What Is LoU or Letters Of Undertaking?

Letter of Undertaking is a form of a guarantee issued by a banking entity to a person concerned for availing short term credit from the overseas branch of an Indian bank. These letters of undertaking (LoUs) are not issued against general retail transactions and instead are used for business or trade transactions.

What Is LoU or Letters Of Undertaking?

The issued LoU in favour of the bank customer is hence a guarantee to the overseas branch of the Indian bank of the repayment in the foreign currency.

How LoUs are obtained?

In an ordinary case, LoUs for securing credit line are backed by margin money or sanctioned credit limit by the banking entity. This means the borrower of funds or the customer has to pay margin money to the LoU issuing bank which then sanctions a credit limit.

Further the issuance of LoUs happen in line with the foreign trade policy or FTP which govern the import of goods and services.

 

How LoUs work?'

After the initial formality per se obtaining LoU is done i.e the bank is convinced with the collateral received against the credit sought from the overseas Indian bank branch, bank then processes the LoU to the foreign branch.

It may be noted that the margin money backing the credit can go even higher in value than the credit amount sought depending upon the relationship of the bank and customer.

Thereafter, the amount is released by the foreign branch of the Indian bank in foreign currency. It is to be noted that the amount is credited to the banker's bank account back home called Nostro account and now the customer can choose the beneficiary in whose name the payment has to be made.

 

 

PNBs multi-crore scam involving LoUs and SWIFT transactions

The multi-crore scam which is set to value even higher than the previously estimated Rs. 11400 crore has fraudulent LoUs issued in the sense that neither the margin money amount was provided by the credit seeker i.e Nirav Modi nor any credit limit was sanctioned. Also, as against what is prescribed or laid down in the rules, in the Nirav Modi PNB scam, credit was extended for over 90 days. Also it is to be noted that the term for credit depends on the nature of goods involved in the trade transaction.

 

Bank's stance post the massive scam

In a general case, the letter of undertaking is released for customer's who already share a credit relationship with the bank. In its circular in relation to guarantees and co-acceptances under the precautions for averting frauds head, the RBI said, "Banks should refrain from issuing guarantees on behalf of customers who do not enjoy credit facilities with them. As non-compliance of RBI regulations in this regard is likely to vitiate credit discipline, RBI will consider penalising non-compliant banks." Now, after facing a huge blow of this order, banks as per a PTI report are issuing LoUs for short term credit at a premium of 10-30 basis points.