RBI Bans Use of Letters of Understanding & Letter of Comfort

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RBI intervenes in the wake of PNB fraud

The Times Of India reports on the 14th of March, 2018 that the Reserve Bank of India will ban the use of Letters of Understanding and Letters of Comfort. This is to serve as a countermeasure in the wake of the 12,700 crore fraud at Punjab National Bank at the hands of diamond merchants Nirav Modi and Mehul Choski. The directive was issued on Tuesday, 13th of March upon the discovery that PNB had been defrauded of over 2 billion $. These two financial instruments (LoU’s and LoC’s) were issued by Indian banks to domestic importers to acquire foreign exchange from banks abroad at cheaper rates, given the understanding that the currency will be used for the importing of goods, commodities or services for sale into India.

Consequences

This step is going to hurt Small and Medium Enterprises, as the president of the Small & Medium Business Development Chamber of India, Chandrakant Salunkhe confirms – ‘banning LoU’s will severely impact the SME sector as it was an important credibility building option for the smaller players.’ He further adds ‘“Due to some big corporates who have cheated the banks, why should the SMEs suffer? The RBI should withdraw the LoU ban. Instead, it can insist that the banking sector create a new compliance model to avoid frauds and allow LoU issuances to genuine borrowers,”. The withdrawal of such financial instruments would mean a minor spike in the cost of imports. On the flipside this means that foreign banks will finally find an even playing field along with their Indian counterparts, in the task of financing imports (Joiel Akilan, Executive Director and chief representative to India for Banco Bilbao Vizcaya Argentaria, Europe’s 8th largest bank.)

Collateral

Industry estimates indicate that around 25,000 small firms and 75,000 medium-sized firms will be affected by the ban. Salunke insists that such a decision is a blow to India’s ambition of becoming a manufacturing hub and that the Small & Medium Business Development Chamber of India, will be taking up the issue with the RBI.

Further Investigation

Former RBI Governor, Raghuram Rajan said that during his tenure the RBI had sent a list of bank frauds to the Prime Minister’s Office. Raghuram Rajan however does not elaborate as to which prime minister the list was sent to, nor does he mention whether any action was taken or not. He does however raise a number of key questions. 1. Why was the Letter of Understading given? 2. Why was it not recorded in the banking system? 3. Did management take notice of it? 4. Was it put before the board? 5. If so, why didn’t the auditors pick it u as they go branch by branch? 6. Were they regulator’s instructions obeyed, and if not – why? Perhaps most worryingly, the owner in this case is the government which appoints both, board members as well as management, the question that cannot be avoided is 7. What is their culpability in this case?