In the wake of over Rs 13,000 crores fraud perpetrated by Nirav Modi and Mehul Choksi on Punjab National Bank [PNB] – second largest public sector bank [PSB] – the Reserve Bank of India [RBI] has barred banks from issuing letters of undertaking [LoUs] and letters of comfort [LoCs] with immediate effect. However, it has allowed banks to continue to issue letters of credit [LCs] and bank guarantees [BGs].
The decision has caused consternation in industry circles who argue that this move will cause a big disruption in trade financing [as LoUs/LoCs currently account for about US$ 20-40 billion worth of outstanding finance] and raise credit costs for importers.
In a country ridden with a flood of scams, it is common practice for fraudsters to first leverage loopholes in systems to defraud public institutions and then, industry and trade bemoaning corrective actions taken by the regulator to plug these loopholes. The events in the present case are symptomatic of this pattern.
This instrument [read: LoU] is intrinsically amenable to the possibility of misuse. It is a generic undertaking given by the issuing bank to foreign branches of Indian banks on the strength of which the latter pay the mentioned amount to the beneficiary [albeit in foreign exchange] on behalf of the party. If, the party fails to pay back at the end of stipulated credit period, the issuing bank foots the bill.
The capital of the bank would be safe if before issuing the undertaking, it had taken margin money [MM] or collateral from the party to fully cover the loan amount. Indeed, RBI regulations stipulate such requirement for LoU [in case of LoC even this stipulation is not there]. But, what if the party does not give MM/collateral? In such a scenario, the outcome is Nirav Modi/ Mehul Choksi type fraud.
The vulnerability arises primarily because the LoU is not transaction related and not backed by any document. Its issue is predicated entirely on the satisfaction of the issuing bank about the genuineness of the party. The determination of genuineness or otherwise, in turn, is entirely at the discretion of management. If, the management decides to compromise, there is no escape from the bank suffering loss.
In the instant case, the LoUs were fraudulently issued by bank officials [2011-2018] under a quid pro quo arrangement with fraudsters. The latter got so much used to this tacit understanding with the former that when a new official on that sensitive seat asked for MM/collateral for a issuing fresh LoU, they had the audacity to shot back ‘in the past, it was never asked, so why now’. Indeed, at that stage scam stood exposed.
Clearly, given the architecture of LoU, the chances of fraud happening are real. The use of LoU or LoC may be justified in the garb of ease of doing business or reducing the cost of credit or garnering more business for banks [for an attractive fee]. But, all this is at the cost of putting bank’s capital at unprecedented risk.
The chances of loot can be substantially minimized if only the issue of authorization is backed by solid documentation [reg. source of supply, name and address of supplier, quantity, price etc] to verify the genuineness of the transaction. These requirements are there in the case of LC. LC is issued against a transaction that has happened but payment has not gone through. These are issued in serially numbered security forms, and there is a clause for beneficiaries that “they should, in their own interest, verify genuineness of the guarantee with the issuing bank”.
Therefore, RBI has ordered ban on the use of LoUs and LoCs [which were susceptible to misuse] and recommended use of safer instruments viz. LC and BG for financing export-import transactions. Merely, because the former account for a good chunk of import finance [requiring less documentation] and available at lower cost cannot be a valid basis for continuing with these instruments.
The apex bank has also mooted additional safety features by reducing the tenure of guarantees and standby LCs to one year from three years earlier and requiring banks to ensure that these are used by their clients for the intended purposes only. The guidelines also require banks not to take too much of an unsecured exposure.
There are also strict criteria for BG, such as any guarantee issued for Rs 50,000 and above should be signed by two officials jointly [a lower cut-off limit is also followed by some banks]. In case, exceptions are made for affixing of only one signature, banks should devise a system for subjecting such instruments to special scrutiny by the auditors or inspectors at the time of internal inspection of branches.
The responsibility for ensuring the adequacy and effectiveness of the systems and procedures for preventing perpetration of fraud and malpractice by their officials would, in such cases, rest on the top managements of the banks.
Notwithstanding the above, there is an urgent need for inculcating a deep sense of ‘responsibility’ and ‘accountability’ at all levels in the management that makes them recognize the importance of safeguarding public funds while carrying out their functions. The penal provisions for disregarding these basics should be stern; for instance, in a leading private sector bank viz. IDFC Bank, a mere act of giving password to someone else is met with dismissal of the employee.
Even more crucial is dire need for shielding PSBs from political influence as all systems and procedures – meant to deter bank staff from going off track – fall like a pack of cards if a pliable ruling dispensation issues tacit diktats to soft pedal if only to favor a borrower/industrialist/businessman. Hence, the government should consider relinquishing majority ownership and control to enable running of banks on professional lines free from outside interference.