Behind RBI's move to cap FLDG at 5% and why it’s not good news for fintechs

Even as the RBI was cracking down on fintechs last year through multiple regulations, a few of the startups had been changing their modus operandi to Second Loss Default Guarantee and performance guarantees.

Last week, when the Reserve Bank of India (RBI) announced its formal approval of the first loss default guarantee (FLDG) system, most fintechs in the lending business cheered the move. However, a lot of smaller fintechs think that this is not going to help them, as the FLDG has been capped at 5 percent. In fact, a few feel that this could even hurt digital lending to people with limited credit history, and the goal of bringing more people into the formal credit system.

FLDG is a popular product used by fintechs to partner with lenders. It helps banks and NBFCs cover potential losses that occur when customers default on payments. Since fintechs find customers, some of whom do not have a credit history, and also underwrite the credit risk, the lenders often wanted FLDG coverage. There are various forms of coverage whereby the fintechs mostly covered losses between 10-25 percent of the total loan amount. Now, the RBI has insisted that this should be capped at 5 percent.

Most digital lending by fintechs outside of housing and personal loans was at a much higher rate of FLDG, often upwards of 10 percent, depending on their negotiation power with the banking and non-banking financial company (NBFC) partners. The regulated entities (REs) — the financial institutions regulated by the RBI — are not comfortable lending to such a segment of the population, where the risks are uncertain or cannot be determined by their existing underwriting models.

To avoid any systemic risks arising out of fintechs going bankrupt or not being able to make good on the FLDG promise, the RBI has clarified that the amount must be paid upfront as a bank guarantee or cash. This reduces the risks for REs, since the funding slowdown to startups could impact the lenders if there is a large default rate in the loan portfolio. A lower FLDG means that banks will be cautious about who their end-customers (borrowers) are, and in their ability to pay back.

Also Read: Why fintechs are cheering RBI’s guideline allowing 5% default loss cover

"Earlier it was illegal and now it is kosher. It was a sense of relief that the regulator has approved one of the key models of a bank and fintech partnership. While this is beneficial for a few fintechs, most will not survive," says a senior executive at a private sector bank, who works with fintechs.

According to the executive, because of the cap, most companies will end up lending to customers with good credit scores, who are coveted by all financial institutions.

"Even the fintechs who were chasing newer credit segments will now go after the same customer profile that banks go after," says the founder of a fintech company, adding that the funding slowdown could also mean that even if they have their own NBFCs, the lack of capital could mean that they are at the mercy of larger financial institutions and partnerships for the lending business. "Since the lenders will also have to share the risk with a relatively lower FLDG rate, they will be careful as to who fintechs are lending to," the founder adds.

Why is FLDG at 5%?

“With the guidelines coming into effect immediately, we expect the co-lending market to see a drop in volumes in segments with relatively higher FLDG as the industry adjusts to the new normal. The market may see sourcing lenders adapting their business models to align with the revised regulations," says Subha Sri Narayanan, Director at CRISIL Ratings, in a report earlier this week.

According to the report, in some asset classes, a higher hurdle rate could be offered to offset the impact of the cap on the FLDG cover. However, the situation could take some time to stabilise, it adds. Hurdle rate is the rate of return at which a particular product will compensate the operating cost. FLDG provided for that and REs asked for higher FLDGs when they felt that the segments were riskier.

"From the RBI’s perspective, a higher FLDG would cause overleverage and concentration risk," says a senior executive with a large private sector lender, adding that it was more about principles for the regulator.

Let us look at an example, simplifying an operating metric of a large NBFC. Their cost of funds is usually around 8 percent and they charge  20 percent interest, which means a net interest margin of 12 percent. Assuming a 4 percent cost for operations and an industry standard of 1.5-2 percent non-performing asset (NPA), the profit margin could still be 6 percent.

So even when NPAs shoot up to 4-6 percent while lending to riskier segments, the institution could still manage a normal profit if the FLDG is 5 percent. But then, several fintechs were operating in segments where NPA risks are above 12 percent and occasionally reaching 20 percent, where a 5 percent FLDG would not work.

