[Ritvij Ratn Tiwari is a 3rd-year B.A., LL.B. (Hons.) student at the National Law School of India University, Bangalore.]
In June 2023, the Reserve Bank of India (“RBI”) issued guidelines regulating the arrangements for sharing the losses arising from defaulted loans, popularly called default loss guarantee (“DLG”), between regulated entities (“REs”) and lending service providers (“LSPs”). These guidelines also encompass arrangements between two REs. These guidelines are critical for operationalizing “fintech” lending in India which generally involves agreements among REs themselves or between REs on the one hand and LSPs on the other. Under the fintech lending business model, LSPs act as agents of REs and carry out one or more of the lender’s functions such as customer acquisition, recovery, servicing, etc. The guidelines mandate the fulfilling of various conditions, key ones being a five percent cap on the DLG and the obligation of regulatory entities (REs) of identifying and provisioning for individual loan assets within their portfolio as non-performing assets (“NPAs”) to implement first loss default guarantee (“FLDG”).
This post argues that although the RBI guidelines provide crucial regulatory standards, they neglect to take into account the important element of sectoral default rates, employing a generalized approach that overlooks sector specific nuances. This piece discusses the unique arrangement of FDLG and unpacks the arguments supporting and opposing a fixed default cap. It then seeks to make a case for applying sectoral caps on default loss guarantee by LSPs on the basis of sector specific default rates.
The Arrangement of FLDG
Collaborations with fintech firms are becoming increasingly crucial for traditional banks as they strive to foster growth through innovation and maintain relevance within a dynamic and rapidly changing market environment. Similarly, for fintech platforms, lending is one of the top sources of revenue.
FLDG is a contractual arrangement under which an LSP guarantees to compensate the RE, loss due to loan default up to a certain percentage of the loan portfolio of the RE, specified upfront. FLDG, thus, is one of the most important contractual arrangements between a fintech company acting as an LSP and a RE such as a bank or an NBFC. Under the FLDG arrangement, the LSP effectively cushions the RE against the first loss up to a certain level. REs are, however, obligated to adhere to existing standards pertaining to ownership, accountability, credit underwriting, credit risk management policies, regulatory capital requirements, asset classification, provisioning, and due diligence over the LSPs.
The guidelines also mandate that the LSP must disclose information on their websites through a mechanism established by the RE. This mechanism entails publishing the total number of portfolios and the corresponding amount of each portfolio on which DLG has been provided. This ensures that the entire process is transparent and subject to scrutiny by competitors, thereby promoting a climate of healthy competition.
The Fixed Five Percent Default Cover
The guidelines stipulate a hard limit of five percent of the amount lent as the default cover. On the one hand, it is arguedthat a default cover of five percent is well justified as it makes sure that REs do not shirk off their responsibility of underwriting. It assures that REs are doing what is required and ensures that borrowers are not being subjected to predatory practices. Finally, it makes sure that fintech LSPs are not at a greater risk of bearing the burden in cases of default.
On the other hand, it can also be argued that a default cover of five percent is low and an increment will enable access to credit to the fintech platforms. It also instils greater trust among REs due to greater commitment and involvement in lending by fintech platforms as they have more skin in the game.
However, if one sees the underlying idea behind these two arguments, it is evident that the entire game of guarantee is based on the delicate balance between ensuring responsible underwriting and fostering access to credit for fintech firms. The variable of default rate comes into play here. The greater the propensity to default in a sector, the lesser will be the tendency of the fintech platforms to advance FLDG.
Sectoral Cap on the Basis of Default Rates
When providing FLDG, it is crucial to assess and understand the default rates for several reasons. Default rates help in assessing the level of risk associated while providing a guarantee. By analyzing historical default rates, fintech platforms can evaluate the likelihood of borrowers defaulting on their obligations. This assessment can help them determine whether they can afford to provide the guarantee and at what cost. Thus, fintech platforms might only extend a five percent default cover to a specific sector while it might be wise for them to extend a default cover of 50 percent in a sector with low default rates.
For instance, in India, default rates among micro small and medium industries (“MSMEs”) are lower than large corporations. Similarly, the default rates in the microfinance sector have been decreasing whereas they are on the rise in the education sector. Overall, sector-specific default rates tend to follow business cycles, reflecting the broader economic conditions and dynamics within each sector. While some sectors exhibit lower default rates due to specific characteristics or effective risk management practices, others may face challenges that lead to higher default rates. Recognizing these cyclical patterns is crucial for fintech platforms, to appropriately assess and manage risks associated with different sectors. It is argued that implementing a fixed cap of five percent is inadequate and fails to consider the varying characteristics of different sectors and business cycles. By extending FDLG in sectors characterized by lower default rates, fintech firms have the opportunity to secure credit and enhance their lending activity.
To address this issue, two potential solutions can be considered. First, the RBI could consider increasing the default cap to a higher percentage range of 20-30 percent. This would provide greater flexibility for fintech firms to access credit while still maintaining a reasonable level of risk mitigation. Secondly, the RBI could establish a list of sectoral caps, based on historical and current default rates within each sector. By tailoring the default cover percentages according to the specific risk profiles of different sectors, the RBI can ensure a more targeted and balanced approach to risk management in fintech lending partnerships. The RBI may also choose to revise this list on a periodic basis without affecting previous loans.
The implementation of the FDLG guidelines can be regarded as a significant achievement that fosters innovation and expansion within the lending sector without causing major disruptions. The RBI has made serious efforts to facilitate fintech and innovation benefiting 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.
However, a strict cap applied in a broad-brush fashion disregards the diversity in sectors. Interestingly, in the wake of the pandemic, more than ten percent of borrowers did not repay their loans leading the fintech lenders to have massive commitments towards banks. If there had been a sectoral assessment of default rates and subsequent sectoral caps, such a fiasco could have been prevented. The RBI can view this as a valuable lesson and a chance to establish a mechanism for incorporating the standard of sectoral default rates in the FLDG framework. This is especially important considering that the acknowledgement of FLDG is a relatively recent development.
– Ritvij Ratn Tiwari