Resolving the Conundrum Around Buy-Now-Pay-Later
[Aashna and Priyanshi are students at Institute of Law, Nirma University.]
The market for buy now pay later (BNPL) has gained a lot of traction; ranging from 569% in 2020 to 637% in 2021 year-on-year growth rates. In a BNPL transaction, the borrower is allowed to purchase products on a deferred payment basis and is required to pay the debt in predetermined instalments.
It has become increasingly popular amongst new to credit classes considering it involves scant or no assessment of the borrower’s credit worthiness. Additionally, borrowers can obtain hassle free credit without interest. These products are modelled as credit card challengers because of the ease that it provides to the customers.
On the contrary, the delinquency rates have also increased which can cause systematic financial risk. Consequently, the Reserve Bank of India (RBI) released a notification which bars all non-bank prepaid payment instrument issuers from loading prepaid payment instruments (PPI) through credit lines. Non-compliance of this notification shall lead to penal action under the Payment and Settlement Systems Act 2007. This notification has adversely impacted the business models of fintech companies such as Slice that load PPIs through credit lines.
In this article, the authors intend to explore the regulatory framework for BNPL and analyse the plausible reasons for imposing a ban on loading of PPIs through credit lines.
RBI’s Master Directions on Prepaid Payment Instruments 2021
The Master Directions on Prepaid Payment Instruments issued by the RBI permits co-branding between banks and non-banks with the PPI issuers. As a result of this co-branding arrangement, the banks carry the function of PPI issuer and the fintechs usually cater to the marketing and distribution of the PPIs. The banks and non-banks must mandatorily take the authorization from RBI before issuing the PPIs.
The guidelines mandate that banks and non-banks were to load or reload the PPI through cash, debit or credit cards, debit to bank accounts. That said, the question which remained unvoiced was whether the fintech companies were allowed to load PPIs through credit lines or not. However, the recent clarification issued by the RBI makes it amply clear that non-bank entities are not allowed to fund PPIs through credit lines.
The fundamental concern of the RBI was that PPIs were following the trail of shadow credit cards. The repayment schedules, interest rates and many other terms were similar to credit card, but PPIs did not follow the regulatory regime governing those cards. The lack of fair practices concerning minimum amounts due, weak customer grievance redressal mechanism coupled with inadequate measures to govern fraudulent transactions were the factors about which the regulator raised concerns.
In light of these, the fate of BNPL may be riddled with ambiguity. On the one hand, the RBI has restricted the entry for authorized non-banks through credit lines and while on the other, it is silent on the aspect of authorized bank entities. Therefore, amidst all these things, how the clarification will unfold for BNPL is yet to be seen.
Decoding RBI’s Report of the Working Group on Digital Lending
The RBI constituted a working group to restrain digital lending activities by entities outside the regulatory ambit. The report classified fintech entities which provide BNPL products as lending service providers, whose main service is to provide a marketplace for lenders and borrowers. Due to the rise of innovation in the fintech market, these entities also offer various ancillary services such as sourcing of loans to underwriting risk.
The report suggested that a definition of ‘credit’ should be introduced. This will help resolve the ambiguity regarding the classification of BNPL as a lending activity. Put simply, BNPL can be considered a form of credit because the borrower is permitted to pay later and incur debt. However, BNPL transactions do not involve levying of interest, and therefore, do not fulfil the essentials of credit.
Defining credit will enable credit information companies (CIC) to report BNPL transactions. In the press release by RBI, it is stated that regulated entities which extend loans through fintechs are required to report all deferred payment products to CIC. Earlier, BNPL players used to employ unconventional methods to determine the credit worthiness of customers. They use AI and machine learning tools to track the customer’s payment history on various e-commerce websites, utility bill payments, etc. Thus, reporting BNPL transactions will help ascertain the credit worthiness of borrowers whose credit histories are unknown as they do not qualify for the traditional credit facilities. It shall also increase transparency and reduce the delinquency rates of such transactions as BNPL players can weed out defaulters.
Though, if borrowers’ default on small ticket loans, sharing of such information may force them to resort to unorganized lending. Hence, in alignment with the RBI’s objective to prohibit predatory lending, the authors suggest that the regulator release guidelines specifying all information which should be shared with CIC and the methods for credit assessment.
The report also suggested that risk participation by fintechs in the form of first loss default guarantees (FLDG) should be prohibited. Fintech entities enter into synthetic structures with the banks/NBFCs (rent-an-NBFC-model), where they undertake to compensate the lender if the borrower defaults on repayment. These entities enter into indemnity agreements to demonstrate their underwriting capabilities and have skin in the game. This is beneficial for loan originators because it would ensure that the borrower quality is not diluted.
Since these underwriting activities do not meet the principal business criteria to be regulated by the RBI, they do not need to maintain regulatory capital. Unregulated entities take exposure in their balance sheets and report it on a deferred payment basis. Therefore, undercapitalized entities bear the credit risk, which is a form of regulatory arbitrage.
This recommendation is still under consideration. For the time being, all FLDG business models need to comply with the RBI’s Master Direction on Securitisation of Standard Assets (MD-SSA) norms. However, the implementation of RBI’s MD-SSA directions is still unclear and requires specific clarification. The authors opine that a blanket ban on FLDGs can be detrimental to the digital lending ecosystem. FLDGs promote lending and add to the credibility of the fintech risk evaluation.
Another concern while deciding on the legality of FLDG would be financial inclusivity. BNPL products provide support to the excluded classes; they help to narrow the credit gap amongst classes. Therefore, the regulator should ensure that the policy changes are aligned with the goal to democratize credit.
The regulator has also prescribed a minimum cooling-off period, which has to be adopted by the banks and non-bank entities. The said rules will be applicable to the borrower and will provide a time to exit the digital loan by paying the principal amount coupled with that of the interest. For loans having a tenor of fewer than seven days, at least a day cooling off period will be provided and for other loans, at least three days' cooling off period will be provided.
Fintechs require a fine-tuned balance between fostering growth and managing the risks. The recent move by the RBI is not overtly dictatory in nature if we see the trends across the globe. The fintech market is booming, which justifies the need for greater regulatory supervision. RBI’s concern, if implemented vigorously, might force all BNPLs to revamp their business models. For instance, Slice has already begun the bandwagon. However, RBI has seen the growth of this fintech and its recent declaration of Payment Visions 2025 also seems to be promising. Hence, RBI, though pushing toward traditional regulation, does not aim to ignore the potential space of fintech.