An LoC is a document that gives a degree of assurance that an obligation – like servicing of interest and repayment of a loan – will be ultimately met. But, unlike an irrevocable guarantee, an LoC is not a firm promise.
In the wake of two communiques – first, from the Reserve Bank of India in April, followed by the ministry of finance in June – there is now a lack of clarity on the existing LoCs by public sector undertakings.
While allowing only state-controlled non-banking finance companies funding infrastructure to issue LoCs for certain activities, a June 10, 2022 directive of the finance ministry laid down that “under no circumstances, the liability under the LoC shall evolve on the government”.
However, the central bank guidance note to credit rating agencies said that LoC (unlike guarantees) is just a “diluted, non-prudent” support structure and, therefore, cannot be used to prop up rating and reduce the interest cost on a loan that is backed by an LoC.
According to the RBI, only LoCs which are as solid as a legally enforceable guarantee or where the structure – in the case of LoCs issued by PSUs – allows the liability to boil over to the sovereign in the event of default by the borrowing entity, are admissible support mechanisms for credit enhancement or rating improvement.
“What the finance ministry’s June circular does not clarify is whether the rule applies to outstanding (or existing) LoCs or only those that are given by PSUs after the date of the June circular,” said a banker.