The Reserve Bank of India today decided to discontinue issuance of letters of undertaking (LoU) and letters of comfort (LoC) for trade credit for imports into India.
Authorised dealer-1 (AD-1) category banks will not be allowed to issue LoCs and LoUs for this line of business, the regulator said in a notification on its website. Most universal banks, domestic and foreign, come under this category, according to two bankers in the know.
Banks may continue to issue letters of credit and bank guarantees for trade credit for imports into India as per the current guidelines applicable, the notification added.
This is part of a series of moves from the RBI after details of the Nirav Modi scam came to light. In the case, Nirav Modi’s associates approached the domestic branch of Punjab National Bank to issue fraudulent LoUs to foreign branches of other Indian banks through the SWIFT network. These LoUs were not registered in the core banking system for PNB. This means that the bank was virtually unaware of any such transactions taking place.
According to the two bankers quoted above, 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. Globally though, letters of credit and bank guarantees are the followed norm.
The difference between these products is that 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 the case of letters of credit 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.
Earlier buyers were able to enjoy credit for a year using the LoU facility. 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, Chief Executive Officer of Indian Banks Association, VG Kannan told BloombergQuint in an interview. In case the supplier wants the money, he should discount the bills with his own banks and take the money after getting the credit value of the bill, he explained.
This means there won’t be a change in the requirement of the funding limit. But even if the supplier refuses to extend credit, the domestic buyer has to arrange for rupee or foreign currency funds to make the payment on the due date, Kannan added.
The process of getting the credit will be essentially the same. This will in affect end up having more funded facilities made available to the domestic players.VG Kannan, CEO, Indian Banks Association
Kannan said that LoUs in itself were a good product and the fraud at PNB was more of a systemic issue. He added that discontinuing these facilities is not the ideal solution as bank guarantees can also be misused.