Reserve Bank of India has scrapped quasi bank guarantee instruments such as the Letter of Undertaking (LoU) and Letter of Comfort (LoC) that blew a Rs 14,000 crore hole in the books of Punjab National Bank (PNB) as the regulator attempts to plug a loophole and improve banks’ due diligence in trade credit. Banks can continue to issue guarantees and letter of credit for trade purposes which are the international norm, and also have features that makes the claim on the issuer strong. Doing away with these trade instruments would raise the cost of funding for companies that use them, but would increase the responsibility of banks that are lending based on these instruments.

It has been decided to discontinue the practice of issuance of LoUs/LoCs for trade credits for imports into India with immediate effect. Letters of Credit and Bank Guarantees for Trade Credits for imports into India may continue to be issued subject to compliance with the provisions contained in Department of Banking Regulation. Ever since the scandal broke out, banks, PNB, regulator and the government have been bickering over how to settle the liabilities arising out of the fraud. While banks that possess the LoU say that PNB has to honour, the state-run lender in the thick of the scam says that it was a due to a series of fraudulent transactions and others were also lax in due diligence.

This move is welcome in light of the PNB fraud. LoUs were not recognized as a banking instrument according to the international code and now everything will have to be routed through letters of credit. After weeks of deliberations, PNB has come to a kind of a proposal that could lead to part settlement of the liabilities with a caveat. While PNB has agreed to honour claims due by March end, the payments will have conditions attached.

[Source: The Economic Times]

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