Mumbai: The RBI on Tuesday barred banks from issuing guarantees in the form of letters of undertaking (LoUs) as it clamped down on the import financing route used by fugitive jeweller Nirav Modi and his uncle Mehul Choksi for allegedly committing India's biggest bank fraud.

The Reserve Bank of India also banned with immediate effect issuance of letters of comfort which, like LoUs, are used by importers to fund their overseas purchases.

"On a review of the extant guidelines, it has been decided to discontinue the practice of issuance of LoUs/LoCs for trade credits for imports into India by authorised dealer (AD) Category-I banks with immediate effect," the central bank said in a notification.

However, letters of credit and bank guarantees for trade credit will continue upon meeting certain conditions, the central bank said.

A letter of credit is an assurance from the bank that if the importer defaults, the bank will pay on his behalf.

The RBI's action comes nearly a month after PNB announced that it had detected fraudulent and unauthorised transactions at its Brady House branch in Mumbai.

LoUs were allegedly used by diamantaires Nirav Modi and his uncle Mehul Choksi to defraud the state-owned bank in connivance with its officials. The CBI has in its two FIRs filed on the PNB scam accused that fake LoUs were issued without keeping any margin money as security. Moreover, the buyer's credit raised was not used for specific purposes in many cases. They did not have any pre-approved credit limit either.

Buyer's credit is a loan an importer (from India) gets from foreign banks which may be subsidiaries of Indian banks. It is used (by the importer) to pay for the imports into the country. This buyer's credit is provided on the basis of an LoU, which is akin to a guarantee and is issued by the importer's local bank.

An LoU is provided against a margin or a collateral which could be in the form of a fixed deposit. Banks charge a fee from the importer for the LoU. On the other hand, an LoC is an instrument which is similar to an LoU, except that it is an intra-bank transaction.

The buyer's credit usually goes to an overseas nostro account from where the payment to the importer's bank is made. The payment can also be made directly to the importer. A nostro account is an account held by an Indian lender in a foreign bank in their currency.

Experts said the RBI's move to bar LoUs could affect genuine importers. "The instrument (LoU/LoC) is being blamed, taking the focus away from the system failure in PNB," Sanjay Mandavia, an expert on trade finance who arranges buyers credit for SMEs, told The Telegraph.