The 2018 Ban on Letters of Undertaking
Since March 2018, no AD bank may back trade credit with an LoU or LoC. Here's what they were and what replaced them.
On March 13, 2018, RBI told AD Category-I banks to stop issuing Letters of Undertaking (LoUs) and Letters of Comfort (LoCs) for trade credits for imports into India, with immediate effect. The rule still stands: RBI's current Master Direction on trade credits says issuing LoUs or LoCs for trade credit is not permitted.
The trigger was the fraud at Punjab National Bank that became public in February 2018, in which LoUs were the instrument. To understand both the fraud and the ban, start with what an LoU did.
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The Instruments
- Letter of Undertaking (LoU)
- A message from the importer's Indian bank to an overseas lender, usually the overseas branch of another Indian bank, undertaking to repay the buyers' credit the lender gives the importer. It went bank to bank as a message, and the lender relied on it much as it would on a guarantee.
- Letter of Comfort (LoC)
- A softer version: the Indian bank told the overseas lender it was comfortable with the importer's credit and would support repayment.
- Bank guarantee
- A formal guarantee, issued within a sanctioned limit and under the bank's guarantee rules. Still allowed for trade credit, within the credit amount and period.
- Letter of credit
- The issuing bank's undertaking to pay against complying documents. Also still allowed.
How an LoU-Backed Buyers' Credit Worked Before 2018
A Mumbai diamond importer needs 180 days to pay for rough diamonds from Antwerp.
- 1
Importer asks its bank
The importer's Indian bank, against a sanctioned limit and cash margin, agrees to support a buyers' credit.
- 2
LoU sent
The Indian bank sends an LoU to the Hong Kong branch of another Indian bank, undertaking to repay the loan on maturity.
- 3
Lender funds
Relying only on the LoU, the Hong Kong branch credits the funds to the Indian bank's nostro account, from where the Antwerp supplier is paid.
- 4
Maturity
At maturity the importer repays through its bank. Often a fresh LoU was issued to a new lender to repay the old one, rolling the credit over.
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Why It Broke
The weakness was structural. An LoU created a real liability for the issuing bank, yet it was only a message: if one went out without a sanctioned limit or an entry in the bank's own records, the overseas lender would still pay against it, and a new LoU at maturity could repay the old one. The exposure could grow without the issuing bank's books showing it.
In a speech on March 14, 2018, the RBI Governor said RBI had identified this exact operational hazard on cyber-risk grounds and had issued three circulars in 2016 asking banks to close it; the bank had not done so. RBI's answer to the product risk came a day earlier: ban the instrument for trade credit altogether and push banks back to guarantees and LCs, which sit inside sanction, limit and accounting controls.
How the IIBF Exam Tests This
Expect direct questions (the date, who it applies to, what replaced it) and case questions where an importer wants buyers' credit and the options list LoU, LoC, bank guarantee and LC. The answer is a bank guarantee or LC, not an LoU or LoC. A trap option says the ban covers all bank guarantees; it does not. Another says it applies only to public sector banks; it applies to every AD Category-I bank.
FAQs
When did RBI ban Letters of Undertaking?expand_more
By A.P. (DIR Series) Circular No. 20 dated March 13, 2018, with immediate effect, for trade credits for imports into India.
Why did RBI stop LoUs?expand_more
It followed the Punjab National Bank fraud that became public in February 2018, in which LoUs were the instrument. RBI removed the instrument from trade credit and kept guarantees and LCs, which sit inside sanction, limit and accounting controls.
Can banks still issue guarantees for buyers' credit?expand_more
Yes. Letters of credit and bank guarantees for trade credit continued after the ban, within the credit amount and period and subject to RBI's guarantee rules.
What is the difference between an LoU and a bank guarantee?expand_more
An LoU was a bank-to-bank undertaking, sent as a message, to repay a buyers' credit lender. A bank guarantee is a formal guarantee issued within a sanctioned limit under the bank's guarantee rules. Only the guarantee is now allowed for trade credit.
Next steps
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