[Sibasish and Ayush are students at National Law University Odisha.]
Digital lending has emerged as a crucial aspect of the financial sector, with numerous participants entering the market and providing quick access to credit for even small financial needs through online platforms. In a report, the Boston Consulting Group predicted that by 2023, almost 48% of the lending would be digital. In 2021, it was reported that lending start-ups would see a rise from 13% in 2020-21 to 35% in 2024-25 and that much of the venture funding went into fintech lending (29%), second only to payments.
India is a hotspot for the rise of digital lending start-ups and fintech companies. Default loan guarantee (DLG) structures, which are an important part of the digital lending sphere, had come to a halt pursuant to their prohibition and unclear stance in the digital lending guidelines of the Reserve Bank of India (RBI) in September 2022 (September guidelines).
After constant demands of the fintechs, the financial regulator changed its stance on the much-anticipated DLG structures. On the 8 June 2023, the financial regulator not only permitted these structures in the sphere of digital lending but also released guidelines for the same. The authors in the post analyze the viability of the same from a Fin-tech company’s perspective.
What is a First Loss Default Guarantee (FLDG)?
An FLDG is a contractual arrangement in which a third party such as a fintech company guarantees to cover only up to a certain percentage of the default in the loan portfolio of the regulated entity (RE) (bank or NBFC). However, the entire pool of loans is not guaranteed. It is different from a co-lending arrangement in the sense that the third party in an FLDG only guarantees the default and does not transfer the underlying loan exposure from the books of the RE to its books.
The RBI has made it clear that DLG arrangements will not be considered "synthetic securitization" or be subject to the regulations concerning "loan participation." This decision could potentially provide commercial entities with new opportunities to effectively handle risk and enhance their loan servicing abilities, without having to deal with the complications associated with these two financial structures.
The RBI has expanded the scope of the definition of 'direct lending to government'. According to the new guidelines, implicit guarantees can now be included within 'direct lending to government' without being classified as "synthetic securitization" or falling under the provisions of "loan participation." However, implicit guarantees will be subjected to the same requirements as explicit guarantees.
One Plus One Makes it Eleven
Fintech lending is an important piece in the financial landscape of the country. The traditional balance sheet lenders function by the traditional way of banking, hence they need the fintech companies which provide them the digital flavour and technical competence. The fintech companies act as a medium to connect the lender with the borrower. The required capital for loans is infused by the banks and the fin-techs through their technology help disseminate it to a large number of borrowers. This way, attention is also focused on the customers who are in actual need of loans.
The fintech companies (the DLG providers) also come up with technological advancements that assess the credit ratings of the borrowers. This helps the lenders find people credible enough to avail the loan. In return, the fintechs provide a guarantee to the bank for the initial setback in case of a default. These kinds of structures also provide a cushion to investors in financing riskier projects
In return, the DLG providers will be paid some fees, the details of which are mentioned in the circular. Up till now, the DLG providers used to sweep a share of or the entire residual income in exchange for the guarantee provided. However, this also exposes them to certain risks. The regulator has left it to the parties to mutually decide and contract on the returns to be given to the DLG providers.
The Umbrella of RBI Regulation
The primary concern with the sphere of digital lending was its unregulated nature. In the September guidelines, RBI had taken the first step to assuage the same. With the recent FLDG guidelines, it has added the much-necessitated chink to its armor.
All the commercial banks including small finance banks, cooperative banks, and also the NBFCs are now covered under the sphere of REs. They can enter into DLG arrangements with lending service providers (LSPs). LSPs, as stated in the September guidelines, are not limited to REs. This is a departure from the RBI's Working Group report on 10 November 2021 (WG Report), which suggested prohibiting unregulated entities from participating in synthetic structures like FLDG to prevent them from assuming credit risk on the balance sheets of REs. However, the new DLG guidelines appear to allow even unregulated entities to serve as DLG providers. LSPs are, however, mandated to be incorporated as a company under the Companies Act 2013.
The REs can also enter into a DLG with another RE. These measures provide both the lender banks and the fintechs the much-needed regulatory oversight such as that of the Directorate of Enforcement along with the basic corporate governance compliance for the DLG provider entity.
