Recent recommendations of a Reserve Bank of India (RBI)-appointed internal working group on digital lending, if accepted, may effect major changes in the business models of digital lenders, including the First Loss Default Guarantee (FLDG) and Buy Now Pay Later (BNPL) models, experts said.
On November 18, the RBI released the report of the working group on digital lending, which addresses key grey areas and how they can be regulated.
Some of the key recommendations include setting up a nodal agency for verification of digital lending applications, setting up a self-regulatory organisation, and allowing lending by balance sheet lenders only.
The recommendations act on three levels: regulated entities, authorised entities and unregulated entities (including third-party service providers in the financial world).
One of the key aspects addressed officially for the first time are FLDG and BNPL.
FLDG is an arrangement whereby a third party compensates a lender if the borrower defaults. In an FLDG setup, the credit risk is borne by the loan service provider (LSP) without maintaining any regulatory capital.
'Buy now pay later' – is a point of sale product where buyers typically get credit for a 15-30 day interest-free repayment period.
These are significant areas, since FLDG sowed the seeds of digital lending, while BNPL is emerging and in demand among the new-to-credit customer base and in point-of-sale transactions.
FLDG: To prohibit or not to prohibit?
In an FLDG model, the working group highlights that there could be high operational risk that can arise due to the increasing reliance of lenders on third-party service providers and a potential risk build-up because of these platforms.
The report recommends that regulated entities should not be allowed to extend any arrangement involving synthetic structure, such as FLDG, to such entities. It adds that regulated entities should not allow their balance sheets to be used by unregulated entities in any form to assume credit risk.
The founder of a prominent digital lending company said FLDG has been a grey area for a long time, and a few NBFCs were using their license as a rent-an-NBFC model through FLDG, allowing the build-up of a proxy portfolio by loan service providers. It was flagged off as a concern in terms of overall risk to the system and how it will pan out remains to be seen, he added.
Policy experts believe that total prohibition wouldn't be right as this could impact credit expansion.
Mandar Kagade, Founder & Principal at Black Dot Public Policy Advisors, said, "Basic principles of financial markets have taught us that risk is allocated to the most efficient bearer. These LSPs have borrower-specific information that makes them an efficient bearer of risk through FLDG in this case."
In the absence of such a mechanism regulated lenders will shrink from lending to otherwise creditworthy borrowers. That will hurt India’s already poor household debt/GDP ratio (12%), further hurting the push towards financial inclusion, Kagade adds.
Is BNPL a loan product?
As per the report, the volumes in the BNPL category are picking up, with private banks and NBFCs the leading facilitators in terms of volume.
Even though the amount disbursed under BNPL loans is only 0.73 percent (SCBs) and 2.07 per cent (NBFCs) of the total amount disbursed through digital channels, the volumes are quite significant, indicating a large number of small-size loans for consumption, the report said.
The report recommends that short-term lending products going under the guise of deferred payments such as BNPL should be treated as part of balance-sheet lending, not like merchants' operational credit. Further, as these products do not meet the requirement of traditional credit facilities, a suitable notification may be issued by the Government of India in this regard. However, the report doesn't indicate what the notification could be about.
New-age short-term liquid lending products have created a niche and are now filling in a critical credit void in the ecosystem. A traditional lending framework cannot be applied on these products, says Jaikrishnan G, Partner, Financial Services Consulting at Grant Thornton Bharat.
So far, as per industry sources, in India, not all companies do soft or hard checks and not all report to the bureaus in case of defaults.
The primary challenge that emerged here was some of the players were not reporting to the bureaus, says Anuj Kacker, Founder, Freo (formerly known as MoneyTap). But, he added that as long as it is reported to the bureau, there shouldn't be a problem.
Kagade of Black Dot adds that BNPL has to be seen as a supply chain product from a B2C construct, similar to B2B products like invoice discounting. The consumer gets an even number of days to repay though credit risk is definitely there.
Experts add that an upside exists in terms of being reported to the bureau and has to be explicitly conveyed as most BNPL users are new to credit.
But if BNPL has to be done only on a balance-sheet lending basis, it might slow down growth on the BNPL side and thus the agenda of financial inclusion and credit expansion, Kagade said.
Shilpa Mankar Ahluwalia, Partner & Head – Fintech, at Shardul Amarchand Mangaldas, says the existing BNPL models will undergo some change as BNPL will now be seen as a credit product to be done only by licensed entities.
Further, the model has worked to some extent because the platforms with the customer provide credit relevant data by understanding user behaviour and profiles. However, the moment this ability is taken away, it might change the risk profile, Ahluwalia said.
On condition of anonymity, the founder of a large digital lending organisation said that BNPL should be a part of balance sheet lending, as it is a credit exposure at the end of the day.
Some of the players doing BNPL who didn't have NBFC licenses were still doing through the float. Float is the money within the banking system getting accounted for twice due to the time gap in settlement of the transaction.
So, many of them were falling between the cracks; that way, the regulator would want to tighten it, the founder added.
Industry welcomes recommendations
The executive committee of the digital lending association of India (DLAI) said the recommendations are a step forward towards creating a safer and trustworthy ecosystem for both customers and digital lending firms.
Fintech Association for Consumer Empowerment (FACE), in a statement, said that these suggestions would encourage healthy competition for a healthy industry and responsible lending to create a positive consumption economy with transparency and consumer protection.
A senior industry official said lending is a serious business and not just a feature. Companies in the lending business have to be serious about this and comply with regulations, which should be clear; otherwise, they could entail a lot of chaos.