PNB Fraud Case: Understanding LOUs and How They Were Misused
The Punjab National Bank (PNB) scam, one of India's biggest banking frauds, involved the misuse of Letters of Undertaking (LOUs). This article explains what LOUs are, how they work, and how Nirav Modi and Mehul Choksi used them to defraud PNB of ₹14,000 crore.
📌 What is a Letter of Undertaking (LOU)?
An LOU (Letter of Undertaking) is a guarantee issued by a bank on behalf of a customer, allowing them to get short-term credit from a foreign bank.
🔹 How Does an LOU Work in Banking?
Here’s a step-by-step process of how LOUs are used in legitimate banking:
- A company approaches its bank (e.g., PNB) and requests an LOU.
- The bank issues an LOU, promising a foreign bank that the company will repay the loan.
- Based on this LOU, the foreign bank gives a short-term loan to the company.
- The company later repays the loan to its original bank (PNB), which then settles the amount with the foreign bank.
Example: Imagine you want to buy goods from the USA, but you don’t have cash upfront. You ask your Indian bank to issue an LOU. The Indian bank gives a guarantee to a US bank, which then provides a loan to complete your purchase. Later, you repay your Indian bank, which in turn clears the loan with the US bank.
🚨 How Did Nirav Modi & Mehul Choksi Exploit LOUs?
In the PNB fraud case, Nirav Modi’s firms misused LOUs in a way that resulted in huge losses for the bank. Here’s how the scam worked:
🔴 Step-by-Step Breakdown of the Fraud
- Fake LOUs Without Collateral: Normally, banks require collateral before issuing an LOU. However, PNB employees issued LOUs to Nirav Modi’s firms without any security.
- Foreign Banks Gave Loans Based on These LOUs: Banks like Axis Bank, Allahabad Bank (Hong Kong), and others provided loans to Nirav Modi’s companies because PNB had guaranteed repayment.
- Money Was Diverted: Instead of using the funds for business, Nirav Modi’s firms diverted the money to shell companies or used it to repay old loans.
- No Repayment to PNB: Since the LOUs were fake, Nirav Modi’s firms never repaid PNB.
- Foreign Banks Demanded Money from PNB: Since PNB had issued the LOUs, it was legally responsible for repayment.
- PNB Paid ₹14,000 Crore: When the fraud was exposed, PNB had to cover the outstanding loans, leading to massive losses.
💡 Difference Between LOU and Bank Guarantee
| Feature | Letter of Undertaking (LOU) | Bank Guarantee (BG) |
|---|---|---|
| Purpose | Used for obtaining short-term foreign credit | Used to assure payment in case of default |
| Who Pays First? | The foreign bank gives a loan based on the LOU | The borrower must pay first, and the bank only pays if the borrower defaults |
| Bank’s Liability | The bank (PNB) is directly responsible for repayment | The bank only pays if the borrower fails |
| Collateral Requirement | Generally requires collateral, but PNB issued LOUs without it | Always requires collateral or margin money |
🔚 Conclusion
The PNB fraud case exposed loopholes in India’s banking system. Nirav Modi and Mehul Choksi misused LOUs by obtaining loans without collateral and diverting funds. As a result, RBI banned LOUs in 2018 to prevent such frauds in the future.
By understanding these financial instruments, we can see how banks operate and why strict regulations are necessary to prevent fraud.