[RS Sanjanaa is a 3rd year BA LLB (Hons.) student at Symbiosis Law School, Pune]
The Reserve Bank of India (RBI) has granted approval to and released guidelines (on June 8, 2023) on the much-contended topic of default loss guarantee (DLG). A DLG model according to this refers to the default loss cover provided to a bank or non-banking finance company (NBFC) by the fintech company that was the originator of the loan, for a default on the loan. This announcement was made in the second bi-monthly monetary policy outcomes.
According to clause 6 of these guidelines, the fintech companies (lending service providers) can partner with banks and non-banking financial companies (regulated entities) to provide up to 5% guarantee cover for the defaults across all bank/NBFC-fintech deals undertaken. This comes as a relief for the companies who were seeking clarity on the pre-existing DLG norms in the digital lending ecosystem and the outsourcing industry.
This post highlights the pre-existing issues and considerations of the RBI prior to these guidelines. It then explains the guidelines in brief in addition to analyzing the implications it could have on the industry. The post concludes that this move by the RBI is much-needed, but the issues apparent in the guidelines need to be clarified at the earliest.
Crafting the Guidelines
Prior to these 2023 guidelines, the RBI had concerns regarding DLG agreements as it predicted a systematic risk if it were allowed. For instance, it could encourage lenders to take up undue risk through the assurance of receiving the guarantee in case of default. Even in the 2022 September guidelines on digital lending by the RBI, there was no clarity on the DLG structure.
However, as mentioned in the report of the 2021 working committee of RBI, though fintech entities have been engaging in financial lending activities on both a stand-alone basis and through partnerships, they have operated in a regulatory gray area by not satisfying the “principal business” criteria to be subjected to the RBI regulations on lending. Popularly known as the 50-50 test, this entails that to be registered with the RBI as a NBFC and be regulated by it, the financial lending activity must be the principal business of the entity, provided that:
- the financial assets gained through the lending activity must amount to at least 50% of the total assets; and,
- the income from the process must amount to at least 50% of the total income of the entity.
Now, at a time when the aforementioned regulated entities are becoming increasingly reliant on fintech companies, this lack of regulation paved way for massive financial vulnerability.
Guidelines in Brief
The guidelines came into effect on June 8, 2023, and they solely apply to digital lending. Default loss guarantee has been defined under clause 2.1 to also include implicit guarantee. Implicit guarantee refers to those contractual arrangements that are not explicitly structured as a guarantee, but the resulting economic impact resembles a guarantee. Any other means of guarantee agreements would classify as synthetic securitization or can attract provisions on loan participation.
For a fintech company to classify as a lending service provider, it needs to be a company incorporated under the Companies Act, 2013 as per clause 3 of the guidelines. A lending service provider pursuant to clause 2.5 of the 2022 guidelines refers to an agent of a regulated entity who undertakes functions of the latter such as customer acquisition.
In terms of clause 4, a DLG agreement must have an explicit contract between the regulated entity and the lending service provider. It should include details such as the extent of the cover, the form of maintenance of the cover pursuant to clause 5, timeline for invocation and disclosure requirements pursuant to clause 11. The lending service provider shall have to showcase on their website, the number of loan portfolios and the respective amount of cover offered on the assured portfolios.
The tenor of this contract shall at least for the longest period of the loan in the underlying loan portfolio pursuant to clause 10. According to clause 9, the DLG agreement must be invoked within 120 days of the default by the regulated entity.
The guidelines under clause 14 enlist two circumstances where the guarantee agreements will not fall under the ambit of DLG. One, all guarantee schemes of “Credit Guarantee Fund Trust for Micro and Small Enterprises, Credit Risk Guarantee Fund Trust for Low Income Housing, and individual schemes under National Credit Guarantee Trustee Company Ltd.”
Two, credit guarantee provided by Bank of International Settlements, the International Monetary Fund, and any other multilateral development banks as per clause 5.5 of the RBI master circular issued on May 12, 2023.
