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R. Viswanathan

"THIS corrupt Government must go right now,'' said the erudite spokesman of the main Opposition party on the March 20, adding that ``due to the lack, or more correctly, absence of supervision over banks, greedy and corrupt foreign financial institutions have looted the public sector banks of over Rs 10,000 crore''. The Leftist spokesmen joined the fray and lambasted the Finance Minister and the policies of the Government for allowing foreign investment institutions to play havoc in the Indian markets.

``Was the staggering sum not the hard earned money of the Indian people?,'' they asked indignantly. Many observers were reminded of 1992, when a scam of similar magnitude shook the very foundations of the banking system. If it was the Bankers Receipt Fraud then, it is the letter of credit fraud now.

Truth to tell, the Finance Minister had only a few days earlier presented a totally growth-oriented Budget, of which even Mr Allan Greenspan, the Governor of US Federal Reserve will be proud. In his Budget speech, the Minister had approvingly quoted figures from the RBI to the effect that bank credit had surged by nearly Rs 10,000 crore in the first two months of 2002, reflecting the growing confidence of trade and industry in the basic soundness of the economy. He added that the stock market was also showing signs of robust activity with the indices going up.

More important, he said that the prices of shares of leading industrial companies in the futures market shot up, indicating the confidence of investment institutions in the future upward movement of share prices.

When the scam burst into the open, it was revealed that bank credit had gone up only in the form of bills discounted under letters of credit (LC) and the money was siphoned off to the share market. Almost all banks were caught in the vortex, with some foreign and private sector banks rather deeply involved. It was alleged, but later denied, that even Nabard which had surplus funds, because banks were not taking refinance, had lent large sums in discounting bills under LC. Vociferous demands for the heads of Finance Minister and RBI top brass were heard.

THIS was but in a dream of the author. However, the staggering potential for committing massive fraud on the system in the form of discounting LC bills is real. Many banks have incurred big losses in discounting LC bills, because these bills were — and are still being — used to obtain totally unsecured loans from the banking system. This phenomenon is peculiar to India, like the old badla system in the share market.

However, to many perceptive observers of the financial scene, LCs are useful financial instruments necessary for oiling trade in goods and services. Basically, LCs were developed over the centuries in international trade as a banking instrument for financing movement of goods. When the seller did not know the credentials of the buyer and was doubtful of the buyer paying for the goods, he wanted a form of guarantee from the buyer's bank that he would pay, as per the original terms. This was needed because the seller and buyer were in two different countries and once the goods left the shores of the seller, he had little control over the goods; if the buyer was recalcitrant, the seller had no way of forcing him to pay and the seller was in no position — financially or physically — to retrieve the goods, without incurring losses. Therefore, many sellers asked the foreign buyers to open LCs in their favour. These LCs assured the seller that, if they ship goods as per the description agreed upon between them and the buyer, the price will be paid by the buyer or if he fails to pay, the banker will pay.

LCs are internationally recognised instruments and to ensure that these are widely used, the International Chamber of Commerce (ICC) based in Paris has codified some rules to govern the LC transactions; these are called Uniform Customs and Practice for Documentary Credits (UCPDC) and are applicable to all LCs the world over, if the bank issuing the LC declares that the UCPDC will govern the LC. It is not unusual for courts to uphold the validity of UCPDC, even if the local laws are not fully in tune with them. As trade agreements can lead to any number of interpretations, the ICC took the initiative in ensuring that the wordings in LCs give very little, if any, room for disputes. It was thus laid down that if the letter of credit mentions the documents of title to goods (bills of lading) the bank opening the LC shall undertake to pay the value, on the seller tendering the documents indicated in the LC. It is thus stipulated that in LCs all parties — the seller, buyer, seller's bank and buyer's bank — deal only in documents and not at all concerned with the underlying sale contract.

Once the documents mentioned in the LC are tendered by the seller, the buyer's banker is bound to pay for the amount stated in the LC. To take an extreme example, if the LC calls for bill of lading purporting to ship 4,000 tonnes of steel material (if need be, inspected at the port of shipment by an international agency) and if an unscrupulous seller were to ship 4,000 tonnes of stones and get it duly certified, by bribing his way through, the buyer's bank is bound to pay the amount. Earlier, the primary obligation to pay was of the buyer and, on his failure, his bank was bound to pay. However, since 1993, the ICC brought forth a new version of the Uniform Rules called UCPDC-version 500 and fastened the primary obligation to pay on the bank opening LC, irrespective of the buyer's inclinations or intentions.

There are many rules governing LCs and a variety of LCs are now in vogue. This article examines the peculiar type of LC that seems to be stalking the financial markets, with dangerous potential. These are LCs opened by banks for financing the so-called movement of goods between a buyer and seller situated in the same city; such a **strange animal is perhaps unique to the Indian markets. In these LCs, a trader/industrialist allegedly buys materials from another trader in the same city on credit terms — undertakes to pay for the goods after some period, usually two or three months and this is backed by an LC opened by the buyer's bank in favour of the seller.

