Can surety bonds replace bank guarantees for infrastructure projects?
Talk to a developer these days and there’s a good chance they’ll end up complaining about their precious cash stuck in bank guarantees for extended periods of time. However, this could reduce considerably if the country adopts sureties rather than bank guarantees for infrastructure projects.
The demand for surety weighting as an innovative financial instrument is slowly gaining ground. First proposed in the last few years of the last decade, its main advocates believe it could be a viable alternative to ensure a smooth pipeline of public works projects.
“With the known deterioration of the balance sheets of companies and associated service providers, such as consulting engineers or operation and maintenance service providers, persuading banks to issue a bank guarantee to the contracting authority ensuring that the service provider concerned will comply with all its obligations have become a serious bottleneck, âlamented Vinayak Chatterjee, president of infrastructure services company Feedback Infra.
A contract requires the developer to provide various bonds during the life cycle of a project, including bid bonds, performance bonds, prepayment bonds, retention bonds, etc., which together can represent up to 20% of the total cost of the project.
âCurrently, 100% of the guarantee requirements for the infrastructure sector are covered by the banks. These guarantees are inherently an inefficient way of doing business as they cut all bank lines and consume collateral and margin money to suck working capital from an entrepreneur who is already cash strapped, âsaid Vikash Khandelwal, CEO of surety solutions company Eqaro Guarantees.
A surety bond is a legally binding tripartite agreement signed between the principal, the creditor and the surety. Simply put, the bond is provided by an insurance company on behalf of a principal or contractor to the creditor or government entity awarding the project.
Guarantees are therefore also a gateway for the insurance sector in the field of project financing.
Advantages of sureties
Listing the main advantages of secured bonds, Chatterjee noted: âFirst of all, they are not guaranteed as bank guarantees and are provided largely on the basis of the entrepreneur’s track record and financial health, so that bank guarantees generally require a minimum of tangible security. Second, sureties tend to be in effect throughout the life of the project, while bank guarantees need to be renewed periodically.
âMore importantly, bank guarantees are unconditional and payable on demand, while sureties can be repaid as an insurance policy if the claim is valid,â he added.
âThe adoption of surety bonds will result in increased participation of contractors in project bids, which will result in more efficient price discovery, the release of collateral to meet working capital needs and improved performance. efficiency of project implementation, and reduction of pressure on government social protection programs, âKhandelwal said.
Bonds are a preferred financial instrument in several developed western economies. In the United States, for example, the Miller Act of 1935 requires contractors to provide performance and payment guarantees in connection with the construction, modification or repair of public works.
Since the risks associated with a project are assessed through the underwriting process, surety bonds do not require the contractor to offer valuable guarantees to offset the guarantees issued.
Speed ââup regulation
Experts recommended that for the surety market to thrive, the necessary regulations must be finalized quickly.
Commenting on the surety market, Practice Leader and Director, Transport and Logistics at CRISIL Infrastructure Advisory, Jagannarayan Padmanabhan believes that over time the concept could also become a proxy for identifying effective developers in India.
Speaking about the challenges inherent in financing infrastructure, Padmanabhan stressed: âOn the insurers side, it is important that they avoid concentration risk and market this product appropriately so that there is sufficient demand that is generated. In addition, it is equally important that they improve their underwriting skills and understand the nuances of infrastructure projects, especially at the development and construction stages. “
In 2020, a working group formed by the Insurance Regulatory and Development Authority of India (IRDAI) favorably viewed sureties as an alternative to financial guarantees such as bank guarantees. Following the group’s recommendations, the regulator published draft guidelines in September 2021 to promote and regulate the surety insurance business in India.
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