RBI Bans Letters of Undertaking and Letters of Comfort for Trade Credit Amid PNB Fraud

Introduction

In March 2018, following the revelation of a ₹14,000-crore fraud at Punjab National Bank (PNB), the Reserve Bank of India issued a circular discontinuing the use of Letters of Undertaking (LoUs) and Letters of Comfort (LoCs) as instruments of trade credit. This guide explains the regulatory change, the underlying fraud mechanics, and what trade finance practitioners need to know about operating under the new framework.

Failure Modes

1. Unauthorized issuance of LoUs without board-approved credit limits. In the PNB case, junior officers at the Brady House branch issued LoUs without following internal credit sanction procedures, bypassing the bank's core banking system entirely.

2. Absence of SWIFT message authentication controls. The fraudulent LoUs were issued through the SWIFT messaging system, but PNB's internal controls did not reconcile SWIFT messages with credit approvals, allowing unauthorized messages to pass undetected.

3. Correspondent bank reliance on domestic bank reputation rather than independent due diligence. Overseas branches of Indian banks extended credit based on LoUs without independently verifying the underlying trade transactions or the domestic bank's internal approval records.

4. Regulatory gap in monitoring cross-border interbank exposures. The RBI and SEBI did not have a unified mechanism to track aggregate interbank exposure through LoUs, allowing a single branch to accumulate massive undisclosed liabilities.

5. Failure of concurrent audit and internal audit functions. PNB's internal audit processes did not detect the fraudulent LoUs because the transactions were routed outside the standard core banking system, evading automated controls.

Resolution Steps

1. Immediate cessation of LoU and LoC issuance. The RBI circular required all AD Category-I banks to stop issuing LoUs and LoCs for trade credit with immediate effect, closing the instrument that enabled the fraud.

2. SWIFT system audit and reconciliation. Banks were directed to reconcile all outstanding SWIFT messages with internal credit approval records, identify unauthorized messages, and implement mandatory dual-authorization for SWIFT transactions.

3. Enhanced KYC and trade due diligence. The RBI mandated that banks verify the genuineness of underlying trade transactions before extending any form of trade credit, including documentary credits and bank guarantees.

4. Board-level oversight of trade finance operations. Banks were required to establish board-approved policies for all trade finance products, with clear delegation-of-authority frameworks and limits on individual branch exposure.

5. Engagement with international correspondent banks. Indian banks needed to inform overseas correspondents of the regulatory change and renegotiate trade financing arrangements that relied on LoUs or LoCs.

6. Legal proceedings against involved parties. The Central Bureau of Investigation (CBI) and Enforcement Directorate (ED) initiated cases against bank officials, the accused firms, and their promoters, with asset attachment proceedings under the Prevention of Money Laundering Act.

7. Industry-wide remediation of trade finance controls. Banks conducted comprehensive reviews of their trade finance operations, implementing additional checks such as end-use verification, post-disbursement monitoring, and limits on inter-branch and interbank exposures.

8. Parliamentary and regulatory review. A parliamentary committee examined the regulatory framework, recommending that LoUs could be resumed under stricter conditions, including mandatory board approval, enhanced monitoring, and limits on exposure per counterparty.

Conclusion

The discontinuation of LoUs and LoCs represented a significant regulatory response to a fraud that exposed systemic weaknesses in India's trade finance oversight. While the instruments served legitimate trade financing purposes, the absence of adequate internal controls and regulatory monitoring allowed their misuse on a massive scale. Trade finance practitioners must now operate within tighter constraints, with greater emphasis on independent verification and documented approvals.

Frequently Asked Questions

Q: What was the total amount involved in the PNB fraud?
A: The fraud involved approximately ₹14,000 crore (roughly USD 2 billion) in unauthorized LoUs issued by PNB's Brady House branch in Mumbai to diamond merchant Nirav Modi and associates.

Q: Can LoUs ever be reissued for trade credit?
A: The parliamentary committee recommended that LoUs could be resumed under stricter conditions, but the RBI has not yet issued a formal circular repermitting their use. Banks continue to operate without LoUs for trade credit.

Q: How does this affect existing documentary credit transactions?
A: Existing documentary credits governed by UCP 600 are unaffected. The ban applies specifically to LoUs and LoCs as trade credit instruments, not to letters of credit issued under UCP 600 or ISBP 745 standards.

Q: What replaced LoUs for trade financing?
A: Banks shifted to using established instruments such as letters of credit, bank guarantees, and supply chain finance arrangements, all subject to existing regulatory and internal control frameworks.

Q: Were any bank officials held accountable?
A: Yes, multiple PNB officials, including branch managers and officers, faced criminal charges from the CBI. Several were arrested, and proceedings continue in Indian courts.

Q: How do Indian banks now handle correspondent banking for trade finance?
A: Indian banks maintain correspondent relationships through standard documentary credit mechanisms (UCP 600) and bank guarantees (URDG 758), with enhanced due diligence requirements imposed by the RBI following the fraud.

Source Notes

1. "RBI must resume issuing LoUs, LoCs, says parliamentary panel" — The Hindu. Context only.
2. "India bans trade finance product at the heart of PNB fraud" — Global Trade Review (GTR). Context only.
3. "RBI Bans LoUs and LoCs for Trade Credit Amid PNB Fraud Scandal" — The Dollar Business. Context only.
4. "RBI bans all Indian banks from issuing LoUs, LoCs" — The Times of India. Context only.
5. "RBI discontinues Letter of Undertaking, Letter of Comfort as instruments of trade credit" — The Economic Times. Context only.