Banks Need Stricter Norms For Non-Funded Credit Guarantees, Says Former RBI Deputy Governor HR Khan

The Indian banking system needs greater checks and balances in issue of non-funded credit guarantees, one of the mechanisms that was abused in the Rs 12,700 crore fraud at the Punjab National Bank, according to a former deputy RBI governor.

“One of the major problem is that in the non-funded business the standard of appraisal and the standard of underwriting has not been the same as required for funded exposure,” Former Reserve Bank of India Deputy Governor HR Khan told BloombergQuint in an interview. “We need to tighten underwriting standards and monitoring.”

Also Read: RBI Discontinues Letters Of Undertaking For Trade Credit For Imports

Khan's comments come after the RBI discontinued the issuance of letters of undertaking (LoUs) and letters of comfort (LoCs) for trade credit for imports in India. Banks can still issue letters of credit and bank guarantees. RBI's move stems from the details of the PNB bank fraud that came to light over last month. Firms linked to billionaire jeweller Nirav Modi had obtained fraudulent LoUs without the bank knowing.

Even though LoUs were providing cheaper funding options for Indian traders, they'd acquired a “bad name” because of abuse and reports of some people using them to make arbitrage gains, Khan said. “If you misuse such instruments, then you have to face the consequences,” he added.

The letters of credit, which RBI has allowed, are a better option from a risk management perspective, according to RK Bakshi, former executive director of the Bank of Baroda. "LoUs have their own distinct benefits but from a risk management perspective, a letter of credit is a more monitorable document," he said. With letters of credit an invoice must be submitted by the exporter's bank to the importer's bank, giving lenders more control, Bakshi explained.

Also Read: Letters Of Undertaking Ban Will Hit Smaller Gold Firms, Gems And Jewellery Trade Body Says