Anticipating the Beneficial Effects on Industry
While the effects of the regulations on the industry are yet to be determined accurately, this has been welcomed by all entities, as it comes as a relief in the wake of last year’s disruptive guidelines on digital lending. The regulations offer a source of confidence for investors. They provides investors with the required assurance and mitigate the risk to participate in digital lending. In addition, traditional lending systems are downgrading in India due to reasons such as demonetization, advent of Unified Payment Interface and the lingering post-COVID experience. In such a light, the regulation of the digital lending ecosystem assists in promoting the same by assuring more customers, and more capital to customers by encouraging partnerships between regulated entities and lending service providers. The U.K. based company “Zopa” for instance, saw a 197% increase in 2013 in the number of lenders using its website in the first quarter, as opposed to the first quarter of 2012 after bringing forth a similar system. This ultimately also leads to a massive economic boost. Furthermore, with the aforementioned disclosure requirements, any new regulated entity has the ability to assess the deal-worthiness of the lending service provider prior to entering into a contract.
Deficiencies and Loopholes in Digital Lending Agreement Guidelines
The regulations have the potential to cause a moral hazard by aiding the regulated entities to undertake undue risks with such guarantees by the lending service providers. But this moral hazard also extends to the borrowers as they could become lax knowing that a portion of their loans will be covered. This could also mean that the regulations could attract borrowers who are more prone to defaulting, affecting the quality of the loan portfolio.
Furthermore, there would arise a need for restructuring the existing loan mechanism in order to increase the funds for guaranteeing the defaults. This implies an increase in interest rates. In contrast, prior to this regulation, lending service providers were offering as high as 100% guarantee, with an average of 25-30%. Five percent thus imposes a substantially lesser amount of guarantee. This could deter investors. This dichotomy imposes a dangerously unpredictable situation for the digital lending ecosystem.
Moreover, the performance-led payout models that were previously in execution would, in all possibility, continue to exist. By this, the regulated entities would carry the potential to receive beyond the 5% cap. The RBI will not have the power to control the commission-led model as the regulator cannot mandate commission rates.
Apart from the issues with the potential impact of the guidelines, there exist certain inherent loopholes in the guidelines. While the RBI has specific 5% as the cap, 5% of what has not been clarified. Though it states that it will be 5% of the books, there are several interpretations of this. Claimants could state one amount that they want to achieve on the books, but in actuality have a lesser amount. And there would be penalization as loan portfolios are dynamic due to several risk factors. Furthermore, even if it is to be maintained at 5%, it becomes difficult to keep track of and ensure that the limit is maintained. The onus to keep track of the same, has also not been clarified.
The other major implication of this 5% threshold is that, most of the fintech companies such as Simpl, Moneytap, Lazypay, Uni and Zestmoney, have been bringing in new segments of the population into the credit system. And this threshold would possibly limit the lenders from providing loans to anyone without a good Cibil score, thereby also reducing partnerships. Coupled with the existing PPI and LRS norms, this could also lead to institutions shutting down their lending services.
Conclusion and Recommendations
While the issues pertaining to the regulations are crucial, they do not undermine the necessity for such regulation. Institutionalizing DLG was envisioned by the Boston Consulting Group in 2021 itself, as the action agenda for governments and regulators. By maintaining the right balance between innovation and consumer protection, properly regulated DLG agreements can facilitate orderly development of the digital lending ecosystem and enhance credit penetration in the economy, as envisioned by the RBI Governor.
In furtherance of this, the regulations firstly need to accommodate a higher cap amount. Based on previous base rates of lending by fintech companies outside of housing and personal loans, this should at least be 10%. Provisions on compliance monitoring also need to be provided to ensure lesser burden for the regulated entities. The disclosure requirements mentioned must also be enhanced to include information such as history of defaults and the success or failure of the related guarantee transactions. Furthermore, in order to ensure that the interest rates or other charges are not unfairly increased citing DLG norms, any changes must be scrutinized by the RBI and the process must be transparent. This should come with a breakdown of costs.
– RS Sanjanaa