By now, you would have come across the term ‘letter of undertaking’ (LoU), in the context of investigations into the alleged multi-crore fraud involving the Punjab National Bank and the credit facilities it offered to some jewellers. At the core of this investigation are some LoUs that were allegedly issued fraudulently. So, what are LoUs? LoU is an undertaking provided by one bank to another bank, in favour of or on behalf of a customer. Let’s cut through the jargon and look at them in greater detail.
LoUs are used by a bank’s customer to avail short-term credit in a foreign country. These transactions are not retail in nature and are mostly used by businesses for import of goods.
The borrower uses her existing credit relationship with a bank in India to avail the required credit outside the country. “An authorised dealer may give a guarantee, letter of undertaking or letter of comfort in respect of any debt, obligation or other liability incurred by a person resident in India and owned to a person resident outside India (being an overseas supplier of goods, bank or a financial institution), for import of goods, as permitted under the Foreign Trade Policy…," the Reserve Bank of India (RBI) had said in its directives for import of goods and services. It can be read here.
Let’s say you are a customer of an Indian bank and you require a short-term credit in a foreign country to import something. You can approach the foreign exchange department of your bank and ask for an LoU. In return, the bank would ask you for a collateral or a guarantee, which could be in the form of fixed deposits or other assets. This could even be 100% or even more of the credit sought, depending on your relationship with the bank. If your bank is convinced, it will issue an LoU, which when given to an overseas branch of another Indian bank would result in release of the amount in foreign currency. This amount does not come in to your account directly; it goes to a specific bank account of your banker back home. It is called Nostro account. You can then decide in whose favour the payment needs to be done.
The RBI has specifically advised the banks to issue LoUs to only those who have existing credit relationships with a bank. In the master circular on guarantees and co-acceptances, from July 2014, 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." Validity of an LoU depends on the category of goods that are imported.
The overseas bank lending to the borrower based on the LoU earns interest on the amount, the bank issuing the LoU gets a fee and the borrower gets a credit facility at a place where she may not have banking relationships. Moreover, interest rates in India are higher compared to international benchmark rates. So the effective outgo on interest for the borrower is also beneficial. If the collateral is in the form of a fixed deposit, there is further gain on the interest earned, while the bank also gets some funds to use.