The Reserve Bank of India (RBI) has prohibited the usage of Letters of Comfort (LoC), a document that gives a guarantee of support to the borrower without any promise to make good any defaults.
- This move will downgrade the credit ratings of roughly 100 firms, equal to Rs. 35,000 crore of debt.
All credit rating agencies (CRAs) were instructed to disregard these letters in a guidance note and Frequently Asked Questions (FAQs) document that the RBI published in 2022 on April 22 and July 26, respectively.
Letter of Comfort (LoC)
i. A Letter of Comfort (LoC) is a document issued by a parent company telling a bank that one of its subsidiaries has acquired a loan. According to it, the parent company “supports” the subsidiary during the process and will offer assistance as needed.
- Generally, it is granted by foreign companies with subsidiaries and branches in India.
ii.Despite the fact that they may have issued a LoC, it should be emphasized that the company is not bound by law to cover for the defaults of its subsidiary.
- It is simply issued to reassure the lending bank that the parent company is aware of the credit application.
iii. In contrast to guarantees, which have an explicit commitment to return, the LoC is a vaguely worded undertaking with no legal backing.
i. This directive is likely to downgrade the credit ratings of roughly 100 firms, equal to Rs 35,000 crore of debt rated by ICRA.
- 60% of the total entities whose ratings could be impacted are in the power, healthcare, engineering, construction, and road sectors.
- 44% of the total debt that could be impacted comes from these sectors.
- ICRA Limited (formerly Investment Information and Credit Rating Agency of India Limited) is an independent and professional investment Information and Credit Rating Agency.
ii.The RBI may,in future, prohibit credit enhancement for Public Sector Undertakings (PSUs) based on a government LoC without an explicit guarantee.
- However, it is possible that it will not have an immediate effect on the borrowers.
iii. Historically, CRAs have given weightage to such a letter and awarded an AA rating to an A-rated borrower.
- To make sure that the decision maker is aware of the Credit Enhancement (CE), they would add the letters ” CE” to the rating.
Directions Given by RBI
i. The RBI has directed that credit rating agencies can only rely on explicit guarantees issued by externally rated third parties, including parent/group entities, or financial institutions such as Banks and Non-Banking Finance Companies (NBFCs), for credit enhancement comfort.
ii.Additionally, the RBI stated that CRAs are not allowed to use alternative support systems, such as letters of support or obligor/co-obligor structures, to determine rating comfort while assigning CE ratings.
iii. While rating agencies are regulated by the Securities and Exchange Board of India (SEBI), the RBI has limited its directives to only those contracts used by banks to provide credit.
Steps Taken by RBI & Ministry of Finance:
i. According to RBI guidelines, the official LoC must also include the parent company’s financial details in the form of the most recent Audited Balance Sheet / Account Statement verified by a certified Public Accountant.
ii.In an effort to increase fiscal and budgetary transparency, the Finance Ministry prohibited the ministries and departments from issuing a LoC on behalf of the hired entities as of March 31, 2022.
- The entities use the LoC to obtain funding to finish the projects that are entrusted to them.
- In 2017, the Finance Ministry had approved the issuance of such “Letters of Comfort” by departments and ministries.
Recent Related News:
The Reserve Bank of India (RBI) in its ‘Annual report for 2021-2022’ has cautioned commercial banks of the risk of increased slippages on advances that were restructured during the Covid-19 pandemic.
Slippages are when a bank’s assets become a non-performing asset (NPA) owing to the borrower not paying interest for over 90 days. While, advances are funds provided by the bank to an entity for a specific purpose, to be repayable after a short duration.
About Reserve Bank of India (RBI)
Governor – Shaktikanta Das
Establishment – 1935
Headquarters – Mumbai, Maharashtra