On June 8, 2023, the Reserve Bank of India (RBI) issued the guidelines on Default Loss Guarantee (DLG) in Digital Lending (FLDG guidelines) recognising the default loan guarantee structure in the digital lending sector, commonly known as first loss default guarantee (FLDG). The said recognition by the RBI was important as there has been a substantial rise in the number of fintech companies that have implemented synthetic business structures and are acting as digital lending platforms.
This validation of FLDG comes as an opportunity for fintech companies to foster strategic partnerships and cooperation between the regulated entities (REs) and the lending service providers (LSPs) to promote financial inclusion, prudent risk management, innovation and ensure transparency in the digital lending ecosystem, while enhancing the credit penetration in the industry at the same time.
Since the advent of digital lending in India, the RBI has taken a cautious approach. Under the FLDG guidelines as well, the same approach is being carried forward in terms of restrictions and conditions. For example, an RE is required to ensure that the total amount of DLG cover on any outstanding portfolio which is specified upfront does not exceed 5% of the amount of that loan portfolio. In the case of implicit guarantee arrangements, the DLG provider should not bear a performance risk of more than 5% of the underlying loan portfolio. Further, RE can accept DLG only in the form of cash deposited with the RE, fixed deposits maintained with a scheduled commercial bank with a lien marked in favour of the RE, or bank guarantee in favour of the RE, which will have the effect of making the entire process of FDLG as a pseudo digital process.
By introducing the FLDG guidelines, RBI has not only provided a level playing field to the fintech industry operating in the digital lending sector but also ensured that such entities will now be required to adhere to the restricted guidelines rather than operating under the radar by implementing synthetic structures. Since, RBI advised in the guidelines on Digital Lending on September 2, 2022 that REs shall adhere to the provisions of the Securitisation Master Directions, 2021, especially, synthetic securitisation provisions.
Further, the FLDG guidelines also provide a ray of hope for the fintech industry where foreign investments have been sluggish. This gives an opportunity for the fintech players to structure their business in a more compliant and recognized manner, allowing them to draw investors who have been wary of investing in such entities due to a lack of sufficient clarity from the regulators. One of the biggest problems in the fintech industry is a proven revenue model, which has worsened due to the advent of UPI payments, as most fintech companies are losing out on revenue streams through digital payments. Therefore, the most sought-after revenue stream for a fintech player is the interest income from various forms of credit/lending. In the current scenario, the FLDG guidelines will give a boost to the revenue stream of the fintech players, as the FDLG structuring would allow an increase in the digital lending transactions and thereby increasing the revenue for such players.
It is important to understand that the RBI does not want a situation where borrowings and loans are offered to any person without sufficient safeguards. Therefore, RBI has provided various conditions which are required to be met by REs and DLG providers before entering into a DLG transaction. For instance, REs are required to put in place Board approved policy before entering into any DLG arrangement, maintain the standards of ownership and accountability given aspects such as credit underwriting and credit risk management policies, regulatory capital requirement, diligence over the LSP, and so on, as per existing standards, which should include at the minimum, the eligibility criteria for DLG provider, the nature and extent of DLG cover, the process of monitoring and reviewing the DLG arrangement, the RE shall invoke DLG within a maximum overdue period of 120 days, unless made good by the borrower before that and the details of the fees, if any, payable to the DLG provider.
In terms of asset quality, recognition of individual loan assets in the portfolio as non-performing asset and consequent provisioning shall also be the responsibility of the RE as per the extant asset classification and provisioning norms irrespective of any DLG cover available at the portfolio level and the amount of DLG invoked shall not be set off against the underlying individual loans.
RBI has been known to tread with caution and it has always been wary of the digital lending sector. However, seeing the growing trend in the digital lending space with new-age fintech companies constantly innovating, providing solutions, and much-needed financial inclusion, especially in semi-urban and rural parts of the country, RBI has made significant steps to support fintech industry and has ensure that no synthetic structuring risk with respect to DLG-backed transactions is faced by the digital ending eco-system and would do more harm to the economy than good, simultaneously has also ensure that RE's duties are not weakened in the process on the other hand.
Therefore, RBI, in order to push towards a more regulated economy, had to provide regulatory sanctity to the FLDG arrangements. This will ensure that the DLG providers are not required to adopt synthetic structuring to avoid any grey areas of law, rather such entities will structure their existing setup to comply with the FLDG Guidelines. Once RBI is satisfied that FLDG can be a part of sound financial structuring, we can expect the existing cap of 5% of the underlying loan portfolio to be increased to 10% or even 20%.
(Rajat Agarwal and Vishal Mehta are Partners at Vertices Partners)
