Fintechs' loss guarantee scheme for lenders gets RBI approval

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The Reserve Bank of India (RBI) has approved the First Loss Default Guarantee (FLDG) programme, a popular product that fintechs in the country use to form partnerships with banks and non-banking financial companies (NBFCs).

The RBI had said in its Digital Lending Guidelines last year that it was not opposed to the idea of FLDG. This is the first time that the banking regulator has explicitly approved such a product. However, RBI has capped the FLDG amount at 5 percent of the total loan value.

“RE (Regulated Entity) shall ensure that the total amount of DLG cover on any outstanding portfolio which is specified upfront shall not exceed five percent 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,” RBI’s circular said.

FLDG helps banks and NBFCs cover potential losses, as well as gives them confidence that fintechs understand credit risk. Under FLDG, fintechs help banks and NBFCs recoup losses that occur when customers default on payments.

While some fintechs only provide coverage for the first month, a few aggressive partnerships have resulted in fintechs covering losses for up to three months of defaults, hence referred to as DLG (Default Loss Guarantee). Another form of arrangement involves fintechs compensating lenders for defaulting up to five loans in a portfolio of 100 loans, under the new 5 percent cap. This arrangement ensures that lenders do not face losses as long as the non-performing assets remain below 5 percent.

Prime Venture’s Managing Partner Sanjay Swamy wrote on Twitter that the 5 percent cap is reasonable for a credit-starved country like India. The VC firm focuses on fintechs.

“RBI has come out with clarification on the #FLDG  - a 5% cap is reasonable. In a country which is credit starved, and where the economy can be meaningfully impacted by availability of credit, Fintechs and Regulated Entities have an opportunity to partner for more than just for their own economic benefit - and a reasonable amount of risk and reward sharing is the only way to go,” he said.

What RBI said

“Arrangements between Regulated Entities (REs) and Lending Service Providers (LSPs) or between two REs involving default loss guarantee (DLG), commonly known as FLDG, has since been examined by the Bank and it has been decided to permit such arrangements subject to the guidelines DLG arrangements conforming to these guidelines shall not be treated as ‘synthetic securitisation’ and shall also not attract the provisions of ‘loan participation’,” the circular added.

This means that the fintechs facilitating this lending are neither participants in lending nor lenders themselves. Last year, the Reserve Bank of India (RBI) stated in the Digital Lending Guidelines that only regulated entities should be lending to end customers. Additionally, the customer relationship should be directly with the lenders, and the collections should also be remitted directly to the lender's account.

As per the RBI's circular, these guidelines are applicable to DLG arrangements entered into by all commercial banks (including small finance banks), primary (urban) co-operative banks, state co-operative banks, central cooperative banks, and NBFCs (including housing finance companies) involved in digital lending operations.

As part of the due diligence, the RBI has said that banks and NBFCs must put in place a board-approved policy before entering into any DLG arrangement.

“Such policy 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,” the circular said.

Fintechs rejoice  

“One of the key asks from most sector players has been to provide clarity on the permissible structure for DLG arrangements between two parties. The circular specifies details on scope, eligibility, structure, form, cap, disclosure requirements and exceptions,” said Jatinder Handoo, CEO, Digital Lenders Association of India (DLAI),

According to him, this leaves limited room for ambiguity. He added that the well-defined structure will facilitate all players to participate in an effective and transparent manner and make the best use of the DLG facility.

“Best outcome that strikes a balance between innovation and regulation. A lot of fintech ideas that were waiting in the wings to see how the FLDG will play out and will now start drawing up their plans,” said Madhusudanan R, cofounder of M2P fintech.

Fintechs welcome 5 percent cap

“As a lending service provider, I am very happy. It is cash-based and hence there is no risk. The  5 percent cover is more than adequate to cover the edge risk scenarios which REs worry about. It is fantastic,” said Nitin Gupta, founder of Uni.

While fintechs are desperate to meet the credit demand, a few banks have requested much higher guarantees from loan originators/fintechs in exchange for lending partnerships. The 5 percent cap could also mean that certain financial institutions that are not willing to take much risk may opt out of this nascent segment.

“Fintech in India is back! Formalising this FLDG arrangement is excellent and much needed for the ecosystem. Capping deposits at five per cent helps further and can spur creation of innovative products that are much needed for India,” said Osborne Saldanha, partner at Emphasis Ventures (EMVC) which invests in fintech and insurtech startups.