Zubin Mehta, Mohit Bhatia, and Jasraj Singh Narula
The fintech industry has recently been in crosshairs with Reserve Bank of India (RBI)’s measures to address systemic issues of the digital lending ecosystem. As the RBI gears up to introduce formal regulations for the digital lending ecosystem, let’s look at a prominent digital lending structure — first loss default guarantees (FLDGs).
Digital lending involves borrowers availing loans from lenders through digital platforms operated by digital lending service providers (LSPs). Such loans are mostly small ticket ones, including the buy now, pay later (BNPL) credit lines. The LSPs bridge the credit profile mismatch for traditional lenders through FLDGs.
Digital lending entails two players: One, balance sheet lenders (BSLs) — lenders who carry out the credit risk on their balance sheet, and meet capital adequacy norms for associated credit risks; and, two, the LSPs who match the needs of lenders and borrowers through risk participation to demonstrate skin in the game.
First Loss Default Guarantee
The LSPs and the BSLs partner for digital lending through outsourcing arrangements and pursuant to such arrangements, the RBI indirectly exercises limited supervision on LSPs. Generally, the expectation of the BSLs is that the LSPs develop and maintain robust underwriting standards for appropriate credit scoring and conduct adequate know your customer (KYC) checks.
Considering that these underwriting and credit scoring are untested in time, the BSLs disburse the loans to the borrowers once the underlying credit risk is adequately addressed through FLDGs or ‘loss-default indemnity’; where the LSP is expected to compensate the BSL for the loss, in the event a borrower defaults payment.
One of the cornerstones of the RBI’s outsourcing guidelines is that such arrangements should neither diminish a regulated entity’s obligations, nor impede effective supervision by the RBI. When the BSLs lend largely on the reliance of the FLDGs provided by the LSPs, instead of conducting appropriate credit checks through traditional methods, the RBI may possibly view this as excessive reliance on untested modern credit scoring. This could pose systematic risks for the financial system — as core-financial activities such as credit underwriting seem to be outsourced to entities which are not licensed by the RBI.
The RBI in its ‘Report of Working Group on Digital Lending including Lending through Online Platforms and Mobile’ (November 18, 2021) seems to have expressed its reservations against the FLDGs, and mentions that they are a back-door entry of sorts to the licensing regime, since the LSPs bear the actual credit risk without maintaining any regulatory capital or complying with prudential norms applicable to regulated lending.
Another regulatory concern embedded in the FLDGs is that the cost of the LSPs undertaking the credit risk gets passed on to the borrowers in the form of high platform fee, processing fee, or default interest. The RBI has also recognised that there are shadow lenders operating without licenses, creating an informal market. Considering the anonymity and velocity provided by technology, it has become a challenging task for the RBI to identify and monitor such fraudulent platforms on a real time basis.
The report recommends that regulated entities not allow their balance sheets to be used by the LSPs in any form to assume credit risk, and proposes a blanket prohibition on unregulated entities issuing the FLDGs.
Analysis And Recommendations
If the arrangements between the LSPs and the BSLs are within the contours of outsourcing guidelines, the commercial wisdom of the parties to freely enter into contracts, including FLDG arrangements should ideally not be objected by the RBI. In cases where the FLDG provisions are drafted as loss indemnities, the RBI’s jurisdiction to prohibit such arrangements could possibly be challenged.
Pursuant to the RBI regulations, a company is required to be registered as an NBFC if its financial assets constitute more than 50 percent of its total assets, and 50 percent of its income is from financial assets (50:50 Test). Considering that an entity can undertake lending business without triggering the RBI licensing requirements, an outright ban on the FLDGs could possibly raise questions in terms of the RBI’s ambit.
While the working group’s concern in the report towards the FLDG has certain merits, a blanket ban on the FLDGs could possibly discourage traditional lenders from partnering with the LSPs, and derail RBI’s goal of financial inclusion. One may rather consider a risk-based regulation of the FLDGs on a piece-meal basis to better address such risks:
Capping of FLDGs: To ensure that the LSPs do not over-leverage their balance sheets or pose systemic risks, the central bank can introduce guidelines such as: the LSPs’ total exposure to the FLDGs is capped to a fixed percentage of its capital/net worth; and the BSLs’ comfort of the FLDGs is capped to a fixed percentage of the underlying loan amount.
Framework for intermediaries: For effective regulation of the LSPs, a framework for financial intermediaries can be introduced, which could include net worth requirements, robust fair practices code, registration with a nodal agency, stronger background checks, and a cap on the maximum fees charged to borrowers.
Technology specifications: Given that the LSPs peg their value to proprietary technology - necessary information their security certifications and restriction on access to customer personal data can be prescribed.
At the least, any future guidelines regulating/restricting the FLDGs should not have a retrospective application to avoid any adverse effect on the existing loan portfolios comforted by the FLDGs.Zubin Mehta (Partner), Mohit Bhatia (Counsel), and Jasraj Singh Narula (Senior Associate) are part of the banking and financial regulatory practise, Shardul Amarachand and Mangaldas. Views are personal, and do not represent the stand of this publication.