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RBI discontinues Letter of Undertaking, Letter of Comfort as instruments of trade credit

The Reserve Bank of India has scrapped quasi bank guarantee instruments such as the Letter of Undertaking and Letter of Comfort that blew a Rs. 14,000 crore hole in the books of Punjab National Bank. This reform comes underway as the regulator attempts to plug a loophole and improve banks’ due diligence in trade credit. Banks can continue to issue guarantees and letter of credit for trade purposes which are the international norm, and also have features that makes the claim on the issuer strong. Guarantees and LoCs involve receiving banks conduct their own credit appraisal whereas the Letter of Undertaking and Letter of Comfort led to receiving banks depending completely on the issuing bank on creditworthiness. Doing away with these trade instruments would raise the cost of funding for companies that use them, but would increase the responsibility of banks that are lending based on these instruments. As per an executive at a state run lender, 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. An LoU lacks these details and when it is not linked to the banking system it cannot be traced like it happened with PNB.