For example, an industrialist in Mumbai's Nariman Point or Chennai's Nungambakkam might buy goods from a trader in Dadar or George Town respectively. The buyer wants a credit period of three months and the seller asks the buyer to open an usance LC for the purpose. Since both the buyer and the seller are in the same city, there will be little evidence of movement of goods, except perhaps an accepted delivery order from the buyer's official to say that the goods have been received. Far too often, these LC bills do not evidence movement of goods, but are known as `accommodation' bills — seller being financially accommodated by the buyer. In banking parlance, these are also described colourfully as `kite flying' transactions.

The practice of these inland — incity — usance LCs started as all such aberrations do, because of certain imperfections or regulatory restrictions in the financial markets. Thus, in the early 1990s, when the RBI permitted newer commercial banks in the private sector, these banks did not have any lending opportunities due to their originally smaller size and the stipulation that no new bank can extend finance to any big borrower, unless it is allowed by the existing bankers to the borrowers, who were in a consortium.

Another problem faced by these banks was that their prime lending rate (PLR) was high and they could not compete with the public sector banks on interest rate front, even if they wanted to. All these restrictive conditions were neatly side-stepped by the new banks by discounting bills under usance LCs. For instance, when a new bank wanted to grant a loan to a big company, it did so by asking the company to sell its goods against usance LCs to be opened by the company's buyer and the relative bills were discounted by the bank. Since the bills were under LCs, the new bank took the view that it did not violate the rules of the consortium lending. More important, the discounting rate was much lower than the bank's PLR; although banks were then prohibited form lending at rates lower than PLR to any big borrower, the banks were of the view that `discount' rates were not interest rates and the bank could apply a lower rate for such discounts.

Possibly, these transactions started as finance for the genuine working capital needs of the discounting companies. But quite soon, they were used for financing sham trade transactions. The PSBs were generally the banks opening such usance LCs and the private or foreign banks were the discounting banks. For instance, at least two big cases of frauds involving such usance LCs were reported.

In Mumbai, a few years back, Centurion Bank had reportedly discounted bills under inland usance LCs opened by PSBs. The discounter had reportedly fraudulent intentions and the LCs were allegedly forged instruments. Therefore, the LC opening banks disowned their liability under forged LCs and Centurion Bank, reportedly incurred losses running to around Rs 40 crore. And the Executive Director of Centurion Bank left the bank soon thereafter.

The other case was in Kolkata, involving State Bank of India. One of the bank's branches in that city reportedly opened LCs for purchase of seafood by its customer in favour of a supplier situated in Kolkata. No goods were sold or bought — the buyer and the seller belonged to the same group — and the group enjoyed bank credit on an unsecured basis. When the bank woke up to the shenanigan, the total value of bills drawn under the LCs and unpaid amounted to a staggering Rs 100 crore. The bank reportedly refused to pay the bills already accepted by its customer under the bank's LCs and all those banks that had discounted the bills on the strength of LCs had gone to court to make the opening bank pay. It is understood that, despite the big losses incurred by banks in these sham transactions, the business of opening usance LCs for local trade continues and many private and foreign banks are deploying their surplus funds in bills drawn under the LCs.

The uninitiated might ask as to the basic reasons for opening LCs for local sale transactions. The raison d'etre for opening LCs is that the seller does not know the credentials of the buyer.

However, in a trade transaction involving two parties situated in the same town, the seller cannot plead ignorance of the buyer or his financial position. And yet, neither the LC opening bank nor the discounting bank ask the question as to why at all an LC is required in the first place for such transaction. In fact, the LC opening bank would be better off in giving a straight advance to its customer instead of opening usance LCs. It is understood that these transactions, born in fraud or deceit, are being continued in the country; in no other country such a deceit on a massive scale will be perpetrated for so many years. For example, when the merger of an FI and a bank happened, the financial world would know that the new bank would have to invest large sums in government securities within a few months. Since such securities are not available on tap, the entity would have to buy them from others.

A clever foreign financial institution could have bought these securities in advance — taken a long position on them and offered to sell as and when the merged entity needed them. The foreign financial institution could have financed the purchase of securities from a bank by resorting to the discount of bills under inland usance LCs.

In this manner, the foreign financial institution would have got the credit for its purchase and the selling bank would also be happy that its investment in low-yielding government securities is substituted by high-yielding bills.

Once the Fl tasted blood, it is only a small step to virtually draw large sums of money from the banking system and take bets in the share markets both on a spot basis and as margins in the futures markets. Is this possible? Yes. Will it happen? It depends on whether the RBI reviews the practices of banks and comes down heavily on the practice of using LCs for taking money from the banking system for totally unauthorised purposes with little, if any, supervision of banks over how the money is used. It is hoped the RBI will initiate action to weed out the dangerous practice, before it becomes too late.

(The author is former Deputy Managing Director, SBI.)

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