Here is the playbook: First comes the business, the regulator follows the suit. We saw this play in the P2P lending space. And, it's playing now again. Looks like after sandboxing the digital lending, the Reserve Bank of India (“RBI”) is on top of it to set the rules of the game. Else, the foul play would, undoubtedly, be abound.
While digital lending has been there for a while, the RBI never really attempted to define the term until recently. Perhaps, as we write this, there are structures, models and approaches which are being evolved so as to ease the process involved in digital lending –, In January 2021, to understand the lay of the land of the digital lending, the RBI commissioned a working group to swot up the digital lending space. In November, 2021, the working group jotted down a blue print to the RBI for framing the regulations. Finally, on August 10, 2022, the RBI took the first step through a press release to provide an implementation framework (“Press Release”)1.
This Press Release has sparked conversations on how this could augment or decimate the burgeoning digital lending market in India. Hopefully, players in the digital lending market will not stop innovating and the RBI will also welcome innovation within certain risk framework for the credit system in India.
Deconstructing the Press Release
Let's take a dive into the Press Release. Simply, the Press Release has put forth the following step plan for implementation: (1.) Annex I, which contains the recommendations accepted for immediate implementation; (2.) Annex II, which contains the recommendations which are accepted in-principle, but require further examination; and (3.) Annex III which contains the recommendations which require wider engagement with the Government of India and other stakeholders in view of complexities involved in their implementation.
The Press Release acknowledged the lack of a universally acceptable definition of ‘Fintech Credit' or ‘Digital Lending' and did not attempt to define these terms in the Press Release, since new business models are still evolving. However, the Press Release recognized that digital lending is essentially the use of digital technologies, seamlessly to a significant extent, as part of lending processes involving credit assessment and loan approval, loan disbursement, loan repayment, and customer service. Simply put, if the major portion of the lending is digital, it will be considered digital lending and be governed under this Press Release irrespective of certain aspects of the process being physical, like the document procurement or physical execution of documents.
Players in the Digital Lending Space
The Press Note has classified the digital lending space into three (3) groups based on the service provider's business model: (1) Regulated Entities (“REs”) are those entities that are regulated by the RBI to conduct the lending business are called regulated entities and include banks and non-banking financial companies; (2) Lending Service Providers (“LSPs”) who are essentially technology-centric entities which act as both core and ancillary lending service providers and include unregulated fintech players to whom REs outsource credit and lending facilitation services such as customer acquisition, underwriting support, monitoring, collection, etc.; and (3) Digital Lending Apps (“DLAs”) who are mobile and web-based applications with a user interface that facilitate borrowing by a financial consumer from a digital lender. These DLAs may be operated by REs or LSPs engaged by REs. The Press Release outlines the compliance requirements for REs, LSPs, and DLAs. However, the responsibility to ensure the implementation of the requirements by the LSPs and DLAs has been entrusted with the REs.
Annex I which is up for immediate implementation mandates that all loan disbursals and repayments are required to be executed only between the bank accounts of a customer on record and REs, without passing through any third party account or the account of any lending service provider LSP. Currently, in the digital lending space, most fintechs (in this case the LSPs) operate in such a manner that they undertake the responsibility of disbursement to the customer, by collecting the disbursal amount from the RE. LSPs similarly collect the repayment instalment from the customer and remit the same to the RE. This practice has now been explicitly regulated in an attempt to bring transparency to customers contracting with LSPs through DLAs, as most customers often do not know the name of the RE they are engaging with, the terms and conditions of their loans etc. In this manner, the customer and the RE will be compelled to contract directly with each other, thus allowing customers to have greater visibility over their borrowing relationship.
Further, the Press Release adds a layer of complexity and compliance over and above the existing framework provided by the Information Technology Act, 2000 making it a lot more stringent. The REs are required to store all data in servers located within India. Further, any data collected by DLAs must be need-based, must be with the prior and explicit consent of the borrower, and further require that data is not retained for longer than is necessary as disclosed to the customer.
