[Prashant is a student at Maharashtra National Law University Nagpur.]
Time and again the prevalence of digital lending and its inevitable takeover over traditional means of physical lending has been recognized in the lending landscape of India. The digital lending environment in India has been going under serious policy and regulation overhauls which are drastically impacting the majority of existing fintech-aided digital lending in the country. For a very long period, these fintech entities involved in digital lending were active in a grey area of the law but with the introduction of the 2022 Guidelines on Digital Lending Implemented on 2 September 2022, a lot has been demarcated by the law with respect to the functioning of digital lending application / platforms. Prior to the introduction of the 2022 guidelines, digital lending applications functioned through a partnership between two entities. One entity was a regulated institution, such as a bank or NBFC, while the other was an unregulated fintech entity. In this partnership, the bank provided the essential capital, while the fintech-driven digital lending application facilitated credit accessibility to borrowers. The success of fintech in digital lending soared due to its cost-effectiveness and accessibility, both financially and in terms of ease of use. Further backed with technical superiority over their supplier partners i.e the banks in terms of data analytics, these entities had developed their own alternate mode of assessing creditworthiness, but much has been changed with the introduction of 2022 and 2023 default loss guarantee guidelines implemented on 8 June 2023.
Restriction on FLDG
The first loss default guarantee (FLDG) serves as the foundation of partnerships in digital lending transactions within the country. In this arrangement, the lending service provider (LSP) provides a guarantee to the regulated entity (RE) to cover any defaults arising from borrowers who obtained loans through the digital lending agreement (DLA).
This guarantee system instilled a sense of security among lenders, encouraging them to extend and supply capital for lending through the LSP. However, it was criticized for its lack of transparency, as it resulted in the accumulation of risk on the side of LSPs, which, being largely unregulated, did not require public disclosures. Consequently, in accordance with Article 15 of the 2022 guidelines, FLDG was banned.
Lifting FLDG Restriction
Soon, within a year, the RBI recognized the importance of FLDG and was compelled to reintroduce it. However, this time, it came with a capped limit of 5%. This meant that any arrangement to cover default losses on loans extended through digital lending to borrowers was limited to 5%, even though it was typically around 10% to 20%, and in some cases, even 100%.
Now, the problem is more likely to arise because the incentive for the REs to enter partnerships with LSPs has reduced, as the law now requires LSPs to cap their guarantee at only 5%. This limited guarantee of 5% was introduced to ensure active participation by REs in underwriting loans effectively. High FLDG guarantees from LSPs could have made REs complacent in assessing the creditworthiness of borrowers, a task that was previously undertaken by LSPs but is now required to be done by REs themselves under the 2022 guideline.
If we examine this in the context of the institutional lending framework in India from the perspective of the RBI, where the banking sector is highly regulated, the situation could have appeared as if an entity could simply take the authority to underwrite loans based on a simple FLDG agreement on behalf of the REs. This could make it seem like a mockery of the entire regulated banking system in India, where an exclusive license for lending is granted by the RBI after thorough examination.
Diminishes LSPs Role
First of all, the capping of the guarantee significantly reduces the interest of REs in forming partnerships with LSPs. Even though REs were already not exempt from the risks associated with digital lending according to the 2022 guidelines, the subsequent reintroduction of FLDG agreements doesn't provide much relief, except for the fact that a FLDG can exist with a 5% guarantee being extended, which is better than nothing.
Now, this 5% guarantee, as discussed earlier, was not the industry norm for digital lending. Nevertheless, LSPs and REs would be compelled to adhere to it if they are serious about their business. What this results in is that the 2023 FLDG guideline aligns with the 2022 guideline, effectively diminishing the role of LSPs in digital lending to merely bringing borrowers to the REs. Furthermore, the potential profits for LSPs will also decrease because digital lending applications (or LSPs) were already operating in a high-risk lending domain.
