RBI’s Double-Edged Sword: The Digital Lending Guidelines
[Prateek is a graduate of Army Institute of Law, Mohali.]
The RBI implemented the Digital Lending Guidelines on 10 August 2022, based on recommendations of the Working Group on Digital Lending constituted in January 2021. Prima facie, the guidelines are aimed at curbing unfair and predatory lending practices, while providing technological frameworks strengthening privacy and data security, and promoting the use of AI for assistance in underwriting debt by lending service providers (LSP).
Considering the vulnerability of India’s digital lending userbase to predatory lending practices, the RBI has undertaken these guidelines to perform its duty to safeguard the market. Consecutively, these safeguards ensure that consumer trust in the lending and banking sector is maintained. This is especially relevant for digital lending since the digital divide in India causes the most vulnerable classes to lack digital literacy and legal awareness. Conversely, it is this class of users who are shunned by traditional lending sources, whom the rising digital lending platforms aim to serve. This lack of access to traditional sources of credit is due to the underwriting standards requiring formal employment or credit histories to determine creditworthiness. For classes that are new to the financial scene and lack credit history, or lack employment in the formal sectors, digital lending becomes the only source of easy credit. Thus, the guidelines serve the important purpose of ensuring safety in financial inclusivity with the growing digitization of India’s populous.
On the consumer end, the guidelines provide for prohibitions on unconsented and automatic increases in borrowing limits by LSPs, provision for cooling off periods and an assertion of regulatory control of the RBI on unregulated LSPs by requiring Regulated Entities to conduct review of the LSPs at regular intervals. Most importantly, the guidelines mandate LSPs to provide prospective users with a key fact statement (KFS), thus reducing opacity in lending.
On the technological side, the guidelines ensure data privacy through limitations on the nature and extent of data collected by LSPs, along with a mandate requiring localisation of data onto Indian servers.
Need Analysis: RBI’s Safeguarding Perspective
The digital lending market in India is undergoing exponential growth, with new products like 'buy now, pay later' (BNPL) gaining prominence. Expansion of digital lending is further fuelled by collaboration between the fintech sector with financial players. Market leaders in fintech, like One97 Communications’ PayTM, have also entered the market, with PayTM recently announcing a partnership with Piramal Finance to offer merchant lending services, with long-term plans of entering the consumer lending space. Further, global firms have also begun entering the Indian digital lending space through strategic investments in domestic players.
This sector is plagued by risky underwriting and predatory lending practices due to a prior lack of regulatory framework. The 'rent-an-NBFC' model, which allows for high-risk underwriting by lenders owing to first loss default guarantee (FLDG) by LSPs, is evidence of the same. The FLDG model allows non-regulated LSPs to guarantee a predetermined proportion of the loan in case of default. This encourages risky underwriting of credit by NBFC partners as they find reassurance in LSPs having some skin in the game.
Thus, a need was felt for hegemonizing risky underwriting practices in the digital lending space, especially when Non-Performing Assets are already a major issue in India. Inflation, in the age of consumerism, also increases the propensity for impulse purchases, as evidenced by spikes observed in BNPL models during festive seasons. This provides legitimacy to the regulatory frameworks that the guidelines provide.
The Dual Counternarrative of Market Incentivisation
While the guidelines are fairly comprehensive, the probable counternarrative is dichotomous in terms of market incentivisation. This dichotomy is in the form of disincentives harming consumer adoption, as well as disincentives creating low profitability for businesses.
Consumer incentive in this sector is largely driven by low accessibility to traditional credit sources for certain classes that either lack formal employment, or lack substantial credit history which makes underwriting riskier for institutions. Since these classes are shunned by traditional banking systems with regards to extension of credit, they provide a ripe market for the digital lending market, which till now was lacking any regulatory mandate requiring underwriting standards applicable to the traditional sources of credit. The FLDG model, for instance, makes underwriting loans easier for NBFCs since part of the risk is borne by the LSP. This allows NBFCs to underwrite loans for individuals who might not meet the high standards of creditworthiness set by traditional lending agencies. Regulation of these models will inevitably cause exclusion of the classes that earlier provided a ripe market for these digital lending platforms.
On the business incentive end, BNPL models are increasingly popular as a business opportunity for FinTech players. RBI has made the Digital Lending Guidelines specifically applicable on the BNPL model as well, thereby increasing the operating costs for these businesses due to regulatory requirements creating compliance cost. This hampers prospective growth for these capital-intensive businesses, since profitability of BNPL business is materially dependent on late fees by consumers for models lacking interest fees. For models that include interest fees, ambiguity on cooling-off period may translate into a regulatory bar on prepayment penalty, thus reducing profitability for them as well. Counterintuitively, competition in the sector is already high, fuelled by domestic and foreign investments hoping to cash-in on the massive potential consumer base. This increased competition also leads to an increase in customer acquisition cost for LSPs due to advertising costs. The lowered profitability paired with a high customer acquisition cost is a death sentence for many of these platforms lacking the necessary capital, creating breeding grounds for domination by larger players.
Digital lending in India is in its nascent stage, with massive scope for driving market growth in other sectors by increasing consumer spending through ease of access to credit. Current limitations range from primacy of traditional credit sources and prevalent credit-aversive behaviour of consumers. Thus, there is a need to create trust in the lending sector to normalise undertaking credit, through the establishment of better recollection practices. Therefore, the debt recovery framework should not be deferred or left to market players for formulation, and should instead be formalised more effectively by the legislature itself.
RBI’s intention is to safeguard consumers from predatory lending practices, while minimizing default propensity. But the guidelines in their current stage, as observed above, fail to provide the necessary levels of debt security. Counter-intuitively, it can be argued that growth of public trust in digital lending spawns a cognitive dissonance in consumer borrowing mindsets where undertaking short-term digital debts are perceived as more viable. Current apprehensiveness regarding data security, debt-recollection, uncertainty on lender policy and costs, create an environment where digital lending might be perceived as an option undertaken as per need, not to simply satisfy wants. As evidenced by spikes in consumer purchases during festive season through BNPL programs, simplification leads to lowered apprehension about undertaking such debts for consumer wants. The guidelines, while currently unable to provide structural debt security, enable systematic changes that create consumer trust in digital lending. This weakens the cognitive dissonance between ease of liquidity that debt provides, against credit aversion, with the latter being weakened by consumer trust.
Such a systematic change might enable risk-seeking behaviour, and thus, the need for structural modifications to models like 'rent-an-NBFC' are only exasperated by the guidelines in their current state. That being said, the Working Committee’s recommendation of completely eliminating FLDG models would be detrimental to the niche customer base that digital lending businesses aim at targeting, since it is this demonstration of underwriting skills, which allow for disbursal of credit to individuals otherwise deemed less creditworthy by traditional sources of credit.