[Sourav Paul is a final year student at the West Bengal National University of Juridical Sciences, Kolkata]
In recent years, the fintech industry in India has witnessed significant growth, particularly within the digital lending sector. A prominent example is the peer-to-peer (‘P2P’) lending model, which has expanded rapidly in India, supported by a favourable regulatory environment. P2P lending platforms create a marketplace that connects investors willing to provide loans with borrowers seeking credit, thereby bypassing traditional banks as intermediaries. These platforms play an important role in promoting financial inclusion by extending credit to traditionally unbanked populations.
More recently, the Reserve Bank of India (‘RBI’) has intensified its oversight of P2P lending platforms by requesting detailed information regarding their business models, and conducting supervisory visits to their offices. On August 16, 2024 the RBI amended the Master Directions on Non-Banking Financial Company – Peer to Peer Lending Platform (Reserve Bank) Directions, 2017 (‘Master Directions’) to improve transparency within the P2P lending industry. Furthermore, the regulator has imposed substantial fines on prominent P2P lending platforms such as LiquiLoans and LenDen Club, causing significant a disruption across the sector.
Against this backdrop, this post analyses the amended Master Directions and comments on the regulatory approach adopted by the RBI. It further explores the potential impact of these amendments on the broader fintech-led digital lending sector in India.
Decoding the RBI’s Amendment to the Master Directions
P2P lending platforms offered lenders the option to exit their outstanding loans prematurely by replacing them with new lenders. Although this modus operandi led to regulatory uncertainty, it effectively created a secondary market for loan transfers. In response, the amended Master Directions have explicitly prohibited P2P lending platforms from using one lender’s funds to replace those of another. Furthermore, they specify that the lender’s funds deployed on the platform can be utilised only for the purposes outlined in the amended Master Directions.
The RBI also observed that P2P lending platforms were promoting their services as investment product with assured returns. In 2016, the RBI released the Consultation Paper on Peer to Peer Lending (‘Consultation Paper’), which explained the regulator’s vision for P2P lending platforms. The Consultation Paper specifically stated that P2P lending platforms would be prohibited from offering any form of assured returns, whether directly or indirectly, as this would imply a guarantee of returns to lenders. Consequently, the practices adopted by these platforms were misaligned with the RBI’s stated objectives.
According to the amended Master Directions, P2P lending platforms are barred from providing any assurance or guarantee for the recovery of loans or from promoting peer-to-peer lending as an investment product. Additionally, the platform must obtain a declaration from the lender affirming that they understand the associated risks and acknowledging that the platform does not guarantee the return of either the principal or the interest amount.
In any debt-related transaction, the lender faces the risk that the borrower may default. P2P lending platforms devised an innovative solution to mitigate the risk for lenders. These platforms generated income from the spread between the lending rate and the borrowing rate. For instance, if a P2P lending platform lent money at 20% and borrowed at 5%, the resulting 15% spread allowed the platform to absorb defaults. However, without any restrictions on the interest rates charged to borrowers, P2P lending platforms began to assume credit risk and functioned akin to deposit-taking non-banking financial companies (‘NBFC’). It is important to note that in India, P2P lending platforms are registered as non-deposit taking NBFCs.
The amended Master Directions have provided some regulatory clarity on this issue. Specifically, P2P lending platforms are now prohibited from offering any form of credit enhancement or credit guarantee to the lenders. Consequently, any loss of the principal or interest must be borne by the lenders themselves, rather than by the platform. Additionally, the platforms are restricted from cross-selling any products except loan-related insurance products. Further, such insurance products must not serve as credit enhancement or credit guarantees. Consequently, P2P lending platforms can no longer absorb the default-related risks for lenders using their services.
To diversify the risks faced by lenders on the platform, loans were divided into smaller amounts, leading to an imbalance in the ratio of borrowers to lenders, often with more borrowers than lenders. Previously, P2P lending platforms were required to have a board-approved policy outlining the criteria for matching borrowers and lenders. Lenders could select a borrower based on multiple factors including the credit score in an equitable and non-discriminatory manner. However, the RBI has now imposed stricter obligations on these platforms, requiring them to map the prospective borrowers and lenders according to the board-approved policy based on specific parameters. The amended Master Directions also prohibit the practice of matching or mapping the lenders and borrowers within a closed user group i.e., borrowers or lenders sourced through an affiliate to the P2P lending platforms.
Prior to the amendment, P2P lending platforms were required to maintain two escrow accounts – one for funds from lenders pending disbursals and another for collections from borrowers. There was no specific timeline for settling these transactions, which allowed lenders to re-invest their funds after making an exit by selling their outstanding debt in the secondary market. However, the RBI has revised the Master Directions to introduce a T+1 settlement cycle i.e., the funds cannot remain in the escrow accounts for a period exceeding T+1 days in terms of the Annex I of the Master Directions. Furthermore, the funds in the lender’s escrow account cannot be used for loan repayments, and the funds in the borrower’s escrow account cannot be used for loan disbursements.
The RBI has also introduced disclosure requirements for P2P lending platforms to improve transparency and reduce information asymmetry among the stakeholders. According to the amended Master Directions, platforms must disclose on their websites the performance of their portfolios, including the percentage of non-performing assets on a monthly basis. Additionally, platforms are required to report any losses incurred by lenders on the principal amount or interest, or both.
