RBI DISCONTINUED LoU AND LoC AS INSTRUMENTS OF TRADE CREDIT
The Reserve Bank of India has scrapped quasi bank guarantee instruments such as the Letter of Undertaking and Letter of Comfort that blew a Rs. 14,000 crore hole in the books of Punjab National Bank as the regulator attempts to plug a loophole and improve banks’ due diligence in trade credit.
LETTER OF UNDERTAKING (LoU)
- It is a widely accepted provision of bank guarantees under which a bank can allow its customer to raise money from another Indian bank's foreign branch in the form of a short term credit. The LoU serves the purpose of a bank guarantee for a bank's customer for making payment to its offshore suppliers in the foreign currency.
- LoUs are used by a bank’s customer to avail short-term credit in a foreign country. These transactions are not retail in nature and are mostly used by businesses for import of goods.
- It is a letter of assurance or guarantee issued by one bank to branches of other banks to meet a liability on behalf of an importer, based on which foreign branches offer credit to buyers.
- For raising the LOU, the customer (importer) is supposed to pay margin money to the bank that issues the LOU and accordingly, they are granted a credit limit.
- The issuer bank messages overseas branches of other banks through the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network and that bank immediately pays the client against the LoU.
LETTER OF COMFORT (LoC)
- A letter of comfort is a written document that provides a level of assurance that an obligation will ultimately be met. In its traditional context, a letter of comfort is given to organizations or persons of interest by external auditors regarding statutory audits, statements, and reports used in a prospectus.
- The letter of comfort will be attached to the preliminary statements as assurance that it will not be materially different from the final version.
IMPACT OF DISCONTINUITY
- Guarantees and LoCs involve receiving banks conduct their own credit appraisal on companies before accepting them which reduces the risk of defaults. Thus, the banning of the Letter of Undertaking and Letter of Comfort will lead to receiving banks depending completely on the issuing bank on creditworthiness.
- Doing away with these trade instruments would raise the cost of funding for companies that use them, but would increase the responsibility of banks that are lending based on these instruments.
- Cost of funding for companies may rise as LCs are more expensive, but it will make banking system less vulnerable to fraud.
- RBI move will improve banks’ due diligence when it comes to trade credit.
Indian banking system is facing its biggest fraud with fashion jeweller Nirav Modi duping Punjab National Bank by using the Letter of Undertaking issued by the bank. Ever since the scandal broke out, banks, PNB, regulator and the government have been bickering over how to settle the liabilities arising out of the fraud. This move is welcome in light of the PNB fraud. LoUs were not recognized as a banking instrument according to the international code and now everything will have to be routed through letters of credit.