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

FLDG

Non-Banking Financial Companies (NBFC) and fintech firms are cheering the Reserve Bank of India’s (RBI) move to approve First Loss Default Guarantees (FLDG) between regulated and unregulated entities, while capping the same at 5 percent of the loan portfolio value.

“As a lending service provider (LSP), I am very happy. The  5 percent cap is more than adequate to cover the risk scenarios which regulated entities (RE) worry about,” Nitin Gupta, Founder of pay-later cards startup Uni, told Moneycontrol.

In September 2022, the RBI prohibited REs from entering into FLDG arrangements with unregulated entities. It had said that the loan offered to a consumer is ‘strictly between the lender and the consumer,’ and the fintech partner is just a loan originator, basically like an agent.

But now the central bank has permitted REs to enter into FLDG arrangements with unregulated entities, subject to a 5 percent cap. As per the new framework, the default cover could be provided for up to 5% of the loan portfolio and shall be invoked within a maximum overdue period of 120 days.

“The RE shall ensure that the total DLG cover on any portfolio which is specified upfront shall not exceed 5 percent of that loan portfolio. In case of implicit guarantee arrangements, the DLG provider shall not bear performance risk of more than five percent of the underlying loan portfolio,” RBI’s circular issued on June 8 said.

Who are regulated entities and lending service partners (LSPs)?

As per RBI's circular, Regulated entities include all commercial banks (including Small Finance Banks), primary (Urban) cooperative banks, state cooperative banks, central cooperative banks and Non-Banking Financial Companies (NBFCs), including Housing Finance Companies.

LSPs are 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.

These regulations will expand credit access to the masses, said Rajan Bajaj, Founder-CEO, slice.

"Their pro-consumer stance refrained it from an outright ban last year, allowing continued innovation until comprehensive guidelines are formulated, including appropriate safeguards such as accurate NPA recognition," Bajaj said.

Why 5 percent? 

Before the digital lending norms were introduced, fintechs and banks had developed an FLDG model on their own, where the former provided a guarantee to compensate the latter up to a certain percentage of the loan portfolio in case of default.

Sources said that earlier the cover was usually around 10-12 percent, with some banks demanding as much as 18-20 percent as DLG from smaller LSPs.

This arrangement was beneficial for banks as they were protected from default as the fintech took care of a substantial percentage of the risk. However, RBI was not comfortable with fintechs taking such a high default risk as they were not REs. RBI’s 5 percent cap is to control and manage the risk of loans turning into large NPAs (non-performing assets).
“Now banks and NBFCs will be careful not to lend to people who don't have the capacity to pay,” said a fintech expert.

If LSPs gave a 20 percent guarantee, then banks really wouldn't mind lending. However, that causes problems in debt collection as high DLG loans can be a debt trap as these are high-interest loans, often as high as  24 percent per annum, the fintech expert said.

“This circular provides clarity on digital lending. The new guideline will allow REs to work with non-REs to source loans, which will aid financial inclusion. If REs expect more than 5 percent cover then probably they should question their lending strategy itself,” said Srinath Sridharan, Member, Governance,  Fintech Association for Consumer Empowerment (FACE).

Innovative products in the BNPL (buy now, pay later) model, and MSME lending in tier 2-4 towns come with higher risk which REs typically don't entertain. Which is where the FLDG comes in, providing a safety cover for lenders, said  Manish Lunia, Co-Founder of the lending platform  Flexiloans.

However, the move may force some smaller LSPs out of business, said experts.

“Bigger LSPs like  Pine Labs, LendingKart or any LSPs with more than Rs 500 crore of revenue were anyway following the 5 percent cap with their banking partners. But smaller LSPs would initially propose a higher DLG rate, slowly gain trust, and then reduce the rate. Now there is no scope for this,” said a digital lending startup founder.

More clarity in terms of risk-bearing, founders and investors say

"Considering the pros and cons of the challenges that the industry was facing, the regulator has once again put the right format on the table, keeping the default loss guarantee (DLG) cover limited to 5%," said Anand Kumar Bajaj, Founder, MD & CEO of PayNearby, a money transfer and bill payment firm.

The 5 percent cap is reasonable, say investors.

“A 5 percent cap is reasonable. In a country that is credit-starved, and where the economy can be meaningfully impacted by the availability of credit, fintechs and REs have an opportunity to partner for more than just their own economic benefit. A reasonable amount of risk and reward sharing is the only way to go,” wrote Sanjay Swamy, Managing Partner, Prime Ventures, on Twitter.

This ensures that the lender doesn’t face loss as long as the NPAs are below 5%. This made it a win-win for the fintech platform and the lender, said Anshul Gupta, cofounder of the WintWealth asset management Platform.

"A key risk was if a fintech had equity of 50 crore they were giving cover that was 5X that number. Which means they wouldn't be able to make good should defaults happen," Gupta wrote on Twitter on Thursday.

Fintechs are also welcoming RBI’s move to accept DLGs only in cash and cash equivalent forms.

The LSPs must provide the hard guarantee in the form of cash deposits, fixed deposits maintained with a Scheduled Commercial Bank with a lien marked in favour of the RE or a bank guarantee in favour of the RE.

“It is a judicious view. The collateral should be safe and liquid, not the other way round,” Sridharan.