What are LoUs and how will RBI move to discontinue them impact trade?

According to bankers, the business risk for importers will increase because they will need higher finance limits from banks, which banks are anyway reluctant to provide financing.

What is LoU and LC?

Essentially, LoUs and LoCs were issued by domestic banks at the behest of the importer. The importer would negotiate the right price for these loans from the foreign branches of other Indian banks and then get these letters issued by a domestic bank. The exporter, or seller, would be paid from the nostro account.

In this case, the bank is virtually guaranteeing the genuineness of the trade and the buyer that if the party does not pay up, the bank will step in with payment.

Letters of Credit and Bank Guarantees

In letters of credit (LCs) and bank guarantees, domestic banks issue these in favour of the exporter, or seller’s bank. Typically in these transactions, the seller would take the foreign exchange cost and would build that into the price of the product.

So, the LC is issued by a party (in this case the bank) to other banks certifying the financial soundness of the transaction of the supplier but the financier has to ensure the due diligence and only after the bank is sure about the genuineness of the transactions are payments made.

LCs are issued in serially numbered security forms with solid documentation, and there is a clause for the beneficiaries/financier that “they should, in their own interest, verify the genuineness of the guarantee with the issuing bank”.

Bank Guarantees

In case of a bank guarantee, a promise is made by the bank that if a borrower defaults, the bank will cover the loss.

Further, the LCs and bank guarantees come with riders that banks should not take too much of an unsecured exposure.

There are also strict criteria for bank guarantees, such as any guarantee issued for Rs 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.

Former Governor Raghuram Rajan told CNBC TV18, "One of my concerns in India is that there is sometimes a very -- cavalier treatment of guarantees whether it is bank given guarantees or government given guarantees. We don’t think these are real and it is only when they are called upon by the entity that has relied on them that we understand that it is almost like giving a loan or in fact more than giving a loan because it usually called upon when the loan is in distressed. So, it is actually like providing equity.

"Unless we account for these properly there are huge contingent liabilities on the government balance sheet as well as on the bank balance sheet and it is important that we acknowledge them," he said.

Global practice

Internationally, letters of credit and bank guarantees are used by buyers. To ease the high cost imports, LoUs and LoCs were largely issued by domestic branches of Indian banks for customers to avail trade credit from foreign branches of other Indian banks.

This was for the period of a typical business cycle of 90 days but buyers were able to enjoy credit for a year using the LoU facility. Discount rates are 40-50 basis points above the London Interbank Offered Rate, or Libor. Hence, importers used to secure financing at 2 percent 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.

The RBI circular now requires companies to directly use letters of credit for up to one year and let the supplier himself provide the credit.

Another banker said, LoUs were also a profitable other income for foreign branches of banks which would now face trouble.

Nirav Modi kills LoU business

The RBI move is a clear fallout of the scam, which came to light last month, perpetrated by Nirav Modi and Mehul Choksi's group firms that fraudulently received LoUs through PNB's SWIFT network and used them to raise money in overseas Bank branches.

The SWIFT channel was not linked to PNB's core banking solutions which meant the bank was virtually unaware of any such transactions taking place and only two bank officials who connived with Modi and Choksi's associates were privy to the LoUs being issued.

On Tuesday, Finance Minister Arun Jaitley in a written reply to the Rajya Sabha said Nirav Modi obtained his first fraudulent guarantee from PNB's Brady House branch in Mumbai on March 10, 2011 and managed to get 1,212 more such guarantees over the next 74 months.