BACKGROUND
While the Reserve Bank of India (“RBI”) had in its August 10, 2022 press release stated that it is examining the First Loss Default Guarantee (“FLDG”) structures, the Digital Lending Guidelines issued by the RBI on September 2, 2022 neither permitted nor expressly prohibited loss sharing arrangements such as FLDGs, but recommended that provisions of paragraph 6(c) of the Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 dated September 24, 2021 (“Securitisation MD”) be adhered to for financial products involving contractual agreements such as FLDG. Paragraph 6(c) of Securitisation MD prohibits Regulated Entities (“RE”) from undertaking or assuming exposure under “synthetic securitisation” structures. This led to industry-wide confusion regarding the permissibility of loss sharing arrangements such as FLDG.
The RBI has now released Guidelines on Default Loss Guarantee (“DLG”) in Digital Lending, dated June 8, 2023 (“DLG Guidelines”), bringing in much needed clarity and permissibility regarding loss sharing arrangements. Following are the key takeaways:
Key Takeaways:
- DLG permitted – The DLG Guidelines have set out conditions, subject to which DLG cover will now be permitted. The confusion, fear or taboo related to DLG has been put to rest, permitting loss sharing arrangements in the form of DLG, in accordance with the DLG Guidelines. To that extent, DLG Guidelines are a huge game changer and have brought much needed relief and clarity in the digital lending space;
- DLG, explicit and implicit, covered in the ambit – DLG is defined to include explicit and implicit arrangements. Hence, as long as DLG arrangements are aligned with the DLG Guidelines, the same shall not constitute as synthetic securitisation and not attract compliance of loan participation. This will streamline the various service level default guarantees, collection efficiency and other varied models adopted by numerous players;
- DLG provider to include unregulated entities – REs are permitted to seek DLG cover from other regulated entities as well as LSPs. LSPs as defined under the Digital Lending Guidelines of September 2, 2022, do not restrict its ambit to only regulated entities. Thus, deviating from the RBI’s Working Group report dated November 10, 2021 on digital lending, including lending through online platforms and mobile apps (“WG Report”), which had recommended prohibition of synthetic structures such as FLDG with unregulated entities to avoid enabling unregulated entities to assume credit risk on the balance sheets of RE, the DLG Guidelines seem to permit even unregulated entities to be DLG Provider. Though in its attempt to respond to the WG Report, the RBI has mandated REs to classify and provision for individual loans irrespective of the availability of DLG cover;
- DLG Provider – Indian company – DLG Provider needs to be a company resident in India. Also, by ensuring that it is a company under the Companies Act, 2013, the RBI has ensured at least the basic corporate governance mechanism within the DLG Provider entity;
- Fillip to innovation, fintech and financial outreach – The DLG Guidelines evidence RBI’s clear thought process, analysis and due consideration of the industry requirements and this is evidenced by specific provisions such as 5% cap on DLG cover, specific nature and form in which DLG can be provided, timing for invocation and tenor of DLG evidence, etc. This will enable the RE to bring more efficiency in cost of lending and financial outreach by use of LSPs and digital lending platforms and at the same time encourage only the more sincere fintech entities to participate, given the DLG cover is required to be upfront and fully funded;
- Accountability rests with the RE – On the one end, fintech, innovation and efficiency has been given a boost by permitting REs to seek DLG cover, on the other end, the RE is required to maintain the same standards of ownership and accountability given aspects such as credit underwriting and credit risk management policies, regulatory capital requirement, asset classification and provisioning, diligence over the LSP, etc., as per extant standards. With only 5% cap on DLG cover, bulk of the credit risk continues to be with the RE;
- Transparency and small borrower protection at the core – The DLG Guidelines do not specifically require any disclosures in the key fact statements to the borrowers, given the DLG cover is available for an entire loan portfolio as opposed to individual loans. However, full disclosure and transparency is expected to be made to the borrowers and other REs by requiring the DLG Provider to publish on its website the various DLG arrangements, including default on similar portfolio. Of course, the terms of engagement between an RE and LSP will become available even to their respective competitors in the process, but given the specificity of key terms prescribed by the DLG Guidelines, these are likely to evolve as standard documents with more emphasis on profit through actual performance by the LSP than through negotiation of better commercial models.
- Time for regulation of LSPs/ DLG Providers: In its press release dated August 10, 2022, the RBI had mentioned about setting up a Self-regulatory organization (“SRO”) to regulate, guide and monitor the participants in the digital lending sector. As next steps, it is time for such SRO to be established to inter alia oversee and regulate the LSP, borrower protection and development of the digital lending sector. One key initiative in this regard reflected in the DLG Guidelines is where the RBI, although does not regulated and cannot insist on regulatory capital requirement for the DLG Provider, has insisted for the DLG arrangements to be upfront and fully funded with complete disclosure on its website as stated at #7 above.
- Have the industry asks been provided for? – (i) Given the various models that have developed in the backdrop of ambiguity around permissibility of loss sharing arrangements, whether a 5% cap on the default loss guarantee will be acceptable to REs is questionable, though for the moment, the RBI has unequivocally permitted DLG structures, thereby enabling the RE with a clear headroom to bring in efficiency to at least such extent; (ii) the DLG Guidelines require the DLG cover and loan portfolio to be specified upfront and also for the DLG cover to be funded upfront. Most industry players have worked under a structure where the loan portfolio and the DLG cover could evolve with the business between the RE and LSP and the DLG cover would get self-funded through such engagements where essentially the payment of services performed by the LSPs were deferred and paid in accordance with agreed business models; (iii) Another practical issue may arise for REs where they may get compensated by invocation of the DLG, but the loans may continue to reflect as NPA.
Conclusion
The DLG Guidelines can be seen as a big win for innovation and growth in the lending industry in a non-disruptive way. The RBI has made serious efforts to facilitate fintech and innovation benefitting from digital lending on one end, and on the other, maintaining its standards to ensure no systemic risk by re-emphasising that the obligations of the RE are not diluted in the process. This much thoughtful move will also benefit small and medium businesses and also small borrowers with low credit rating, which were otherwise unable to access traditional bank finance.
Whether or not the limitations set out in the DLG Guidelines are adequate for the commercial terms currently being shared between the numerous players in the digital lending sector, the RBI move is evidence of a remarkable shift from scepticism and doubt to an enabling and a thoughtful regime and a great attempt to provide much needed impetus to the industry and the economy.
