"You can always make a loan at a bank,
if you can show sufficient evidence that you don't need it."
Evan Esar, American Humorist
The Reserve Bank of India ("RBI") recently introduced a new framework to regulate First Loss Default Guarantees ("FLDG"), which came into effect on June 8, 2023. The Guidelines on Default Loss Guarantee in Digital Lending ("New Guidelines") bring about new rules and standards to govern the relationship between fintech companies, banks/non-banking finance companies ("NBFCs"), and borrowers.
In this article we discuss the evolution of the FLDG model, the challenges faced by banks/NBFCs and fintech companies, and the implications of the new framework.
Understanding the FLDG Model
In India's current lending ecosystem, there are three (3) main participants: the end customer, fintech companies, and licensed banks/NBFCs. Fintech companies, leveraging technology, a customer base, and specialized knowledge, often act as intermediaries between customers and banks/NBFCs. Banks/NBFCs, on the other end, have in place the necessary funds and licenses to provide loans.
Banks are conservative and cautious about lending to borrowers that deemed 'high risk', due to the likelihood of bad loans and limited financial information. Typically, fintechs, who cannot directly lend, can connect banks with clients and offer specific services such as loan sourcing, monitoring, pricing, and recovery. Additionally, in the event of loan defaults, fintechs often guarantee a portion of the losses up to a specified percentage. By sharing the risk with a fintech partner, banks are encouraged to extend loans to underserved individuals. To illustrate, if a fintech provided a bank with a loan pool of INR 100 crore, it could offer a guarantee to compensate up to 10% of the credit risk associated with the loan pool, i.e., up to Rs 10 crore, in the risk of loss. This, then, is the FLDG model in digital lending.
Before 2022, the FLDG business model allowed fintech companies to provide credit risk guarantees of up to 100%. This was a regulatory concern for the RBI for several reasons. Firstly, most fintech companies faced challenges in bearing the credit risk associated with loan defaults due to limited capital resources. Additionally, these companies lacked the necessary infrastructure for effective risk management, did not meet (or were not subject to) the required debt-to-equity ratio, and fell short of capital adequacy norms, making them ill-prepared to handle potential bad loans. Further, the rapid expansion of instant loan-providing fintechs, especially during the COVID-19 pandemic, resulted in unethical practices such as imposing high-interest rates, compromising borrower data security, and engaging in borrower harassment for repayments.
RBI's Response: Stricter Regulations for Digital Lenders
Despite digital lending being an estimated USD 350 billion industry, the FLDG model in digital lending was not always regulated in India. In 2021, the RBI created a working group was appointed to study the digital lending ecosystem in India and (inter alia) provide recommendations on emerging technologies in financial services. This group suggested that "...regulated entities should not be allowed to extend any arrangement involving a synthetic structure, such as, the FLDG to such entities. Regulated entities should not allow their balance sheets to be used by unregulated entities in any form to assume credit risk." Subsequently, in September 2022, the RBI released its Guidelines on Digital Lending, which imposed a complete ban on FLDGs by referring to them as "synthetic securitization" (an activity that is prohibited under separate RBI guidelines).
The 2022 ban put several fintechs out of business, and affected lending operations of banks, causing them to make representations to the RBI to consider an alternate approach in the matter. This discourse ultimately led to the RBI issuing the new framework.
What do the new regulations cover?
The New Guidelines define FDLG as a contractual arrangement between a regulated entity and an eligible entity, where the latter guarantees to compensate the former for losses due to default up to a certain percentage of the loan portfolio. A cap on the total FDLG cover has been introduced, and it cannot exceed 5% of the outstanding loan portfolio. A bank/ NBFC can now accept FDLG only in the form of cash deposits, fixed deposits with a scheduled commercial bank, or bank guarantees.
FDLG arrangements must also be supported by a legally enforceable contract and specify the extent of FDLG cover, the form in which the cover is maintained, the timeline for invoking FDLG, and disclosure requirements. The responsibility for recognizing individual loan assets as non-performing assets (NPAs) and provisioning lies with the regulated entity, irrespective of the FLDG cover.
Impact of the new FLDG Regulations
Even in its new, regulated avatar, the FLDG model has significant implications for the fintech industry. Many fintechs, even with a 5% cap, view the model as a positive development that creates new business opportunities. The model also opens doors for early stage fintechs to partner with banks and NBFCs to source loans without requiring an NBFC license. Moreover, clarity surrounding the FLDG model is expected to attract increased funding for digital lending fintechs.
However, there are potential pitfalls as well. The scrutiny of fintech businesses is likely to intensify as regulated entities, such as banks and NBFCs, underwrite the FLDG arrangement. This could lead to negotiations over revenue share between the partners, potentially affecting smaller fintech players. Additionally, unlike before, banking institutions can no longer write off losses caused by fintech companies, impacting their balance sheets. Further, the RBI's disallowance of non-cash forms of FLDG, such as corporate guarantees, may dampen business volumes.
The introduction of the FLDG Regulations by the RBI shows that the regulator has accepted that FLDG models are useful for digital lending platforms, and is keen to support transformation in the Indian fintech space. The RBI has used the FLDG Regulations as a medium to address the challenges faced by banking institutions due to loan defaults by fintech companies and provided fintechs a lifeline to revive their businesses. Having said that, the success of the FLDG model will ultimately depend on effective implementation, adherence to stricter regulations, and collaborative efforts between fintechs, banking institutions, and regulatory bodies.
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