A higher FLDG could also mean that the interest rates and other fees are high for end consumers, so that the loan originators as well as the lenders make money. The RBI's approach is that this puts people in a debt trap. Usurious money lending practices will cause a higher default and eventually, lenders will threaten debt-ridden people with highhanded collection measures.

Skin in the game

According to bankers, when the FLDG goes higher, lenders are not likely to suffer losses even when NPAs rise. The REs have no incentives in ensuring whether the borrower has the ability to repay and carry out underwriting diligently, a key responsibility of a lender, according to the RBI.

"This is akin to giving out an RE's lending licence for rent. The financial institutions have no risk and no skin in the game as FLDG goes up. RBI is clearly uncomfortable with creating a habit where REs are engaging in irresponsible lending,” says a former banker, who now works as a consultant for fintechs. “There is a reason why lending is a licensed business and that (the license) is something the RBI gives out after careful consideration. A higher FLDG would make a mockery of the system."

"Even in last year's digital lending guidelines, the RBI was clear that lenders should own the underwriting and balance sheet. There are high-quality fintechs bringing customers to banks at a marginal cost of their usual sales cost. Such fintechs can thrive in this regulated and defined business now," says the founder of a fintech firm that supports the 5 percent FLDG cap and hopes to gain better negotiating power with REs.

The RBI always talks about financial inclusion, and last year, BNPL players such as Slice, Kissht, Uni, Lazypay, EarlySalary (now known as Fibe), Simpl, Moneytap, Axio and Zestmoney, among others, were bringing new segments of the population into the formal credit system. And keeping FLDG at 5 percent means that the lenders will be careful not to lend to people without a Cibil (credit) score. These were payday loans, consumer durable loans for shopping and electronics, and short-term personal loans for regular expenditure, among others.

“We estimate that a substantial proportion of partnership/co-lending arrangements where FLDG is present — especially those with unsecured personal loans and business loan lenders — currently carry an FLDG cover of above 5 percent," says Ajit Velonie, Senior Director at CRISIL Ratings, in the same report. Secured asset classes such as home loans and loan against property, where FLDG is typically within 5 percent, may not see much impact, Velonie adds in the report.

Another fintech founder says that since the digital lending guidelines last year, many BNPL firms were already struggling to find banking partners. Coupled with a funding slowdown that put paid to any hopes of providing a higher FLDG, the new 5 percent cap could kill the business entirely. "From PPI lending to LRS norms to lending guidelines and now the FLDG cap, several firms will be forced to shut shop or pivot. And with the venture funding slowdown, this makes it even tougher," the founder adds.

The RBI does not approve of financial inclusion that does not come under responsible lending, says a senior analyst with a consulting firm. While some fintechs argue that this is about consumer lending, the RBI could also be looking at MSME lending by banks and fintechs, which has been rising at a rapid pace over the last two years, the person adds. Any systemic risk arising due to fintechs and a few NBFCs folding up will not bode well for the ecosystem.

5% as the starting point

Even as the RBI was cracking down on fintechs last year through multiple regulations, a few of the startups had been changing their modus operandi to Second Loss Default Guarantee and performance guarantees. The fintech founder quoted above feels that the RBI has not mentioned anything about performance guarantees and bonuses for good performance and the profits or losses can be shared by the partners.

"Market and risk will reprice through various measures, including interest rates and other methods, which also depends on the customer profile. The RBI was concerned at the pace of lending fintechs had achieved in a couple of years. The measure has slowed them down and made them rethink business models. The excessive funding helped fintechs to cover the FLDG and REs lost ownership of their assets with no risk. That is not a culture RBI wants to promote," says the senior analyst quoted above.

However, the analyst adds that RBI had mentioned that all sort of implicit contingency fees, payoffs and guarantees should come within the 5 percent FLDG, something a few fintech founders had a different view on.

The unanimous view among all bankers, fintechs and analysts, however, is that the 5 percent is not set in stone and the approval itself means that it is flexible and could look at changing the number depending on how the system works.

"There is optimism among a few fintech founders that this is the first step. If the RBI is happy with how the model works, it could be gradually moved up," says the analyst.