RBI discontinues Letter of Undertaking, Letter of Comfort as instruments of trade credit
RBI discontinues Letter of Undertaking, Letter of Comfort as instruments of trade creditET Bureau|Updated: Mar 13, 2018, 07.58 PM ISTThe 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 banksâ due diligence in trade credit.
Banks can continue to issue guarantees and letter of credit for trade purposes which are the international norm, and also have features that makes the claim on the issuer strong.
Guarantees and LoCs involve receiving banks conduct their own credit appraisal on companies before accepting them which reduces the risk of defaults, said bankers. On the other hand, the Letter of Undertaking and Letter of Comfort which were banned, led 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, they said.
"A letter of credit is more secure because it has the details of the purchase by the importer, date of issue, expiry date, the material purchase and other transaction details,ââ said an executive at a state-run lenders. ``An LoU doe s not have these details and when it is not linked to the banking system it cannot be traced like it happened with PNB."
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. A LoU is a promise by the issuing bank to pay in case of default by the one on whose behalf it was issued. The mounting losses have to be borne by the bank as other lenders have loaned Nirav Modi and his uncle Mehul Choksi of Gitanjali Gems based on LoU from PNB.
"It has been decided to discontinue the practice of issuance of LoUs/ LoCs for trade credits for imports into India with immediate effect," the RBI said in a statement. "Letters of Credit and Bank Guarantees for Trade Credits for imports into India may continue to be issued subject to compliance with the provisions contained in Department of Banking Regulation," it said without saying why it is scrapping it.
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. While banks that possess the LoU say that PNB has to honour, the state-run lender in the thick of the scam says that it was a due to a series of fraudulent transactions and others were also lax in due diligence.
"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," said a private sector banker.
After weeks of deliberations, PNB has come to a kind of a proposal that could lead to part settlement of the liabilities with a caveat.
While PNB has agreed to honour claims due by March end, the payments will have conditions attached, said two senior officials with knowledge of the development.
âWhile settling the dues, PNB will issue a letter to counter banks that they would be liable to make good the payment if the findings by the investigative authorities prove that there was malafide intent on the part of peer banks,â said one of them. âOnce this is acknowledged by peer banks, PNB will make payments.â
Read more onPNB fraudLetter of Comfortreserve bank of indialetter of creditLetter of UndertakingBank of IndiaPNB
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