Free-hand to Fin-techs to Provide a Fillip to Innovation and Lending
The new guidelines burden the RE lenders with a lot of responsibilities to safeguard the sphere of digital lending. These include the recognition of non-performing assets and the various disclosure and due diligence requirements. The REs are required to put a Board-approved policy before entering into any DLG arrangement. RBI has also strictly prohibited DLG arrangements as a substitute for increasing credit worthiness of a borrower and mandated robust underwriting practices.
Fintech companies, on the other hand, liberated from extra compliances can focus on providing much-sought innovation and security to the digital lending sphere. The Indian fintech startups can come up with big-data and secure API connections to banking data coupled with artificial intelligence to assess the credit worthiness of the borrowers in a better way. They can study the borrower's behavior with the help of AI. These will prevent the REs from disbursing any bad loans to such borrowers.
The Dichotomy Around Guarantee Cap: Risk Mitigation or Risk Hindrance?
RBI had, in its September guidelines, directed REs to adhere to the RBI Securitization of Standard Assets Directions 2021 while dealing with contractual arrangements such as FLDG. The fintechs, in compliance with the securitization cap, provided a guarantee of averaging around 20% of the loan portfolio. As the regulation was not clear on the same, LSPs sometimes covered even up to 100% of the loan generally averaging around 25-30%.
The market players contemplated the cap to be around 20% however prima facie many Fin-techs seem satisfied with the 5% cap that the RBI has mandated. It is believed to prevent unnecessary risky practices not suitable for the market. This would also bring much-needed confidence and certainty to the market which would contribute in the long run.
However, on the other side of the coin, setting this limit will hinder NBFCs from engaging in high-risk sectors and has required significant arrangements for safeguarding against FLDG structures. Many of the fintech companies would be deterred from providing loans to anyone without a good CIBIL score. Sectors such as student loans or loans aimed at individuals in the blue-collar segment who have no credit history are generally deemed very risky, and both banks and NBFCs usually steer clear of them. However, certain lenders have managed to provide credit programs in these sectors with substantial coverage from fintech companies to protect against potential losses. With a cap of 5%, these lenders would face overly restricted risk exposure, making it difficult for them to operate effectively.
Unravelling the Quirks: Calculating Guarantees in Loan Pools
Another concern that remains on this cap of 5% is around the unclear stance on its computation. An FLDG structure is a part of the so-called static loan cash flow modelling exercise which means if a loan of INR 100 crores is given and a guarantee is sought of INR 5 crores, the INR 100 crore loan will gradually amortize over time. The guarantee will remain at INR 5 crores till the loan drops to that value and then the guarantee will start decreasing along with the loan value say to INR 4 crores. So, the authors believe the calculation of the guarantee, say in a static pool, should be in terms of the disbursal made by the lender as a cohort or as a pool. Now in a revolving loan pool where the pool value is written off, further loans are added to the pool, and the calculation would be based on the cumulative disbursements. The calculation of 5% should always be in terms of the disbursements made according to the guarantee arrangements. This method will help LSPs free up more liquidity as loans get paid.
The guidelines mandate the REs to ensure the guarantee cover is specified upfront. Credit guarantees usually function under a predetermined and fixed arrangement, determined by the size of the designated pool. The entity offering the guarantee may initially deposit the entire amount with the guarantee recipient. However, when it comes to utilizing the guarantee, the recipient can only access it proportionally, depending on the number of loans that have already been disbursed.
Risk is always assigned to the most capable entity, and in this case, the LSPs possess borrower-specific knowledge that qualifies them as effective bearers of risk through FLDG.
The RBI, in its WG Report, had highlighted FLDG as a grey area prohibiting REs to extend any arrangement involving such synthetic structures. It had prohibited REs to share their balance sheets to be used by unregulated entities in any form to assume credit risk. It has now after understanding the financial market's digital and technological needs given the green signal along with the much-needed guidelines on the same.
Although there are a few uncertainties here and there, the fintech companies have welcomed the guidelines with full vigor as it provides the much-needed regulation sanctity. Unsecured personal loan and business loan lenders which currently carry an FLDG cover of above 5% and will however need to rework their arrangements. Considering the limited cap on DLG, where REs bears the majority of the loan portfolio risk, there is an incentive for them to adopt stricter credit risk assessment procedures for every borrower which could lead to the approval of loans exclusively for borrowers who satisfy these criteria. Consequently, the occurrence of loan defaults would decrease, potentially enabling REs to provide more favourable interest rates in the long run.