Letter of Undertaking: How does it Work?

29 Aug 2018  Read 6186 Views

Letter of Undertaking (hereinafter referred to as LoU) can said to be a sort of guarantee that is issued by a banking entity to the concerned person for attaining short term credit from the overseas branch of an Indian bank. Such LoUs are not issued against retail transactions, but are employed in business or trade transactions.

Letter of Undertaking-Meaning

As mentioned above, the LoU that is issued in favor of the customer of the Indian bank is a guarantee to the overseas branch of the said Indian bank for the repayment in foreign currency.

How can a Letter of Undertaking be obtained?

Generally, the LoUs which are applied for securing credit line are supported by margin money or sanctioned credit limit by the concerned banking entity. Owing to this, it can be inferred that the borrower of funds of the customer of the bank needs to pay margin money to the bank issuing the LoU, which subsequently sanctions a credit limit.

Moreover, the issuing of LoUs are in accordance to the foreign trade policy (FTP), which co-ordinate the import of goods and services.

The Working of Letter of Undertaking

Subsequent to the completion of all the necessary formalities to procure a LoU i.e. after the bank is reasonably convinced with the collateral received against the credit sought from the Indian bank branch, the former will then process the LoU to the latter.

Markedly, it is to be considered that the margin money which is backing the credit may be higher in value than the credit amount required for. This could depend upon the relation of the bank and customer.

Further, the amount is released by the foreign branch of the Indian bank in foreign currency. It must be considered that the amount is credited to the customer’s bank account back home, which is known as the Nostro account. Thereafter, the customer can decide upon the beneficiary to whom the payment is to be made.

Punjab National Bank’s Multi-crore Scam

The multi-crore scam is apprehended to be of a value greater than Rs.11,400 crore. Under this scam fraudulent LoUs were issued so that neither the margin money amount was given by the credit seeker, who here is Mr. Nirav Modi, nor a credit limit was sanctioned. Further, in the said scam, the credit prescribed or laid down in the rules was not followed and it was extended for over 90 days; the term for credit is dependent on nature of goods which are a part of the trade transaction.

Current Stance of Banks Post the Scam

Generally, the LoU is released to the customers already sharing a credit relationship with the bank. The RBI in its circular regarding guarantees and co-acceptances under the precautions for averting frauds, stated that, “Banks should refrain from issuing guarantees on behalf of customers who do not enjoy credit facilities with them. As non-compliance of RBI regulations in this regard is likely to vitiate credit discipline, RBI will consider penalizing non-compliant banks." Therefore, as a consequence the banks are now issuing LoUs for short term credit at a premium of 10-30 basis points.

Letter of Undertaking under Goods and Services Tax (GST)

A LoU under GST is not the same as the LoU discussed above. LoU under GST is said to be an agreement between the Government of India and the applicant of the LoU who is the supplier of goods and/or services, wherein the former allows the latter to export goods and/or services without paying the Integrated GST (hereinafter referred to as IGST) if done within given time.

It can also be considered as a guarantee to the Government, as the applicant of the LoU promises to pay the IGST with 18 per cent interest to the Government in an instance of failure to export goods and/or services within the said stipulated time.

About the Author: Ratan Deep Singh | 7 Post(s)

Ratan is a Biotechnology graduate and a former print-media Journalist, who specialized in marketing to take up Brand Communication. He’s a grammar Nazi & big-time foodie who appreciates creativity and often tries his hand in creative poetic writing.

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