The Reserve Bank of India’s (RBI) move to ban letters of undertaking (LoU) and letters of comfort (LoC) for trade credit could accelerate the movement of business to private banks from their public sector counterparts, industry experts said.
The Reserve Bank of India’s (RBI) move to ban letters of undertaking (LoU) and letters of comfort (LoC) for trade credit could accelerate the movement of business to private banks from their public sector counterparts, industry experts said. According to a report by Kotak Institutional Equities on Wednesday, spreads in the trade credit business have widened, resulting in immediate short-term earnings benefit, and private lenders could also play a larger role in trade credit than before. “Key beneficiaries could include the large private banks like ICICI Bank, Axis Bank and possibly IndusInd Bank,” the report said. The report added that public sector banks would have a negative impact on their business but guarantees is a small source of revenue. “While the overall revenue contribution is around 3-4%, the exact contribution of LoU/LoC is unknown,” it said. A public sector banker told FE that following the revelation of the Punjab National Bank (PNB) scam, the guarantee business has been hit as banks are reluctant to extend credit on the basis of an LoU. “While the business was not very big when compared to the entire book of a bank, it was nonetheless impacted as a fallout of the scam, which has eroded the trustworthiness of Indian banks,” he added.
Rajkiran Rai G, MD and CEO, Union Bank of India, told a business news channel that LoU is part of the working capital assessment of any corporate and is assigned to a customer after assessing the working capital requirements. “In case LoUs are stopped, it will shift to some other part of working capital,” he said, adding that customers’ cost of raising funds would go up as LoU was a cheaper option. He added that as a result of RBI stopping further issuance of LoUs, importers reliant on these instruments would seek more domestic credit from Indian banks. While the size of the LoU business is hard to quantify as it is a subset of the overall trade credit business, the Kotak report pointed out that as per the latest data, India had around $86 billion of trade credits, of which $56 billion was for loans between six months and one year, and $30 billion was for less than six months. “We believe that the LoU/LoC business would be a part of this overall credit,” it said.
RBI on Tuesday had disallowed banks from issuing LoUs or guarantees for trade credits for imports into India. The move comes in the aftermath of Rs 13,000-crore LoU-linked fraud unearthed at Punjab National Bank. However, letters of credit and bank guarantees for imports into the country will be permitted provided they meet RBI’s conditions. An LoU is issued as an undertaking that the issuer will honour the lender’s obligations if the borrower fails to do so. While bank guarantees are an internationally-accepted instrument, LoUs are mostly issued by banks in India and used by importers to raise money from foreign branches of Indian banks.