Reserve Bank of India this month banned the issuance of Letters of Undertaking (LoUs) and Letters of Comfort (LoC), used extensively for trade finance, following the unearthing of Nirav Modi fraud case.
Nirav Modi and associates in connivance with some officials of Punjab National Bank (PNB) used LoUs to defrauded the lender of over Rs 13,000 crore.
The cost for trade finance has also gone up because of a shift to letters of credit, as per the representations. These instruments involve a commission fee along with a so-called acceptance charge which is not the case with LoUs as they only involve a guarantee fee.
Earlier this month, RBI barred banks from issuing guarantees in the form of letters of undertaking (LoU) as it clamped down on the import financing route used by fugitive jeweller Nirav Modi and his uncle Mehul Choksi for allegedly committing India’s biggest bank fraud.
RBI also banned with immediate effect issuance of LoCs which, like LoUs, are used by importers to fund their overseas purchases.
The Rs 12,700-crore fraud at Punjab National Bank has prompted the Reserve Bank of India to ban the use of letters of undertaking (LoUs) and letters of comfort (LoCs).
LoUs and LoCs are two of the instruments issued by Indian banks to domestic importers to get the foreign exchange from banks abroad at a cheaper rate.
The RBI issued the directive on LoUs and LoCs about a month after it was discovered that diamond merchants Nirav Modi and Mehul Choksi had misused LoUs issued by PNB to defraud the bank of over $2 billion.
A LoU is a type of guarantee between two banks that allows the issuer bank’s customer to get the foreign exchange from another Indian bank’s foreign branch in the form of short-term credit.