RBI forbids banks from issuing LoUs

The Reserve Bank of India has barred banks from issuing letters of undertaking, the instruments used by Nirav Modi and Mehul Choksi to defraud Punjab National Bank, in a move that may deal a blow to trade financing in India and raise credit costs for importers.

RBI also barred lenders from issuing letters of comfort as trade credit for importing goods into India with immediate effect. It, however, allowed banks to continue to issue letters of credit and bank guarantees.

The central bank’s move is likely to lead to a freeze in trade financing activities in India, increasing costs for importers who have relied on these instruments to get cheaper overseas credit to pay suppliers. It will also put companies that have received credit based on LoUs in a spot, as they have to now repay their borrowings since there will no rollover of existing LoUs.

Importers prefer taking loans based on LoUs as they are denominated in foreign currency and are cheaper than rupee credit. A letter of credit, on the other hand, is used to establish the credit worthiness of the buyer in the purchase of goods.

Lenders will have to look at alternative instruments like bank guarantees. LoUs and LoCs are used widely in several industries including gems and jewellery, oil and gas, electronic goods, solar panels and metals.

Until the PNB fraud surfaced, buyers’ credit was seen as a safe business because of its short term nature and the risk of default was essentially on another lender. That apart, it provided the LoU-issuing bank with a source of fee income.

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