India: RBI Nod On First Loss Default Guarantee For Banks And Fintech Lenders

The Reserve Bank of India ("RBI"), vide its circular RBI/2023-24/41 DOR.CRE.REC.21/21.07.001/2023-24, dated 8^th June 2023 ("Guideline") has allowed banks and non-bank financiers to enter into loss default guarantee arrangements in digital lending if certain conditions are satisfied. These guidelines are applicable to First Default Loss Guarantee ("FDLG") arrangements entered in 'Digital Lending' operations undertaken by entities regulated by the RBI and permitted to carry out lending business (hereinafter referred to as 'Regulated Entities' or 'RE'). A FDLG is a contractual arrangement between a RE and a fintech or lending service provider (mostly unregulated) where the latter guarantees to compensate up to a certain percentage of default in the loan portfolio. The bank is happy to extend the loan as the fintech sources the client (borrower) and also guarantee a part of the loss to the bank, in the event there is a default on the loan.

Under the Guidelines the following are considered to be RE - All Commercial Banks (including Small Finance Banks); Primary (Urban) Co-operative Banks, State Co-operative Banks, Central Co-operative Banks; and Non-Banking Financial Companies (including Housing Finance Companies).

The RBI was of the view that any other implicit guarantee of similar nature linked to the performance of the loan portfolio of the RE and specified upfront shall also be covered under the definition of DLG.

I. Guidelines on Default Loss Guarantee (DLG) in Digital Lending

Eligibility as DLG Provider – RE may enter into DLG arrangements only with a lending service provider ("LSP") or other RE with which it has entered into an outsourcing arrangement. A LSP is an agent of a Regulated Entity who carries out one or more of lender's functions or part thereof in customer acquisition, underwriting support, pricing support, servicing, monitoring, recovery of specific loan or loan portfolio on behalf of REs in conformity with extant outsourcing guidelines issued by the Reserve Bank. Further, the LSP providing DLG must be duly incorporated as a company under the Companies Act, 2013.

Structure of DLG Arrangements:

DLG arrangements must be backed by an explicit legally enforceable contract between the RE and the DLG provider. The contract must contain the extent of default loss guarantee cover, the form in which default loss guarantee cover is to be maintained with the RE, and timeline of default loss guarantee cover.

Cap on DLG: RE shall ensure that total amount of DLG cover on any outstanding portfolio which is specified upfront shall not exceed five per cent of the amount of that loan portfolio. In case of implicit guarantee arrangements, the DLG Provider shall not bear performance risk of more than the equivalent amount of five per cent of the underlying loan portfolio.

Recognition of Non-Performing Assets ("NPA"): Recognition of individual loan assets in the portfolio as NPA and consequent provisioning shall 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. The amount of DLG invoked shall not be set off against the underlying individual loans. Recovery by the RE, if any, from the loans on which DLG has been invoked and realised, can be shared with the DLG provider in terms of the contractual arrangement.

Invocation of DLG: The RE shall invoke DLG within a maximum overdue period of 120 days, unless made good by the borrower before that. The RE shall put in place a mechanism to ensure that LSPs with whom they have a DLG arrangement shall publish the total number of portfolios and the respective amount of each portfolio on which DLG has been offered.

Due Diligence and other requirements: There are certain due diligence requirements the REs need to comply with prior to entering into DLG arrangement. The RE is required to put in place a Board approved policy which shall include, at the minimum, the eligibility criteria for DLG provider, nature and extent of DLG cover, process of monitoring and reviewing the DLG arrangement, and the details of the fees, if any, payable to the DLG provider.

It has been made very clear by the RBI in its Guidelines that any DLG arrangement will not be considered a substitute for credit appraisal requirements and robust credit underwriting standards need to be put in place irrespective of DLG cover. Every time an RE enters into or renews a DLG arrangement, it shall obtain adequate information, which shall include, at a minimum, a declaration from the DLG provider, certified by the statutory auditor, on the aggregate DLG amount outstanding, the number of REs and the respective number of portfolios against which DLG has been provided and any past default rates on similar portfolios. The purpose of gathering such information is for the RE to satisfy itself that the entity extending DLG would be able to honour it.

The lender must ensure that LSPs publish the total number of portfolios and the respective amount of each portfolio on which the guarantee arrangement has been offered on their website. Secondly, the fintechs must provide the hard guarantee in the form of cash deposits, fixed deposits with lieu, or a bank guarantee in favour of the lender.

II. Initial Reservations of RBI

RBI had expressed reservations on the FLDG arrangement because it felt that the model could pose a systemic risk. It was observed that the fintechs were undertaking balance-sheet lending in partnership with a bank/ NBFC or on a standalone basis, while not satisfying the principal business criteria to remain outside regulation. Previously, entities were offering almost 100% FLDG to banking partners which exposed the banks and NBFCs to high risk as they would disburse the loans taking comfort from FDLG, but when defaults occur, the fintech platform may not have money to compensate for the losses. This was happening outside the RBI regulations and RBI opined that there were higher operational risks arising due to the increasing reliance of lenders on third-party service providers.

III. How has the fintech industry reacted?

The new framework was welcomed by the majority of stakeholders and experts who termed it as an enabling move by the RBI, providing much-needed clarity towards the relationship between REs and LSPs. The fintech industry is further of the view that the Guidelines shall serve as a catalyst for encouraging partners of regulated entities to participate in a more expansive and inclusive provision of micro-sized loans. The new norms will force REs to evaluate which LSPs they work with while others said the revival of the FLDG framework was essential for fintechs which are not making much headway in their alternative models or struggling to secure NBFC license for direct lending.

Another fintech player added that the cap of 5% will ensure the emergence of strong underwriting platforms leading to lower lending rates and believes that the Guidelines will encourage healthy competition and drive further improvements in the lending sector. RBI's directives to invoke DLG within a maximum overdue period of 120 days unless resolved by the borrower, demonstrates a commitment to timely resolution of defaults which will not only protect lenders from prolonged defaults but also encourage borrowers to take prompt corrective actions, ultimately fostering a healthier lending environment.

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