Banks must stop issuing guarantees

The RBI on March 13 barred all Indian banks from issuing letter of undertakings (LoUs) and letter of comfort (LoC). This was in response to the $2 billion fraud perpetrated by Nirav Modi, Mehul Choksi and the entities associated with them.

The current state of the Indian banking system, particularly with the public sector banks, has been the subject of intense scrutiny in recent times. The reasons include burgeoning bad loans, multiple instances of frauds and a sharp dip in profitability. The situation is indeed acute the NPA problem is nowhere close to resolution with the banking system reporting over 9 lakh crore of gross NPA at last count.

Apparently, the worst on the NPA front is still not behind us. Further, the PSBs have together posted a loss of over Rs 18,000 crore for the quarter ended December 2017, against Rs 4,300 crore of loss posted in the preceding quarter. Ironically, Punjab National Bank was among the handful of PSBs who had announced a profit during the quarter ended December 2017.

Shortly after that PNB disclosed that they have discovered a Rs 11,400-crore LoU fraud at one of their Mumbai branchesApparently, these LoUs were not routed through the core-banking system, so as to avoid any detection of the fraud.

Now, what exactly are LoUs? A Letter of Undertaking is essentially a bank guarantee issued for overseas import payments guarantees to repay the principal and interest on the client's loan unconditionally in the event of a default by the client.

Indian banks currently cater to 100% of the guarantee requirements within the country, as part of the overall bouquet of products. The recent instances have shaken up our faith in the banking system. The custodians of public money have been making headlines for all the wrong reasons. Over the last couple of years, the RBI has been intervening in an attempt to curb the growing menace of the NPA monster. In January earlier this year, the Government of India too stepped in to announce a capital infusion of a whopping Rs 88,000 crore of tax payer's money in Indian public sector bank under the garb of kick-starting banking reforms. However, no one seems to be focusing on the key reason for such
frauds within PSU banks - an abject failure of corporate governance and control systems.
While the current RBI action of barring Indian banks from issuing LoUs and LoC may be justified in the short term in view of the scam, India should now quickly move to adopt the globally accepted best practices of having specialist guarantee companies issuing guarantees and bonds on the lines of what is prevalent in large parts of Europe and America.

Essentially, banks in India should stop issuing guarantees, here's why:

1. Banks are "generalist" who offer guarantees as part of their bouquet of products and services without a clear understanding of any particular sector or industry. Banks are trying to be everything to everyone. On the contrary, they should be allowed to specialise and create expertise in their own niche segments of business. Sureties are "specialist" in issuing guarantees with depth of expertise and bring immense value to the implementation of the contracted terms.

2. In the current scenario, the banking sector in an effort to keep their NPAs in check has become increasingly wary of any incremental lending to corporates. This is visible in the growth of retail loans outpacing the growth of corporate loans, which had been contracting till August last year. The Indian banking industry is also already stretched to meet capacity needs in the face of increased construction activity.

3. The banker examines the only credit-worthiness of its customer without any understanding of the industry or the project, while the surety relies on their expertise to assess the probability of its principal not performing the contract as per the terms of the contract. In a country which has had its share of companies bidding aggressively for projects in an effort to shore up their order books, the introduction of sureties can help bring sanity and credit worthiness to the entire
bidding process.

4. The contractor currently has no recourse in the event of the project owner improperly declaring the contractor in default and invoking the bank guarantee. The bank guarantees even if issued as a conditional guarantee function as an on demand instrument. The banks do not ascertain whether the contractor in question has committed any breach of the contractual terms, thus leaving them extremely vulnerable.

5. Sureties depend on their underwriting expertise to assess the risks associated with the project. Hence, they usually do not require cash collaterals or margins to issue a performance bond or a security deposit guarantee. Unlike a bank guarantee, sureties do not consume on the working capital limits, thus releasing frozen resources, enhancing valuable liquidity.

6. Sureties more efficient in time and money than a bank guarantee. It is time to have guarantee companies which will help protect the interests of the taxpayer, the public
and private project owners, the lenders, and the prime contractors from the potentially devastating expense of failure/fraud. Bonds and guarantees can also help create a big impact in the economy by infusing liquidity back into the economy by unlocking the money tied up in unproductive cash collateral and security deposits. Such a move would also help ease the pressure on the banks that can then focus on their core activities.

(The writer is CEO of
Srei Guarantee JV)

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