In the aftermath of the PNB fiasco over the issue of fake Letters of Undertaking (LOU), the RBI decided to ban further issues of LOUs and Letters of Comfort (LOC). However, this move will be with prospective effect which means that all existing LOUs and LOCs will be fully honored. However Letters of Credit (LC) and bank guarantees will continue for international trade finance and there will be no change on that front. But first, what exactly is this PNB fiasco?
How PNB misused LOUs…
It did come as a surprise when it became clear that the PNB fraud had been perpetrated using fake LOUs. A group of fraudulent employees at the Brady House branch of PNB had colluded with Nirav Modi and his team to issue fake LOUs. An LOU is a form of bank guarantee that is issued by an India bank based on which the foreign branches of other banks will finance the trade. The PNB officer had issued fake LOUs to the tune of $2 billion on the back of which Nirav Modi companies had obtained funding from other banks like SBI, Allahabad Bank and Axis Bank. It was only when Nirav Modi defaulted on these loans that the entire fraud came to light. This has put the focus back on the LOUs which were used to commit the fraud by also manipulating the SWIFT password. It is to curb such practices in trade finance that the RBI has gone out and banned the fresh issue of LOUs and LOCs altogether.
Off-balance sheet financing…
One of the major downside risks of these LOUs as a source of financing is that it is a form of off-balance sheet financing. What it means is that it is a contingent liability and only impacts the P&L account in extreme cases. But when they do the impact is quite profound. In the case of PNB, the total loss of $2 billion which PNB will have to bear is almost 1/3rd of the net worth of the bank and a multiple of its profits. Currently, the total off-balance sheet financing of trade finance in the form of LOUs, LOCs is to the tune of Rs.1.95 trillion ($30 billion). As a percentage of total trade finance, it is less than 2.5% but in terms of the ability of individual cases to cause damage to bank balance sheets, it is huge. So what is the likely outcome of this move?
How will the LOU ban impact?
There are 3 things we need to understand. For exporters, this shuts the door on a simple, albeit high risk, source of trade finance. Secondly, banks will lose out access to one of the lucrative source of fee based income from global trade finance. Lastly, what does it mean for the trade finance business as a whole? We believe that in the long run it will be positive and value accretive for banks. This ban makes the trade finance business of banks a lot safer and that is worthwhile. It also gives banks time to re-adjust!
