Letter of Undertaking (LoU) is a form of bank guarantee under which a bank can allow its customers to raise money from another Indian bank’s foreign branch in the form of short-term credit. This was in news recently in Punjab National Bank’s case which had issued Letter to Undertaking to diamantaire Nirav Modi. Then what is this Letter of Undertaking exactly? Let’s understand it with a short story.

Short story to understand Letter of Undertaking

Let there is a person whose name is Nirav, he has an account with Punjab National Bank. He is a businessman who runs a jewellery business, so he needs to import some raw material from some another country. Let he import diamonds from Kenya and then finish or polish them and transforms into the diamond jewellery. To import diamonds he needs to pay in Kenyan Shilling to his diamond exporter. Now they have a sales contract.

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Now, Mr Nirav approaches the Punjab National Bank’s branch (which issues LoU) and asks for a Letter of Undertaking. PNB will ask for some margin money from Mr Nirav and a credit limit will be assigned to him (ideal scenario). As per his credit limit, a Letter of  Undertaking will be given to him which he can give to an Indian bank which has a branch in Kenya (Let State Bank of India has branches in Keyna). In the meantime, the PNB which has issued the Letter of Undertaking will inform the Kenyan subsidiary of SBI through SWIFT (Society for Worldwide Interbank Financial Telecommunication) system that a LoU is issued to this person and this is his credit limit and details etc.

Now as this is authenticated through the SWIFT system, the SBI will issue a short-term loan to Mr Nirav and that loan amount will be transferred to the NOSTRO account (explained under) of PNB with Kenyan subsidiary of SBI. Now, ultimately payment will be done to the person from whom Mr Nirav is importing diamonds.

Who is responsible if Mr Nirav doesn’t pay back the amount credited to him?

In the case of Letter of Undertaking, the bank which issues the Letter of Undertaking will be liable for the default in payment if the person doesn’t pay back. Here if Mr Nirav doesn’t pay the interest and principal on time, the PNB will be liable to pay to SBI the loan amount as well as the interest, because SBI’s Kenyan subsidiary had issued the loan on PNB guarantee.

RBI had discontinued the Letter of Undertaking as well as Letter of Comfort after PNB fraud case. This is done to avoid frauds because in these instruments only the Issuing bank knows about credit background of person to whom LoUs are issued while the banks which give credit just look at the guarantee of the issuing bank.

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While the instruments like Letter of Credit and Bank Guarantee will continue as trade credit instruments for importing.

NOSTRO/VOSTRO/LORO Accounts

These are Italian terms related to international bank accounts. These are explained as under:

NOSTRO Account

It means “Our Account with you”. It is the overseas account which is held by the domestic bank with the foreign bank or with the foreign branch of some another domestic bank. e.g. Let SBI don’t have any branches in the USA. If SBI opens a bank account with Bank of America, then it is called NOSTRO account of SBI.

VOSTRO Account

It means “Your Account with us”. It is the account of an overseas bank or foreign bank with some domestic bank. e.g. Take the reverse case, if the Bank of America opens an account with SBI, then it is called VOSTRO account for SBI.

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LORO Account

It means “Their Account with them”. It is in connection with any third bank. e.g. If PNB doesn’t have any NOSTRO account with any bank in the USA nor any branch there. Then if PNB bank uses NOSTRO account of SBI in the Bank of America, then it is called LORO Account for PNB.

The NOSTRO Account for one bank will be VOSTRO Account for another bank and vice-versa. e.g. SBI’s NOSTRO account with Bank of America will be a VOSTRO Account for Bank of America.

Click here to read about Types of Bank Accounts.

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