India bans trade finance product at the heart of PNB fraud
The Reserve Bank of India (RBI) has banned banks from using letters of undertaking (LOUs) to guarantee imports, a month after the uncovering of a huge trade finance fraud at Punjab National Bank (PNB).
Fake LOUs were being used as a form of buyer’s credit in the PNB fraud, the cost of which has so far been estimated at US$1.8bn.
Billionaire diamond jewellers Nirav Modi and Mehul Choksi colluded with bank officials to issue the fraudulent LOUs over seven years via the Swift messaging system. However, these were not registered on the PNB central banking system, meaning the transactions were unauthorised.
The RBI has also banned letters of comfort (LOCs), another form of bank guarantee. Letters of credit will still be permitted. LOUs are guarantees issued by Indian banks, against which a foreign currency can be obtained. They are widely used by Indian companies to fund importers and are often funded with loans from overseas subsidiaries of Indian banks.
“On a review of the extant guidelines, it has been decided to discontinue the practice of issuance of LOUs, LOCs for trade credits for imports into India by AD category-I banks with immediate effect. Letters of credit and bank guarantees for trade credits for imports into India may continue to be issued subject to compliance with the provisions,” the RBI said in a statement.
The move could have the unintended consequences of stifling the access to finance for small Indian importers, which are already seeing a tightening in credit lines following the PNB fraud. International banks have become more reluctant to accept guarantees from some domestic Indian banks and pricing has risen accordingly.
The LOU is predominantly used in the jewellery sector, with many Indian importers in other sectors preferring the more internationally accepted letter of credit to meet their funding needs. This sector is considered riskier in general and more vulnerable to fraud.
“It’s an industry that in normal bank risk profiles, would rank higher. If you were to add the geography, the industry sector and the type of business they’re doing, you’d end up in a risk quadrant in a high or very high level, so you’d spend much more time focused on the type of transactions and the way you manage it,” Tim Phillipps, head of Southeast Asian forensic and analytics at Deloitte, tells GTR.
One banker based in Mumbai, speaking on the condition of anonymity, said that he stopped funding this sector a number of years ago and that his bank – an international player – has limited use for the LOU.
“I got out of these gems and jewellery businesses in 2013. I saw the balance sheets were stressed, the receivable collection period got extended, and their own payables were getting ballooned. They weren’t paying banks on time. I thought something was wrong. Secondly what triggered my thinking is if someone is having a US$15bn or US$16bn turnover, they should have a corresponding number of people working there, I couldn’t correlate that factor. When I went to the offices the body language was not good, so I stopped dealing with them many years ago,” the source says of the PNB fraud, which is the biggest financial scandal in Indian history.take me back