[Tarpan and Shivi are students at Rajiv Gandhi National University of Law, Punjab.]
On 8 June 2023, the Reserve Bank of India (RBI) released the much anticipated guidelines on first loss default guarantee (FLDG Guidelines). These guidelines have been released consequent to the digital lending guidelines released by the central bank in September last year which had in effect prohibited all kinds of FLDG arrangement between a lending service provider (LSP) / digital lending application (DLA) (used as “fintech entity(s)” interchangeably) and the regulated entities (REs). However, the new guidelines have now permitted such FLDG arrangements between fintech entities and REs, which are the banks and the non-banking financial companies (NBFCs), albeit with certain conditions, restrictions and caps. This article first describes what an FLDG arrangement is and then analyzes the guidelines on FLDG arrangement released by RBI. This is followed by certain suggestions as to what should be the way forward for RBI with respect to the same and the conclusion.
Understanding an FLDG Arrangement
FLDG arrangement as defined in the FLDG Guidelines, pertains to an express agreement between the REs and LSPs in which guarantee is provided by an LSP on the outstanding amount of a particular loan portfolio specified upfront between LSP and RE. LSP, as defined in the Digital Lending Guidelines, is the agent of RE that carries out lending functions such as customer acquisition, underwriting support, price supporting and other activities on behalf of the RE and must mandatorily be incorporated as a company under the Companies Act 2013. Such lending functions of LSPs are facilitated using DLAs which are mobile based applications of either the REs or LSPs. These apps are used for extending loan facilities to the end users and are managed in pursuance to the guidelines issued by the RBI for banks and NBFCs for outsourcing their lending activities.
The following example will help in understanding the working of an FLDG agreement in a better way. Let us say X is a DLA that is owned by Y, an LSP company registered under the Companies Act 2013. X facilitates loans in partnership with Z, one of its lending partners which is an NBFC, thereby an RE. Herein, X acquires customers for Z to lend, and most of these customers are those which fail to get credit from banks owing to low credit score, lack of collateral, etc. X provides underwriting support for these customers. Since these loans are high risk loans, the NBFC, that is Z, makes an agreement with the LSP, that is Y, in which Y guarantees to compensate Z for the loss due to default of the certain percentage of the loans of Z, acquired through X.
The Need for Regulation
The abovementioned arrangement proves beneficial for all the parties involved in the transaction as NBFCs get more customers and share the interest income with the fintech entities. At the same time, this provides quick and easy access to credit for people with low credit scores as LSPs perform their underwriting. Furthermore, NBFCs are not hesitant to provide large loans as the LSPs provide guarantee of a certain percentage of the loans acquired by them for the NBFC. However, it is a two-edged sword and has its risks as well. Prior to the coming up of Digital Lending Guidelines in September 2022 there was no cap on the limit to which the guarantee could be provided by the LSPs. This led to arrangements where even 100% default guarantee was being provided by the fintech companies and the NBFCs were freely giving loans as they had virtually no risk, without conducting proper due diligence of the fintech companies. However, this was not a sound financial situation as it could lead to a large number of defaults, and the whole risk was being transferred to completely unregulated entities (LSPs) which posed huge data and systemic risks.
Hence, in order to crack down on these unregulated transactions and to bring the responsibility back to regulated entities, the RBI has come up with the FLDG Guidelines, keeping a cap of 5% of outstanding loan portfolio on FLDG arrangements between NBFCs and fintech entities. This comes after September last year, when RBI had in effect prohibited any kind of FLDG arrangement between fintechs and REs, thereby creating large uncertainty in the emerging fintech lending sector.
Deciphering the RBI Guidelines on FLDG
The RBI, in its bid to regulate these high risk FLDG arrangements, has introduced the FLDG Guidelines. These guidelines have limited the amount of FLDG to 5% of the outstanding amount of a particular loan portfolio, specified upfront between the RE and fintech. Further, RBI has made it mandatory for the REs to categorize the defaulted loans as NPAs only even when they have been made good by its partnering fintech. Apart from that, the guarantee provided by fintech has to be in the form of cash deposit with the RE or as fixed deposits made in the favor of RE in a scheduled commercial bank or as a bank guarantee in favor of the RE. Also, the tenor of the guarantee should not be less than the longest tenor of the longest loan in the portfolio specified between the RE and the fintech entity and the guarantee must be invoked by the RE within 120 days of the default.
Suggestions and the Way Forward
The FLDG guidelines provide a much needed relief to REs and LSPs as there was an atmosphere of uncertainty surrounding the space post the release of the Digital Lending Guidelines last year. However, the RBI should gradually moderate its approach to best reflect the needs of this nascent but high potential industry. The guidelines provide that the defaulted loans that have been made good by fintech should be categorised as non-performing assets (NPA) only. However, this could prove to be detrimental for the REs, especially the smaller NBFCs. The REs would be providing loans to the customers brought by the fintech, considering the FLDG arrangements they have with the fintech entity. Inclusion of those loans as NPAs that have been made good by the fintech entity will unnecessarily increase the NPAs on the books of the REs. For the smaller NBFCs, this will pose a problem as to the outsiders, it will create an outlook that the NBFC is not in a good financial position which might affect an NBFC’s other non lending businesses. This provision might deter the REs from entering into FLDG arrangements with the LSPs. The RBI’s rationale behind this could be that it wants to get a clear picture of all the engagements between the fintechs and the REs in this fast developing sector and to ensure that the REs have the incentive to conduct proper due diligence of the customers being brought by the fintech, which was not being done earlier. Although this may be required initially, in the early stages of this market, as the market players evolve, the RBI must not require categorization of the defaulted covered loans as NPAs.
Further, the guidelines provide that the guarantee should not exceed five percent of the loan portfolio specified upfront between the RE and the LSP. This seems a bit arbitrary considering that all the LSPs do not have the same financial position and condition. Some of the LSPs may be in a better position to provide a larger FLDG cover for the REs. For example, the revenue of fintechs such as Paytm and PhonePe was INR 4,974 crores and INR 1,797 crores respectively in the financial year (FY) 2021-22, whereas the revenue of fintechs such as Chqbook was INR 13 crores in the same FY. Keeping all the LSPs on the same pedestal, when there is a substantial differentiation among the LSPs in the Indian market, is not justified as their risk-taking abilities differ greatly. Hence, it is suggested that the RBI should create a further sub-categorisation of the default limit of these service providers on the basis of their risk taking capacity that could be calculated in accordance with their cash flow, revenue, liquidity, debt-equity ratio etc. Alternatively, RBI should strive to gradually increase the 5% cap on FLDG cover. This is also in consonance with the feedback received from industry players by the RBI in the report of its Working Group on Digital Lending (Working Group Report) which suggested to keep the FLDG limit between 15% and 20%. This will provide the incentive to REs to lend more through these fintech entities and thereby capture the untapped borrowers in the country.
The RBI has indeed done well by allowing FLDG arrangements in India and deviating from RBI’s recommendations in the Working Group Report, which as opposed to the feedback received from industry players, had recommended a total prohibition on such arrangements. This recognition of FLDG arrangements by the RBI is also likely to increase funding for the emerging fintech players as the regulatory concerns have now been completely alleviated. However, in order to ensure that the digital lending industry keeps on making big strides in India, the RBI should gradually move towards a slightly soft touch approach giving flexibility to the fintech players. This will also accelerate the growth of credit availability to the margins of the country where, till now, the informal sources charging extremely high interest rates have been prevalent.