What is the issue ?
- Recent frauds in the banking sector have prompted the RBI to ban the use of letters of undertaking (LoU) and letters of comfort (LoC).
- Letters of credit and bank guarantees for trade credits for imports into India may continue to be issued subject to compliance.
How is a letter of credit more secure when compared to a letter of undertaking ?
- A letter of credit is more secure because it has the details of the purchase by the importer, date of issue, expiry date, the material purchase and other transaction details
What are LoUs and LoCs ?
- LoUs and LoCs are instruments issued by Indian banks to domestic importers to get forex from banks abroad at a cheaper rate.
Essentially, LoUs and LoCs were issued by domestic banks at the behest of the importer.
The importer would negotiate the right price for these loans from the foreign branches of other Indian banks and then get these letters issued by a domestic bank. The exporter, or seller, would be paid from the nostro account.
In this case, the bank is virtually guaranteeing the genuineness of the trade and the buyer that if the party does not pay up, the bank will step in with payment.
A few terms that you need to know :
What is a letter of undertaking ?
- Letter of Undertaking is a bank guarantee and is issued for overseas import payments.
- A bank, while issuing LoUs for a client, agrees to repay the principal and interest on the client's loan unconditionally.
- When an LoU is issued it involves an issuing bank, a receiving bank, an importer and a beneficiary entity overseas.
What is a letter of comfort ?
- Refers to a document which is provided by a person, typically an affiliate (parent company) of the borrower assuring the financial soundness of the borrower to repay its debt(s).
What is SWIFT?
- When an LoU is issued, the message of credit transfer is conveyed to overseas banks through the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system.
- This is a significant information as it gives the bank's consent and guarantee.
- To issue SWIFT, an official has to log in and fill up confidential information such as the account number and SWIFT code.
- It generally has three layers of security - a maker, a checker and a verifier within the core banking system before it is issued.
What is CBS?
- CBS refers to Core Banking System where all branches are inter-connected to ensure that the bank customers - regardless of their home branch - are able to operate their account and transact in any of the member branch located anywhere in the world.
- After the advent of this system, a customer is no more customer of a branch, but s/he becomes customer of bank.
- All the transactions are updated real-time.
What is a 'Letter Of Credit'?
- A letter of credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount.
- In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.