Guidelines Disrupting Profit Models
In the wake of the 2022 ban on FLDG, some LSPs introduced new partnership models based on commission and performance-based payouts. However, the revival of the 5% FLDG has led partner banks to compel LSPs to re-enter FLDG arrangements alongside the existing new models.
As there are no regulations concerning commission-based and performance-based models among these partners, there is always the possibility of banks reducing or deducting payouts in the performance or commission-based models if the loss exceeds the 5% FLDG cover (which is also a subject of dispute in terms of what exactly the 5% covers). This further reduces the profits for LSPs since they are already involved in risk-dominated lending.
Furthermore, the 2022 guidelines state that LSPs cannot charge any fees directly from the borrower for the services they provide; such fees are to be routed through the REs to the LSP. This discourages another source of profit for LSPs. However, LSPs might find ways to circumvent this by charging fees to customers in a different manner, but doing so could potentially harm competitiveness among the DLAs.
RE’s Entry Means CIBIL Based Lending
If we examine both sets of guidelines, the central concern of the RBI is related to the potential failure of the digital lending economy due to a lack of regulation and transparency. This could have spillover effects on the traditional lending ecosystem, which the RBI is primarily interested in protecting. To address this, the RBI aims to bring about the active participation of REs to monitor and regulate the digital lending landscape in India by mandating 'Robust Underwriting Standards.'
This means the introduction of stringent measures for underwriting loans, which would likely involve comprehensive assessments, potentially including the use of data sources such as CIBIL scores. LSPs were known for extending credit to individuals with low or no CIBIL score data, relying on alternative data sources like salary and utility bills. However, under Article 14 of the 2022 guidelines, it is now required to provide information to credit information companies like CIBIL about loans extended through digital lending mediums.
This implies that LSPs will be compelled to reduce their risk to attract partner banks and improve their prospects in terms of forming ties with banks / NBFCs. REs, on the other hand, will conduct more thorough due diligence examinations before partnering with LSPs.
As a result, in their pursuit of minimizing risk and improving their prospects, LSPs may end up targeting only those borrowers whom REs used to deal with, but now only through digital means. In the long run, there is a high possibility of REs gradually excluding LSPs from their digital lending ecosystem and focusing on the same borrowers as LSPs, as LSPs would not be able to serve an alternative segment of borrowers who were previously outside the reach of traditional REs since they would be under the pressure to minimize the risk by targeting reliable borrowers who at the first place do not even constitute the target audience of LSPs as historically they have been serving high risk borrowers such as students and low salaried people.
Furthermore, since the low-risk audience generally consists of individuals from the well-to-do strata of society who already have access to RE's loans at cheaper interest rates, they are not likely to be attracted to the high-interest rate loans offered by LSPs. Additionally, this low-risk segment of borrowers has very little demand for urgent, emergency purpose loans, as most of them are financially sound and have insurance to cover emergencies such as health crises.
Therefore, if we analyze the situation where LSPs continue targeting the low-risk segment in order to minimize their losses and appear attractive to REs for potential partnerships, it would ultimately result in a slow decline for LSPs.
Conclusion: The NBFC Run
In light of the difficulties and restrictions imposed by the RBI's guidelines, what appears to be the most optimal path for LSPs is to form partnerships with entities that are less likely to exploit and more inclined to cooperate, allowing LSPs to have a greater role on lending to borrowers.
Under the current legal framework, from the perspective of LSPs there is limited scope for meaningful cooperation and profit generation unless the partnering RE entity permits it as these REs may find ways to compensate for the capped 5% FLDG cover, which is lower than the previously prevalent cover further depleting the possible profits.
This is where the race among many prominent fintech giants to acquire NBFC licenses has started. This is being done in anticipation of a potential strict crackdown on regulating digital lending. Having an in-house NBFC entity closely related to LSPs provides substantial autonomy to collaborate and underwrite loans and maximize profits, rather than solely focus on profit-sharing negotiations.