More often than not, REs and LSPs employ recovery agents who have often been reported to employ unscrupulous means to recover the pending amounts. The RBI has also specifically regulated the area of recovery agents, considering this has been a huge cause of consumer grievances in the past. REs are responsible for guiding LSPs who are acting as recovery agents and guidance on fair recovery practices is to be further issued by the RBI to REs in this regard. Therefore, REs and LSPs must appoint a nodal grievance redressal officer to address digital lending complaints or complaints against DLAs of borrowers.
For all types of costs, REs are required to ensure that all inclusive costs for the digital loans are required to be disclosed to the borrowers upfront. For the borrowers to make informed decision, the Press Release specifies APR which is the annual percentage rate and it covers all costs applicable including all additional charges such as processing fees, etc. that lenders charge.
Further, a standardized key fact statement must be provided to the borrower before executing the loan agreement. This shall include a cooling-off/ look-up period during which the borrowers can exit digital loans by paying the principal and the proportionate APR without any penalty shall be provided as part of the loan contract. However, the Press Release has not stipulated the number of days for the cooling-off period. The same shall be determined by the respective Boards of the REs. The requirements for a key fact statement and the cooling-off period will directly impact the existing market for loan contracts and may necessitate amendments to existing contracts incorporating the cooling-off provisions.
The Press Release also puts specific emphasis on ensuring that lending carried out through DLAs is reported to credit information companies (“CICs”) and the provision of digital lending products by REs involving short-term, unsecured/ secured credits or deferred payments must also be reported to CICs. This expressly brings all types of BNPL offerings and short-term loans within the ambit of reporting to CICs. This recommendation has received a lukewarm reaction from the fintech industry as such reporting may cause borrowers to shy away from deferred payment or buy-now pay later products in fear of impacting their credit score.
Annex II which has been accepted ‘in-principle' but requires further deliberation to throw light on the much discussed first loss default guarantees. It states that REs shall ensure that financial products involving contractual agreement, in which a third party guarantees to compensate up to a certain percentage of default in a loan portfolio of the RE, shall adhere to Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 dated September 24, 2021.
Further, Annex II contemplates a self-regulatory organization is proposed to be set up for the digital lending industry, with the responsibilities of framing model agreements, codes of conduct, training and accreditation mechanisms, blacklists of errant entities, and framing of standardised code of conduct for recovery, etc.
Annex III which the RBI has marked for wider engagement with the Government and other stakeholders, states that the Government may consider formulating a law to ban unregulated lending activities to cover lending by entities that are not authorized by the RBI. There is no clarity on when these regulations will be released and what will be the ambit of such ban/restriction.
A perusal of the above recommendations reveals that the cornerstone of the report and of the RBI's approach, is to regain control over lending and return the power and responsibility of lending to REs or other entities which are permitted to lend under existing statutes. A prime example of this is the first recommendation: Currently, in the digital lending space, most LSPs operate in such a manner that they undertake the responsibility of disbursement to the customer, by collecting the disbursal amount from the RE. LSPs similarly collect the repayment instalment from the customer and remit the same to the RE. This practice has now been explicitly regulated in an attempt to bring transparency to customers contracting with LSPs through DLAs, as most customers often do not know the name of the RE they are engaging with, the terms and conditions of their loans etc. In this manner, the customer and the RE will be compelled to contract directly with each other, thus allowing customers to have greater visibility over their borrowing relationship.
What is also interesting to note is that the Press Release also requires LSPs and DLAs to implement the recommendations of Annex-I and the onus of ensuring compliance with these recommendations lies with the REs. The burden of compliance is therefore on REs to ensure that any lending done through DLAs is reported to CICs irrespective of its nature/ tenor.
While the RBI has clarified that detailed instructions on the operational aspects of the recommendations can be expected separately, the release of definitive guidelines is a positive step for the future of the fintech industry, since it removes the ambiguity that has clouded the area for the past year and allows players in the market to recalibrate their business models in compliance with the Press Release
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