What is Punjab National Bank’s LoU fraud?

The Punjab National Bank’s Brady House Branch in Mumbai issued fraudulent letter of undertaking (LoU) worth of Rs 11400 crores in favour of Diamond trader Nirav Modi’s firms. Modi’s firms sought the LoU to get buyers’ credit from foreign banks so that they can finance diamond imports to India.

Practically, LoU can be taken as a guarantee for overseas lenders (banks) to give money to an Indian importer. Here, foreign branches of three Indian banks – Union Bank of India, Allahabad Bank and Axis Bank provided credit to Nirav Modi firms based on the PNB LoUs.

Initial report from PNB indicate that the LoU was issued without proper authorisation. This means that some officials in the bank have done a favour to Mr Modi.

To understand the entire issue behind the scam, a proper understanding of concepts like Buyers’ credit and LoU are needed.

What is buyer’s credit?

Buyer’s Credit is a loan given by a foreign bank/foreign branch of Indian bank to finance imports into India. It is provided to the Indian importer (here, Nirav Modi firms).

The buyer’s credit is given by the foreign bank’s foreign branch of the domestic bank based on letter of undertaking (LoU) given by an Indian bank (the Indian bank (here the PNB) should be a Category I authorised dealer who deals with foreign currencies).

What is Letter of Undertaking?

Letter of Undertaking is a contract of promise, to pay a liability (loan), of a third person (the importer; here Nirav Modi) in case of his default. The LoU is between two banks (the issuing Indian bank and the buyer’s credit providing overseas bank). On the other hand, there is Letter of Comfort if the guarantee is provided by an Indian bank to its foreign branch. The LOU in the cases of the PNB case means that the PNB will pay the amount if Mr Modi doesn’t pay the loan obtained from the issuers of buyers of credit(Axis bank etc.).

Why this issue becomes fraudulent?

The entire episode came into the limelight when the importer failed to make repayment. Initial enquiry shows that LoUs were issued date back from 2012-13.

The money doesn’t return as the concerned firms of Mr Modi were in financial troubles. Non-payment implies that the default burden falls on the shoulders of PNB and not that on the three Indian banks as LoU is a financial guarantee in case of non-payment by the importer (Nirav Modi).

What will be the follow up in the PNB transaction?

If the money is paid back by the defaulter, PNB will be financially safe. At the same time, the involvement of bank’s officials for giving undue favour to the importer will be enquired.

What is the RBI guidelines for issuing LoU to diamond importers?

The RBI gives detailed guidelines for issuing LoU in favour of importers. Some of its clauses were changed or updated in February 2018 itself in the context of early symptoms of the PNB issue.

Primarily, the guidelines insist that the importer should have good track record. Here, PNB has not made any mistake as Modi’s firm was well known.

Secondly, the RBI regulation says that it is the responsibility of the bank to undertake the commercial risk involved – “banks should, undertake the transaction based on their commercial judgment and after being satisfied about the bonafides of the transaction.”

The RBI also gives instructions on KYC norms and other documents to be submitted by the importer to the bank.

Message for future regulations

But the entire issue indicates scope for improvement in the RBI’s guidelines to banks (category I ADs) for issuing LoU to diamond and gold importers. If somebody in the banks office favours an importer, the latter can obtain tremendous money. Reports indicate that the bank officials don’t obtained the RBI insisted documents while issuing the LoU.

Here, if a credible importer like Nirav Modi defaults, the bank will be in trouble. Hence, the RBI regulations should be made more specific and strong on LoU.


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