RBI directs Indian Banks not to issue ‘Letter of Undertaking’&‘Letter of Comfort’

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After the detection of fraud by Nirav Modi and his uncle MehulChoksi through PNB for more than Rs.13,000 Crores via Letter of Undertaking (LOU) and Letter of Comfort (LOC), Reserve Bank of India has been constrained to direct all Indian Banks not to further issue LOUs and LOCs.

LOU/LOC is a type of Guarantee by any Bank on behalf of a customer, whereas the customer approaches foreign Banks to avail soft credit from the foreign Bank. Most of these LOUs and LOCs are issued after proper assessment of borrowers’ standing and capacity to repay. Whereas in case of PNB, it has been alleged that LOUs / LOCswere issued to the companies of Nirav Modi and MehulChoksi without any proper assessment. SWIFT Messages were sent without actually affecting the accounts of alleged companies. When the commitments were not met by the alleged companies, defaults were reported to RBI by the beneficiary Banks. Thus, the fraud came into light. It has been reported that since 2011, more than 1200 LOUs and LOCs were issued without affecting the defaulting companies Bank accounts.

Since still in many Banks SWIFT is not connected with the main accounting systems, it has been a very risky practice to issue SWIFT messages without affecting the Bank transactions and has been a grey area. At first stage Banks have been asked to connect their accounting software with SWIFT and now decision to ban LOUs / LOCs by RBI is the next step to prevent fraudulent tactics.

But decision to ban LOUs / LOCs will have its own repercussions on the international trade which will increase cost of funding rather shall make short term funds scarce. Value of Indian currency will go down as compared to other foreign currencies. It will also be difficult for Inter-bank foreign exchange market to tackle the situation of this shortage of foreign exchange.This will also resulted in decrease in other income of the Banking sector, as issuance of LOUs / LOCs was also a source of good income by the Banks.

Credibility of Indian Banking will have long lasting set back in the international Banking sector. Banking shares and stocks have an immediate impact as it has gone down.

Will this of scrapping LOUs & LOCs really prevent such frauds?

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