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The government and the Reserve Bank of India ( RBI ) may have to step in to avoid an unprecedented event in Indian banking. Close to Rs 1,000 crore of Union Bank of India’s exposure on account of letters of undertakings (LoUs) issued by Punjab National Bank is due in the next few days.If the state-owned PNB does not pay back the amount by March 31, Union Bank (another government owned lender) will have to treat PNB as a defaulter in its books, provide for the loan, and even classify the amount as non-performing asset (NPA) if auditors insist.“It would be a peculiar situation because for the first time a bank would be technically described as defaulter,” a senior banker told ET. In the event of fraud, banks are required to make full and immediate provisioning against outstanding as well as categorise the loan as NPA.Such losses are treated differently than other sticky loans where the NPA tag comes 90 days after default. “For us, it’s a genuine claim on PNB backed by documents. It is not a fraud in our books... We will take the auditor’s view. However, we don’t want to list PNB as a defaulter. We are expecting some intervention from either the government or RBI so that there is a resolution by March 31,” said Rajkiran Rai, MD of Union Bank.Even though there are disputes between PNB and some of the banks which had lent against LoUs, the defaults by Nirav Modi and Mehul Choksi (whose clients were funded with the LoUs) have been accepted as an instance of fraud. FIRs have been filed and government agencies are investigating the matter.“Under the circumstances, many bank auditors may insist that LoUs maturing before March 31 be described as NPA for the current financial year,” said another person familiar with the matter. He said even for LoUs maturing after March 31, some of the auditors may ask banks to enter into an understanding or obtain an assurance from PNB.“It’s a tricky situation if a bank’s name figures in the list of defaulters or NPAs. This has happened with NBFCs, but not banks. This can have separate implications even though this is an asset which is very different from other NPAs where corporates are borrowers. Here, there is no question on the capability or intention of the borrower (PNB)."Still, we would wait for some clarity from RBI or the government; directions, if any, to other banks which had financed against LoUs,” said a rating agency official.Meanwhile, many banks are making minor changes in the format for ‘bank guarantee’ to use them in place of LoUs which was an easy, inexpensive instrument for trade finance. A few banks have discussed this with RBI officials.LoU, an instrument that was used only by Indian banks, was banned by RBI a few weeks after the fraud perpetrated by Choksi and Modi came to light.“The industry has to find a replacement for LoUs. The regulator has to spell it out. Secondly, the accounting treatment and provisioning of overdue LoUs has to be addressed. While LoU liabilities are under dispute, a disputed liability does not arise in banks’ books on account of loans and advances. A bank may have disputed liabilities due to other claims such as tax, loss of jewellery,” said a banker.Between $20 billion and $40 billion of trade finance was with LoUs. Volumes had soared in the past 7-8 years amid cheap dollar liquidity created by US Fed’s easy money policy.