PNB Scam: An Important Article | RBI Stops Letters of Undertaking For Overseas Credit

RBI Stops Letters of Undertaking For Overseas Credit

PNB Scam: RBI Stops Letters of Undertaking For Overseas Credit

The Reserve Bank of India has discontinued letters of undertaking (LoUs) or guarantees for overseas credit after the Rs. 12,600 crore Punjab National Bank (PNB) fraud was unearthed last month. LoU credit is ideally meant only for the short-term. It also serves the purpose of a bank guarantee for a bank’s customer for making payment to offshore suppliers in foreign currency.

In the Nirav Modi-Mehul Choksi case, the loan term was allegedly extended far beyond what was prescribed in the rule book.

The RBI said its decision to scrap the practice of issuing LoUs is effective immediately. “On a review of the extant guidelines, it has been decided to discontinue the practice of issuance of LoUs/LoCs for Trade Credits for imports into India by AD Category I banks with immediate effect,” the central bank said in a notification.RBI Stops Letters of Undertaking For Overseas Credit

Nirav Modi and the firms he controls allegedly leveraged the loopholes in the banking system by seeking LoUs and raising credit from foreign banks to pay their merchants.

For the past seven years, Nirav Modi and his three firms – Diamond R Us, Solar Exports and Stellar Diamonds – had been allegedly taking LoUs from PNB’s Brady Road branch in Mumbai.

These bank guarantees allegedly helped Mr Modi raise short-term loans from foreign branches of Indian banks to pay to suppliers of raw material such as rough stones.

See Also: PNB Fraud Explained | 10 Things You Need to Know

Even PNB and other lenders are slugging out over the loan term, which should not have been extended beyond 90 days, says PNB.

PNB has told police that it has also uncovered additional exposure of about Rs. 9.42 billion in connection with a massive fraud, according to a court filing.

PNB last month said it had been defrauded of about Rs. 12,600 crore by two jewellery groups who raised credit from overseas banks based on fraudulent guarantees issued in collusion with rogue PNB staff.

What is LoU (Letter of Undertaking):

LoU is an undertaking provided by one bank to another bank, in favour of or on behalf of a customer. Let’s cut through the jargon and look at them in greater detail.

Who gets an LoU:
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.

The borrower uses her existing credit relationship with a bank in India to avail the required credit outside the country. “An authorised dealer may give a guarantee, letter of undertaking or letter of comfort in respect of any debt, obligation or other liability incurred by a person resident in India and owned to a person resident outside India (being an overseas supplier of goods, bank or a financial institution), for import of goods, as permitted under the Foreign Trade Policy…,” the Reserve Bank of India (RBI) had said in its directives for import of goods and services.

See Also: Read All Important Articles for Descriptive Paper

How does it work:
Let’s say you are a customer of an Indian bank and you require a short-term credit in a foreign country to import something. You can approach the foreign exchange department of your bank and ask for an LoU. In return, the bank would ask you for a collateral or a guarantee, which could be in the form of fixed deposits or other assets. This could even be 100% or even more of the credit sought, depending on your relationship with the bank. If your bank is convinced, it will issue an LoU, which when given to an overseas branch of another Indian bank would result in release of the amount in foreign currency. This amount does not come in to your account directly; it goes to a specific bank account of your banker back home. It is called Nostro account. You can then decide in whose favour the payment needs to be done.

The RBI has specifically advised the banks to issue LoUs to only those who have existing credit relationships with a bank. In the master circular on guarantees and co-acceptances, from July 2014, under the precautions for averting frauds head, the RBI said, “Banks should refrain from issuing guarantees on behalf of customers who do not enjoy credit facilities with them. As non-compliance of RBI regulations in this regard is likely to vitiate credit discipline, RBI will consider penalising non-compliant banks.” Validity of an LoU depends on the category of goods that are imported.

The benefits:
The overseas bank lending to the borrower based on the LoU earns interest on the amount, the bank issuing the LoU gets a fee and the borrower gets a credit facility at a place where she may not have banking relationships. Moreover, interest rates in India are higher compared to international benchmark rates. So the effective outgo on interest for the borrower is also beneficial. If the collateral is in the form of a fixed deposit, there is further gain on the interest earned, while the bank also gets some funds to use.

Source- NDTV, Live Mint

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