The Reserve Bank of India (RBI) had constituted a working group in January 2021 to study all aspects of digital lending activities by regulated and unregulated entities/players in the financial sector with an aim to regulate the digital lending in India.
The working group submitted its report on digital lending to the RBI in November 2021 and provided its recommendations and suggestions with a view to enhance the customer protection and make the digital lending ecosystem safe and sound. While various recommendations of the working group had been accepted and considered by the RBI in the Digital Lending Guidelines issued on 2 September 2022, some of recommendations required further examination by RBI.
With respect to the credit sharing arrangement involving first default loss guarantee (FLDG) between the lenders and the lending service providers (LSPs), the working group had expressed its concerns stating that such a synthetic structure enables the unregulated entities to lend and act as unregulated lender without complying with prudential norms and other criteria specified for the lenders since the loan portfolio backed by FLDG is akin to off-balance sheet portfolio of the LSP. Therefore, the working group had recommended that in order to prevent loan origination by unregulated entities, the lenders should not be allowed to enter into any synthetic structure such as FLDG.
The recommendation pertaining to FLDG was accepted (in-principle) by the RBI subject to further examination. In the Digital Lending Guidelines, the RBI advised the lenders to adhere to the provisions on synthetic securitisation[i] set out in the SSA Directions[ii]. These directions do not permit the lenders to undertake synthetic securitisation. Further, pursuant to the RBI directions on transfer of loan exposure,[iii] a contractual arrangement involving loan participation[iv] (i.e. transfer of economic interest[v]) cannot be entered into by the lenders unless the transferee is a scheduled commercial bank or small financial bank or a NBFC.
On 8 June 2023, the RBI, based on extensive consultations with various stakeholders and in line with its objective of maintaining a balance between innovation and prudent risk management, decided to allow the DLG arrangement in digital lending space and issued the regulatory framework for default loss guarantee in digital lending (DLG Framework).
The DLG Framework has prescribed various Dos and Don’ts which would need to be kept in mind by the lenders at the time of entering into an DLG arrangement. Further, the DLG Framework does not allow any actual transfer of underlying loan exposure from the books of the lender to the books of the DLG provider. If a DLG arrangement does not confirm to the guidelines prescribed under the DLG Framework, such an arrangement would be treated as synthetic securitization attracting the provisions of the SSA Directions and/or the loan exposure transfer directions mentioned above.
Key aspects of the DLG Framework are set out herein below:
- The guidelines are applicable to the DLG arrangements entered by the banks and/or NBFCs in their digital lending operations (i.e. lending process undertaken by using the digital technologies for customer acquisition, credit assessment, disbursement etc.)
- DLG cover can be provided by a lending service provider (being a company under the [Indian] Companies Act) and/or any other bank/NBFC with which the lender has entered into outsourcing arrangements. LSP basically acts as an agent of lenders to carry out one or more of the lenders’ functions such as customer acquisition, pricing support, recovery of loan etc. in line with the RBI’s directions on outsourcing arrangements. The LSPs would need to publish on their website the total number of portfolios and the respective amount of each portfolio on which they have offered DLG.
- The lender and the DLG provider would need to have a legally enforceable contract which must cover, inter alia, the extent of DLG cover, the form of DLG cover, timeline for DLG invocation and the disclosure obligations of the DLG provider (if it is an LSP).
- While the DLG provider can provide explicit guarantee to compensate the loss of the lender upto certain percentage of the loan portfolio (specified upfront), any implicit arrangement of a similar nature linked to the performance of the loan portfolio of the lender and specified upfront would also be covered under the ambit of DLG arrangement.
In order to regulate the risk which may have to be faced by the lenders in case of a default by the borrowers in repayment of the loan, the RBI has capped the total DLG cover on any outstanding loan portfolio upto 5% of the amount of such portfolio. In case of an implicit DLG arrangement, the DLG provider cannot undertake performance risk of more than the equivalent amount of 5% of the underlying loan portfolio.
- DLG would have to be in the form (i) cash deposit, (ii) fixed deposit with a scheduled commercial bank, or (iii) bank guarantee. Additionally, the tenor of DLG arrangement will be the tenor of the longest loan in the underlying loan portfolio.
- In the event of default by the borrowers in repayment obligations, the lenders would be required to invoke the DLG within a period of 120 days from the date of such default. The lenders shall, however, comply the extant norms on NPA recognition and consequent provisioning irrespective of the DLG cover. Further, the amount of DLG invoked cannot be set off against the underlying individual loans. The amount of recovery, if any, from the underlying loans can be shared with the DLG provider as per contractual arrangement.
- At the time of entering into or renewing an DLG arrangement, the lenders would be required to conduct a due diligence on the DLG provider (including obtaining an auditor certified declaration regarding its existing DLG obligations) so as to satisfy itself about the ability of the DLG provider to honour its commitment. Further, the lenders would be required to have a board approved policy before entering into any DLG arrangement.
Due to increase in digitization in financial sector in recent years, the structure of financing has changed. The fintech players have eased the process of lending and borrowing since the borrowers are not required to go through the lengthy process of submission of loan application with banks. DLG Framework indicates a positive approach of RBI towards the development of the digital lending as it would encourage the fintech players while protecting the interests of the regulated entities. The introductory cap of 5% will ensure that the unregulated players do not cause systemic risk to the lending ecosystem. However, the requirement of DLG cover being backed by cash deposit or fixed deposit or bank guarantee, which would practically be locked and cannot be used for other business operations, may pose challenge for the fintech players as they may have to raise further funds to meet their cash requirements for the DLG cover.
Authors: Dinesh Gupta, Jasmeet Kaur Munday
[i] “synthetic securitization” means a structure where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of credit derivatives or credit guarantees that serve to hedge the credit risk of the portfolio which remains on the balance sheet of the lender but it does not include the use of instruments permitted to lenders for hedging under the current regulatory instructions.
[ii] Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021
[iii] Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021
[iv] “loan participation” means a transaction through which the transferor transfers all or part of its economic interest in a loan exposure to transferee(s) without the actual transfer of the loan contract, and the transferee(s) fund the transferor to the extent of the economic interest transferred which may be equal to the principal, interest, fees and other payments, if any, under the transfer agreement.
[v] “economic interest” means the risks and rewards that may arise out of loan exposure through the life of the loan exposure.