RBI ban on Letters of Undertaking: Switch to local credit may squeeze liquidity

RBI, letter of undertaking, local credit, LCR Following the Reserve Bank of India’s (RBI) ban on issuance of letters of undertaking (LoU), at least billion (approximately Rs 35,000 crore) of non-fund credit will need to be converted into domestic loans. (Reuters)

Following the Reserve Bank of India’s (RBI) ban on issuance of letters of undertaking (LoU), at least $5 billion (approximately Rs 35,000 crore) of non-fund credit will need to be converted into domestic loans. The total non-fund based exposure is estimated at $20 billion (Rs 1.4 lakh crore). The migration of customers to the home market could soak up a lot of domestic liquidity in the next few months, say bankers who are apprehensive yields might spike up. “We will need to watch liquidity though the higher FPI investment limits will help,” said a banker. Analysts point out the LoU exposure is hard to quantify as it is a subset of the overall trade credit portfolio. India’s trade credits are estimated at around $86 billion. Of this, $56 billion comprises loans between six months and one year while loans for a period of less than six months, accounts for $30 billion, Kotak Institutional Equities wrote recently citing latest data. “We believe that the LoU/LoC business would be a part of this overall credit,” the brokerage said.

While demand for working capital has picked up somewhat, bankers believe the uptick could accelerate in the coming months. To be sure, banks are collectively holding an excess of government securities — of around 8% — while meeting statutory liquidity ratio (SLR) norms of 19.5% of net demand and time liabilities (NDTL). To that extent, the excess liquidity is approximately `8 lakh crore. However, banks also need to maintain a liquidity coverage ratio (LCR) which leaves `3-4 lakh crore of excess liquidity.

A senior banker at a large public sector lender said its internal calculations suggested a majority of non-fund credit apart from letters of credit (LCs) would need to be converted into loans over the next few months. One public sector bank chief that FE spoke to said the process of migrating to the local market was already on with the LoU ban now more than a month old.
“Our bank is already sanctioning loans for borrowers who have asked for credit,” he said. The banker explained that while the switch to local credit would no doubt boost banks’ margins, it would hurt companies compelled to abandon cheaper overseas loans.

The yield on the benchmark bond has risen by 24 basis points in the past three to four sessions primarily because of fears higher crude oil prices would push up inflation preventing the central bank from lowering interest rates. This is despite the RBI’s fairly soft tone at the last monetary policy meeting and the fact that the government will borrow a smaller share of its annual target — around 47% in H1FY19. The LCR is aimed at ensuring a bank maintains an adequate level of unencumbered high quality liquid assets (HQLAs) that can be converted into cash to meet its liquidity needs, for a 30 calendar day time horizon, in a significantly severe liquidity stress scenario.

When the LCR was introduced in 2015, banks needed to maintain it at 60% (HQLAs as a percentage of net cash outflows over the next 30 days). LCR increases 10% every year till it reaches 100% in 2019. As of now, it stands at 90%. The RBI also reduced SLR to provide flexibility to banks to meet the LCR norms by January 2019 when banks have to reach the minimum LCR of 100%. The RBI had stated in its FY17 annual report that a study will be undertaken to assess as to whether the introduction of the LCR has impacted monetary transmission.

Last month, the central bank had disallowed banks from issuing LoUs or guarantees for trade credits for imports into India. The move came in the aftermath of a Rs 13,000-crore LoU-linked fraud unearthed at Punjab National Bank. However, LCs and bank guarantees for trade credits for imports into the country will be permitted provided they meet RBI’s conditions. An LoU is issued as an undertaking that the issuer will honour a lender’s obligations if the borrower fails to do so. While bank guarantees are an internationally-accepted instrument, LoUs are mostly issued by banks in India and used by importers to raise money from foreign branches of Indian banks.

Source: Financial Express