RBI bans LoUs for importers

The Reserve Bank of India (RBI) on Tuesday discontinued issuance of letters of undertaking (LoUs) and letters of comfort (LoCs) for importers with immediate effect, in an attempt to prevent fraud such as the one allegedly carried out by jewellers Nirav Modi and Mehul Choksi.

Letters of credit (LCs) and guarantees will continue to be issued like before if they meet certain criteria.

Normal trade credit is unlikely to be hampered. However, costs would increase for importers and a profitable business avenue for foreign branches of banks would close down, said senior bankers. Importers were raising these LoUs at a cheaper rate than what they would have done had they gone in for direct dollar financing.

Another issue will be that since importers will now have to buy dollars from the market, the rupee could come under pressure.

The move is likely to hurt large importers severely. According to an importer, it used to import goods taking LoUs and LoCs from banks, while subsequently discounting them in the overseas market.

This was for the period of a normal business cycle (90 days). Discount rates are 40-50 basis points above the London Interbank Offered Rate, or Libor. Hence, importers used to secure financing at 2 per cent per annum from the overseas market. Importers would produce finished goods with the imports and square off the bank loan by selling the finished product.

A corporate treasury official estimated that the LoU discount market was at about 30 per cent of the country’s total imports. According to him, now the business risk for importers will increase because they will need higher finance limits from banks, which banks are anyway reluctant to provide. However, Ajay Sahai, director-general and chief executive, Federation of Indian Exports Organisation (FIEO), said feedback from industry was that discontinuation of LoUs and LoCs would a have limited impact. These were mainly used by the gems and jewellery industry. The alternative means (LCs and bank guarantees) are available for accessing trade finance. Borrowers will have to see if the cost of accessing finance through these guarantees and letters of credit goes up. It will be linked to the rating of the client concerned.

LoUs and LoCs helped importers access cheap money (foreign currency) from the international market. But when converted into rupees for the purpose of accounting, the foreign exchange risk had to be factored in, bankers said.

Bankshavecutdownonissuanceof LoUs after news of Punjab National Bank being defrauded of ~127 billion through these instruments.

While all are essentially guarantees, there are subtle differences. Provisioning requirements also vary.

An LC is issued by a party (in this case the bank) to other banks certifying the financial soundness of the transaction of a firm. In the case of an LoU, the bank is virtually guaranteeing that if the party does not pay up, the bank will step in with payment.

A letter of credit, on the other hand, is based on solid documentation and only after the bank is sure about the genuineness of the transactions are payments made. Essentially, in the case of LoUs, the bank is guaranteeing the genuineness of the trade or the party, whereas in case of LCs, the bank is issuing the document against a transaction that has happened but payment has not gone through. Bank guarantees are a promise from a bank that if a party defaults, the bank will cover the loss.

In the NiravModi scam, LoUs were issued by a few PNB employees bypassing the bank’s core systems. The original size of the scam was determined at ~114 billion, but has increased with further investigation.

The RBI on Monday had reduced the tenure of guarantees and standby LCs to one year from three years earlier and had said banks should ensure that these guarantees are used by their clients for the intended purposes only. It had also modified its guidelines on hedging of commodity risks, but did not extend the facility to firms trading in gold, gems and precious stones.

Even as the RBI has allowed LCs and guarantees, the guidelines said banks should not take too much of an unsecured exposure. LCs are issued in serially numbered security forms, and there is a clause for the beneficiaries that “they should, in their own interest, verify the genuineness of the guarantee with the issuing bank”.

There are also strict criteria for bank guarantees, such as any guarantee issued for ~50,000 and above should be signed by two officials jointly. A lower cut-off limit is also followed by some bank branches. “The responsibility for ensuring the adequacy and effectiveness of the systems and procedures for preventing perpetration of fraud and malpractice by their officials would, in such cases, rest on the top managements of the banks,” the RBI’s master circular says. “In case exceptions are made for affixing of only one signature on the instruments, banks should devise a system for subjecting such instruments to special scrutiny by the auditors or inspectors at the time of internal inspection of branches,” according to RBI norms.