Look Beyond Scrapping of LUTs and LOCs

RBI to scrap Letters of Undertaking and Letters of Comfort

Indications are that the recent banking scam involving Punjab National Bank (PNB) is taking a toll on the financial market of the country. The decision taken by the Reserve Bank of India (RBI) to scrap Letters of Undertaking (LOUs) and Letters of Comfort (LOCs) are meant for cleansing the Indian banking system. That was long overdue. But it is important to see its impact on the market and how it would change the spectrum.

The available information in the public domain suggests that the banks can continue with issuing guarantees and letters of credit (LCs) for trade purposes in line with international norms and practices and in compliance with provisions of the Department of Banking Regulation.

It is now incumbent on the receiving t banks to conduct due diligence and credit appraisal about the companies involved to reduce the frauds and other malpractices. The subtle difference is that when it comes LUTs and LOCs, by way of precedence or practice, the receiving banks depend on the creditworthiness as endorsed by the recommending bank. This system should have worked well for some time or most of the time, barring the manipulations of a few rotten apples.

There are a few lessons that one has to learn from these examples. One, international, or for that matter, domestic trade largely depends on trust. Two, transactions should be swift and fast and any delay in transacting a deal can lead to loss of creditworthiness or even cancellation. An overseas buyer may not know or appreciate the rationale of an appraisal or any other procedure to verify the creditworthiness of a party.

They would attribute such unwarranted delays to red-tapism, causal approach and inefficiency. That way, the first casualty in the entire process will be India’s effort to showcase the world that there is something called ease of doing business. The Modi administration had done well in improving India’s ranking in the ease of doing business-a vault from 130 position to 100 in the pecking order is no mean achievement and the ultimate objective is to take the country to first 10 in the list of business savvy countries.

The second important factor that has to be reckoned is the general reaction of the business community belonging to the so-called MSME sector that they are least affected by the decision of the RBI to scrap the LUTS and LOCs, since, according to them, the maximum exposure of the banks in such transactions are with the big companies and the MSMEs have to go through the route of collateral and securities to obtain trade credit. That indirectly tells us that the banking system is flawed and lop-sided.

There should be a level-playing field for all payers irrespective their size and brand. The banks have to switch over to a system that the assessment and appraisals are objective and not swayed by hyped up branding or political pressure.

In this digital era, when there are so many rating agencies are there to evaluate the creditworthiness of a business enterprise, it is high time the banking sector put in place a credible system. The government has rightly proposing to have a new legislation in place to regulate the working of the chartered accountants. Can we have a similar policy for the credit rating and consulting agencies, which of late, have been blamed to support the wrong cases for considerations other than professional or ethical?

Now about LCs, which can be used for trade credits as stipulated in the recent order of RBI. It may be noted that LCs issued by certain countries and banks are not honoured. Also, LCs are misused and there is a long history of litigation relating to the issuance of LCs. What that suggests is that the RBI has to put in place a transparent system to address the trade issues and merely tweaking the policies may not be the right solution.

Top