In sum, the RBI has introduced onerous obligations on P2P lending platforms and has clarified certain practices that previously operated in a regulatory grey area. Nevertheless, the amended Master Directions represent a shift in the RBI’s regulatory approach regarding the status of a P2P lending platform.
A Paradigm Shift in the RBI’s Regulatory Approach
Due to the unique business model of P2P lending platforms, the RBI has historically found it challenging to regulate these entities. This is due to the RBI’s attempt to fit such innovative business models within the traditional banking structure.
In 2017, when the RBI introduced the Master Directions, it classified P2P lending platforms as NBFCs. This classification enabled the regulator to impose a range of reporting, prudential, and governance obligations on such platforms, providing some directions to the industry. However, the RBI’s classification did not completely account for the unique nature of the P2P lending industry, leading to a regulatory shift under the revised Master Directions in 2024.
NBFCs are required to obtain a licence from the RBI to engage in financial activities. The regulator applies the principal business test, or the 50-50 test to determine whether the entity qualifies as an NBFC. According to the test, an entity is classified as an NBFC only if 50% of their gross income is derived from financial services. This test is valid in a traditional setting where the interest from loans constitutes at least 50% of an NBFC’s gross income. However, P2P lending platforms typically do not lend their own funds or accept deposits; instead, they function as intermediaries connecting lenders with borrowers. This raises questions about the appropriateness of classifying P2P lending platforms as NBFCs. One possible interpretation is that the RBI may have anticipated a broader role for P2P lending platforms beyond mere intermediation, potentially justifying their classification under the NBFC framework.
Under the Master Directions, only the entities having a net-owned fund of INR 2 crore are eligible to apply for the NBFC-P2P licence. They must also maintain a leverage ratio of two. Further, there are caps on the aggregate exposure of a lender to the borrowers operating on the platform. In the traditional banking industry, such stringent norms are required to ensure there are no liquidity concerns. However, it is unclear why P2P lending platforms, which act as intermediaries are subject to these same stringent standards. If the RBI views P2P lending platforms purely as intermediaries, the rigorous regulatory requirements may appear unnecessary.
In light of the above, it is evident that the RBI initially perceived P2P lending platforms as entities with roles extending beyond mere intermediation. The regulator was apprehensive that these platforms might engage in core banking activities. It is also important to appreciate that the rise of innovative products within the P2P lending industry can be largely attributed to the regulatory void. Due to the RBI’s misclassification of P2P lending platforms as NBFCs and the lack of clearly defined regulations, the sector was able to innovate, leveraging the creative interpretations of the Master Directions to its advantage.
Such a regulatory approach is not uncommon in other jurisdictions. For instance, in Japan and the United Kingdom, P2P lending platforms are permitted to issue their own loans. In contrast, the platforms are only allowed to act as an information intermediaries in the United States and China. The recent amendment to the Master Directions follows the latter approach, representing a paradigm shift in the regulatory stance. After allowing the sector to expand rapidly, the RBI’s attempt seems to confine the role of P2P lending platforms as purely an intermediary. Coupled with the opacity regarding the rationale behind the changes, this shift is likely to stifle growth and innovation within the P2P lending industry.
It will also severely impact the fintech-led digital lending ecosystem which has made impressive strides in the recent past. The regulator has adopted a hawkish stance towards this sector, as evidenced by its regulatory approach to buy now pay later (‘BNPL’) apps. This approach led to several prominent BNPL apps exiting the market due to the regulatory uncertainty surrounding restrictions on credit lines under the Master Directions on Prepaid Payment Instruments. Similarly, the introduction of the first loss default guarantee norms under the Guidelines on Digital Lending prompted the fintech industry to explore alternative risk-sharing and co-lending arrangements. Additionally, the RBI’s enforcement action against the Paytm Payments Bank for violating the know-your-customer norms had faced criticism for its lack of transparency regarding the process.
In all, the regulatory shift concerning the role of P2P lending platforms is expected to dampen the momentum of the industry. Reports indicate that several P2P lending platforms have started to adjust their operations and have paused onboarding new customers. As the RBI implements such stringent regulatory measures, the fintech-led digital ecosystem may experience a slowdown, reflecting the regulator’s hardline approach towards the market players in this sector.
Conclusion
The P2P lending industry is projected to reach a market size of USD 10.5 billion by 2026, with a compounded annual growth rate of 21.6%. These platforms have the potential to disrupt the financial sector through innovative products and by extending credit to previously undeserved segments of the society. However, the growth trajectory of this sector is contingent on a favourable and proportionate regulatory environment. The RBI’s amendment to the Master Directions appears to have turned the clock back and negatively impacted the emerging P2P lending sector. This has wider ramifications on the entire fintech-led digital lending ecosystem.
This post does not advocate for a complete overhaul of the regulatory framework for the P2P lending platforms. Nevertheless, it is imperative to acknowledge the unique nature of the industry. The regulatory policy shift largely stemmed from the RBI’s conservative one-size-fits-all approach, which attempted to fit P2P lending platforms within the existing financial sector framework. Further research in this domain may focus on the use of regulatory sandboxesfor P2P lending to develop a proportionate, effective, and transparent regulatory framework. It is hoped that the RBI will reform the regulatory landscape to foster innovation within the P2P lending industry in India.
– Sourav Paul