The Indian banking system has been rocked by a scandal of gigantic magnitude. Two Indian jewelers named Nirav Modi and Mehul Choksi have fled the nation. They owe Indian public sector banks over $2 billion. The banks were fraudulently deceived into making these loans using instruments such as Letters of Credit and Letters of Understanding (LOU).

Also, there was internal corruption on the part of the banks. These jewelers had bribed the bank's officials who misused their powers to grant these loans.

After the Nirav Modi scam was unearthed, the Reserve Bank of India ordered deeper inspections of loan books. This led to the unearthing of many more scams. The extent of rot in the Indian banking system is not known as of now.

Both the government and the Reserve Bank of India have been under immense pressure to take corrective actions. Some corrective actions have been taken. However, it is likely that these corrective actions will also have a negative impact on the Indian economy.

In this article, we will discuss some of the after-effects of the Nirav Modi scam:

• Banning of the LOU: The most significant action by the Reserve Bank of India is the total discontinuation of the Letter of Undertaking (LoU). This was the tool used by Nirav Modi to defraud the Indian taxpayer to the tune of $2 billion. Indian importers have always used Letter of Undertaking (LoU) to obtain very cheap credit. This helps them keep the cost of goods low which in turn helps them to stay competitive in the domestic market.

  A Letter of Undertaking (LoU) is basically an agreement between two branches of a bank. The money is deposited in the domestic branch. This deposit is then used as collateral by the foreign branch to give out a loan. Hence, it is the creditworthiness of the bank that comes into the picture and not the creditworthiness of the individual. This is the reason why credit obtained for Letter of Undertaking (LoU) is very cheap as compared to other forms of credit.

  Also, it needs to be understood that Letter of Undertaking (LoU) was only used by Indian importers. All over the world, instruments such as Letters of Credit and Bank Guarantees are used. These instruments are quite expensive as compared to Letter of Undertaking (LoU) because they consider the creditworthiness of the importer and not of the bank. The discontinuation of the Letter of Undertaking (LoU) will cause importing firms to seek alternate forms of credit. The big firms may find some financiers who are willing to extend loans at reasonable rates. However, the small and medium enterprises are likely to face a cash crunch.

• Loss of Arbitrage: As per the terms and conditions of the Letter of Undertaking (LoU), importers were allowed to earn interest on their deposit made in Indian banks. On the other hand, they had to pay interest which was linked to the LIBOR rate abroad. The domestic interest rate is far higher than the LIBOR rate. As a result, the importers earned money by using the Letter of Undertaking (LoU) route. This was an arbitrage opportunity for importers if they were able to neutralize the foreign exchange risks using derivatives.

• Depreciation of the Rupee: The Letter of Undertaking (LoU) was a mechanism wherein the foreign currency paid to the exporters was taken from a foreign bank. Hence, from India’s point of view, foreign exchange never left the country. As a result, there were very few transactions selling Indian currency and buying foreign currency. Now, the market will be flooded with these transactions. Since a lot of people will be willing to sell the rupee, the rupee will depreciate. This will make the imports a lot more expensive. The competitiveness of these imports vis-a-vis domestic production will also take a hit.

• Exports Impacted: Most Indian exporters are also importers. Consider the case of gems and jewelry businesses. They account for about 15% of India’s exports. However, the sector imports more than 50% of its raw materials. Hence, if the price of imports goes up, so will the price of exports. This will harm the competitiveness of India’s exports in the foreign market. There is a general feeling that the Reserve Bank of India may have gone too far. The Letter of Undertaking (LoU) should have been properly regulated instead of being discontinued.

• Integration with Swift: From the technology point of view, it has now become mandatory for banks to ensure that their core banking systems are well integrated with SWIFT systems. The bank fraud was possible only because the transactions happening in SWFT were not reflecting in the core banking system. Also, multiple levels of approvals have to be designed to prevent the misappropriation of funds in the future. This will be an additional expense for the banks involved which will ultimately be borne by the borrower in the form of high-interest rates.

• Rotation of Employees: The rotation of employees needs to be done every three years. However, in case of Nirav Modi fraud, the same branch manager was handling the branch for seven years. RBI has now issued strict guidelines that rotation of employees needs to be diligently followed.

To sum it up, banking will be more tightly regulated. These regulations will add up to extra cost that will have to be borne by the importers. Nirav Modi has made life difficult for all importers in India.