LOU And FLCs

LOU And FLCs

Subject: Economy

Section: External sector

Context:

The CBI found that Mr. Choksi’s companies were fraudulently issued 165 Letters of Undertaking (LoU). The value of 58 Foreign Letters of Credit (FLCs) were also enhanced in 2017 for payment to dummy overseas suppliers.

Concept:

What is a Letter of Undertaking (LoU)?

LoUs are used in international banking transactions. LoU is a bank guarantee under which a bank allows its customer to raise money from another Indian bank’s foreign branch in the form of short-term credit.

• The loan is used to make payment to the customer’s offshore suppliers in foreign currency.
• The overseas bank usually lends to the importer based on the LoU issued by the importer’s bank.
• The messages are sent through SWIFT — an inter-bank messaging network for securely transmitting instructions for financial transactions.
• The LoU is akin to a letter of credit or a guarantee.
• An LoU involves four parties — an issuing bank, a receiving bank, an importer and a beneficiary entity overseas.

What is a ‘Letter Of Credit’?

A letter of credit is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount.

In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.

Difference between LoU and LoC

• 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.
• LoU does not have these details and when it is not linked to the banking system it cannot be traced like it happened with PNB.

Status:

The Reserve Bank of India in 2018 barred all lenders from issuing letters of undertaking (LOU), a form of credit guarantee.

Implication-It won’t be easy for the importers to pay their suppliers merely on the basis of guarantee letters issued by Indian banks. These letters were used by importers to borrow money from other Indian banks located offshore to pay their suppliers.

Alternatives-The RBI banned the letters of undertaking (LOU) but not the letters of credit. So, the importers can continue to raise money via letters of credit, for instance, which have more international acceptability.