A month after the Punjab National Bank (PNB) reported fraudulent transactions that are now estimated to be over Rs 12,700 crore, the Reserve Bank of India (RBI) Tuesday banned the use of Letters of Undertaking (LoUs), illegally used by companies of diamantaire Nirav Modi and Mehul Choksi to defraud the bank. This decision of the central bank could have repercussions for trade finance activities in the country.
The RBI, in a notification to all banks, said it has decided to discontinue the practice of issuance of LoUs and letters of comforts (LoCs) for trade credits for imports into India by banks with immediate effect.
It, however, said letters of credit and bank guarantees for trade credits for imports into India may continue to be issued subject to compliance with certain provisions — banks should avoid giving unsecured guarantees in large amounts and for medium and long-term periods, and they should avoid undue concentration of such unsecured guarantee commitments to particular groups of customers or trades.
While Choksi’s Gitanjali Group defrauded Rs 7,080.86 crore, the rest is attributed to companies of Nirav Modi. Both Modi and Choksi have fled the country. The CBI, Enforcement Directorate and Serious Fraud Investigation Office (SFIO) are investigating the fraud.
Companies linked to Modi and Choksi obtained LoUs, which were used to get loans from overseas branches of Indian banks, with the help of conniving employees of the PNB branch. The RBI had said it confidentially cautioned and alerted banks of such possible misuse, at least on three occasions since August 2016, advising them to implement safeguards and about the potential malicious use of the SWIFT infrastructure.
The ban on LoUs and LoCs is likely to affect trade finance and the rupee. Importers, especially in the gem and jewellery sector, will have a tough time to finance their import business. Many importers were forced to buy dollars from the spot and forward market after banks tightened the rules for import finance in the wake of the Punjab National Bank fraud.
“Now with the RBI banning LoUs, it’s to be seen how import finance can be done. Banks had tightened the rules for issuing LoUs and other guarantees. They were also asking for more documents. Most banks have tightened the scrutiny of LoUs and letters of comfort. As importers can’t delay payments, they are forced to buy dollars from the spot and forward market,” said a banking source.
If importers go to the open market for dollars, the rupee is likely to come under pressure, dealers said.
LoUs or letter of comfort, are issued against import documents which are normally for 90 days and this facility is used regularly, especially by companies which are in the business of gold, gems and jewellery. Margins on this borrowing depends on the risk profile of the borrower and the company’s credit rating and the terms of the credit limits set by the bank. This is essentially a short-term foreign currency loan on which banks charge say 60 to 90 basis points over the London Interbank Offered Rate or Libor — the international benchmark for pricing loans or lending.
In trade finance, which is the business of imports and exports, companies need funds to pay their suppliers overseas. Such payments are in foreign currency. An Indian company which is into imports or exports first approaches its banker for such funding. Designated officials of the bank have to first approve a credit limit for a company under which a LoU or a letter of credit can be issued at the request of the company.
The actual issuance of the LoU is the next step after the credit limits are sanctioned. The bank then issues a LoU — which the company can present to the overseas branch of a bank — say in Singapore or Hong Kong. A message regarding the funding is then transmitted from India to a bank abroad through the Society for World Interbank Financial Telecommunication System platform or SWIFT which is a global financial messaging service. On receiving this message through SWIFT, banks abroad mostly branches of Indian banks abroad especially in the case of Indian firms provide funds to the company.
Companies take recourse to this form of funding as the costs of raising money overseas are relatively lower compared to rupee funding. For banks, this is good business if all goes well. The RBI had recently constituted an expert committee under the chairmanship of Y H Malegam, a former member of the Central Board of Directors of RBI, to look into the entire gamut of issues relating to classification of bad loans, rising incidents of frauds and effectiveness of audits.