmala Sitharaman is expected to help MSMEs as bank guarantees typically eat into their working capital along with the need for collateral and margin money to secure such guarantees in a public procurement process.

For the uninitiated, government projects usually have clauses by which MSME vendors have to provide a bank guarantee for a certain percentage of the order value. The guarantee is invoked by the government department to recover or realise the amount in case the vendor defaults or is unable to fulfil the contract or complete the project. In order to secure a bank guarantee, the vendor is required to commit a hefty security deposit along with collateral and margin money that put stress on working capital left with the vendor and reduce the vendor’s ability to undertake multiple projects or orders concurrently.

A surety bond is essentially a mechanism that provides government buyers assurance from surety providers (insurance companies) that the latter would compensate in the event of the vendor failing to oblige the contract.

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

“Bank guarantees are very expensive for MSMEs while surety bonds, which are expected to be cheaper, are likely to bring down the cost of doing business. If surety bonds would be more expensive then it would not make sense to go for them. The whole idea of the government seems to be to reduce the cost for MSMEs. In surety bonds, I won’t have to incur any guarantee commission. Hence, it would mean that the cost you will pay for surety bonds would be lesser than the guarantee commission you pay to the bank. Still, we will have to look at more details ahead,” Sunil Badala, Partner and National Head – BFSI and Tax, KPMG India told Financial Express Online. 

According to the budget speech by the finance minister Nirmala Sitharaman: To reduce indirect cost for suppliers and work-contractors, the use of surety bonds as a substitute for bank guarantee will be made acceptable in government procurements.

Currently, the central government has mandated public sector units, government departments, ministries, and others to procure at least 25 per cent of their annual purchases from micro and small enterprises. As per the public procurement policy monitoring portal MSME Sambandh, annual government purchases, collectively by all departments and PSUs, have been more than 25 per cent in the past few years. For instance, the total procurement from small businesses stood at 26 per cent in FY19, 30 per cent in FY20, 28 per cent in FY21, and 32 per cent in the current financial year so far. Out of the Rs 93,776 crore worth procurement made by the government in FY22 so far, Rs 30,493 worth of purchases were made from 1.38 lakh micro and small enterprises. 

As government purchases have been above the annual target limit, the acceptability of surety bonds would likely help those enterprises with limited assets or zero collateral and deep pockets to secure expensive bank guarantees. 

“While details are awaited but certainly there will be a cost of surety bonds as well in terms of a premium. However, it is envisaged that this would not take away the precious little working capital from the existing businesses. Typically, until now only affluent MSMEs who had money or assets as collateral could afford bank guarantees for selling goods to the government but now even those who don’t have much capital can access government orders through surety bonds based on possible metrics like past business performance, experience etc. However, we would have to see how enthusiastic insurance companies are about this, how much premium they will charge and how much risk they would take. For MSMEs, the government is the largest buyer,” said Rajiv Chawla, Chairman at MSME body Integrated Association of Micro, Small and Medium Enterprises of India (IamSMEofIndia) told Financial Express Online.

Comments from IRDAI, banks, and insurance companies weren’t immediately available for this story.

Finance Minister Sitharaman in her speech had noted that IRDAI has given the framework for the issue of surety bonds by insurance companies. According to the IRDAI website, on January 3, 2022, IRDAI (Surety Insurance Contracts) Guidelines, 2022 were released to “regulate and develop Surety Insurance Business.” The guidelines will come into force with effect from April 1, 2022. IRDAI has allowed all general insurance companies for surety insurance business as well. Insurers can offer six kinds of sureties — advance payment bond, bid bond, contract bond, customs and court bond, performance bond, and retention money. 

“This approach may also help the insurance companies to expand their scope of business,” K.R. Sekar, President, BCIC and Partner, Deloitte Touche Tohmatsu India LLP told Financial Express Online. Badala echoed, “Insurance companies are also expected to make money from this process. Going forward, this might lead to healthy competition between banks and insurance companies and an option for MSMEs to choose from. Usually, the bank guarantee process is time-consuming and complicated in comparison to surety bonds.” 

 On the other hand, the replacement of bank guarantees with surety bonds might require a change in government procurement contracts, particularly for small PSUs. “The more sophisticated PSU’s like ONGC will probably not need a nudge. Perhaps, the Credit Guarantee Scheme could be extended for the issuance of surety bonds for MSMEs. Insurance companies will certainly be amenable to issue such bonds but may surely be as selective as banks,” Sujjain Talwar, Partner, Economic Laws Practice told Financial Express Online.

According to IRDAI guidelines, the premium charged for all surety insurance policies underwritten in a financial year, including all instalments due in subsequent years for those policies, should not exceed 10 per cent of the total gross written premium of that year, subject to a maximum of Rs 500 crores. Insurance companies can also work with banks or other financial institutions such as non-banking financial companies (NBFCs) to share risk information, technical expertise to monitor projects, cash flow amongst other aspects. However, the guidelines noted that these surety insurance contracts are to be offered to infrastructure projects. Hence, details around their applicability on government procurement is yet to be ascertained.

“The success of this measure will depend on improving MSMEs’ access to these insurance products. This will require proactive effort both from the insurance companies and IRDA as well,” Shravan Shetty, Managing Director at management consulting firm Primus Partners told Financial Express Online.