FLDG GUIDELINES: REGULATING DIGITAL LENDING

Introduction

On 8^th June 2023, the Reserve Bank of India released the much-awaited guidelines on First Loss Default Guarantee (“FLDG”) in the form of a Notification No. RBI/2023-24/41 titled, “Guidelines on Default Loss Guarantee (DLG) in Digital Lending” (“2023 Guidelines”).[1] This new framework sets out new provisions and rules for strictly regulating the partnership between banks and fintech companies, in the sphere of digital lending. It lays down numerous dos and don’ts which every party involved in the process of digital lending will have to abide by. To that end, this article aims to analyse these guidelines and trace out the potential impact of the same on the digital lending sector.[2]

Defining The Parties Involved

According to the guidelines, there are mainly two parties involved in the FLDG transaction. First is the Regulated Entities (“REs”) and second is the Lending Service Providers (“LSPs”). REs have been defined in the 2023 guidelines as including:

1.     All Commercial Banks (including Small Finance Banks);

2.     Primary (Urban) Co-operative Banks, State Co-operative Banks, Central Co-operative Banks, and;

3.     Non-Banking Financial Companies (including Housing Finance Companies).[3]

LSPs, on the other hand, are not defined under the 2023 guidelines. However, in para 2.2, the guidelines refer to the 02^nd September 2022 Notification No. RBI/2022-23/111 titled, “Guidelines on Digital Lending” (“2022 Guidelines”) for the meaning of the terms used and not defines in the 2023 guidelines.[4] According to para 2.5 of the 2022 guidelines, LSPs are defined as an “agent of a Regulated Entity who carries out one or more of lender’s functions or part thereof in customer acquisition, underwriting support, pricing support, servicing, monitoring, recovery of specific loan or loan portfolio on behalf of REs in conformity with extant outsourcing guidelines issued by the Reserve Bank.”[5] These include fintech companies such as PayTM, PhonePe, MoneyTap, etc.

Why Is FLDG Required?

FLDG is essentially a partnership arrangement between an RE and an LSP within which, the LSP guarantees the RE to compensate it to a certain extent when a customer defaults on paying back a loan taken from the RE through the LSP.[6] The coming together of the RE and the LSP, which is saturated with digital presence and usage, is a combination of the capital, licence and power to lend of REs (like banks) with the technology, innovation and client outreach of the LSPs (like fintech companies). REs, being primarily involved in finance tend to make use of the LSPs technological innovations to lend money and carry out their business in a manner which is different from the traditional loaning method.[7]

Additionally, REs tend to shy away from lending money to customers from categories which are classified as high risk such as different MSMEs, agricultural companies, the blue-collar segments and parties with limited credit history or a low credit score. However, LSPs don’t necessarily have all the restrictions of an RE with regard to sorting the potential borrowers.[8] However, this process poses a great risk for the REs in the form of having asymmetrical financial information and a possible bad loan probability. This is because it is mainly the LSPs who handles the interactions with the customers while the REs are only involved in lending the amount.[9]

It is in such a situation that FLDG plays a significant role. It would not only perform the duty of customer acquisition, but also various services such as underwriting support, sourcing loans, monitoring, pricing support, recovery, etc.[10] The main duty would however, be when the loan gets defaulted, in which case, the LSP would guarantee the REs a certain percentage of the loan amount. This is called as the Default Loan Guarantee (“DLG”) which forms the crux of the FLDG scheme.[11] This idea of sharing risk and having a guarantee for defaults is what drives REs to partner up with these LSPs to extend loans to the latter’s customer base.

History Of FLDG

FLDG evolved along with the emerging market of finance-based digital lending in India. This market, which arose through the digital boom in India coupled with technological advances which reduced costs, posed many issues as well as benefits to the general financial economy of the country.[12] One such danger combated by the FLDG was that of risk of default on an extended loan. However, even when this scheme was launched and brought into the market, there were still various issues surrounding its usage.[13] The percentage of guarantee aspect of the FLDG scheme was contentious and variable depending on the LSP and the RE.

While some offered guarantees of up to 10% of the loan amount, others went up to as high as guaranteeing even 100% of the loan amount. This variation was primarily due to there being no regulation on the part of the RBI on the percentage of guarantee which could be given by the LSPs.[14] The main problem which arose out of this was the LSPs could not take on such a huge credit risk. They have none of the required risk management, debt-to-equity requirements and capital adequacy norms for bearing this guarantee.[15] Hence, when numerous such bad loans came about, the LSP would go under and even upon declaring insolvency, only a small portion of the loan could be recovered from the LSP.

This posed a great risk for the different REs involved in the process due to their loans going bad. Consequently, the RBI, through its 10^th August 2022 press release and the 2022 guidelines, placed heavy restrictions on FLDG arrangements by making them comply with all the provisions concerning “synthetic securitisation” under the Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 (“Securitisation Guidelines”).[16] Para 6(c) of these Securitisation Guidelines prohibits REs from undertaking or assuming exposure under “synthetic securitisation” structures.[17] So, RBI essentially completely restricted any FLDG arrangements in the digital lending market which led to widespread confusion regarding the loss-sharing arrangements in digital lending.[18] However, in 9 months, RBI revived the FLDG scheme with an entirely new framework different from the previous one with strict restrictions and oversight on the partnerships between REs and LSPs involved in an FLDG arrangement.

The New FLDG Model

The new 2023 FLDG Model clearly highlights and lays down provisions for the different aspects of digital lending and guarantee. Para 3 of the 2023 Guidelines permit REs to enter into DLG arrangement only with an LSP or another RE with which it should have entered into an outsourcing arrangement.[19] This outsourcing arrangement is the same as an LSP arrangement except it is signed between two REs. Additionally, the 2023 Guidelines require the LSP which is providing the guarantee, to be a company incorporated and registered under the Companies Act, 2013, which means that it should have a place of business in India.

One of the most important provisions with regard to the DLG part, is para 6 of the 2023 Guidelines which provides for a guarantee capped at 5% of the portfolio amount for all LSPs.[20] Unlike the previous situation, this means that REs and LSPs cannot negotiate for more than 5% guarantee of the portfolio amount. For securing this guarantee even further, para 5 of the 2023 Guidelines provides for the LSPs to give hard guarantee to the REs for their exposure to the risk. This hard guarantee can only be in any one or more of the following forms:

1.     Cash deposits with the RE;

2.     Fixed Deposits maintained with a Scheduled Commercial Bank with a lien marked in favour of the RE;

3.     Bank Guarantee in favour of the RE.[21]

Such a form of hard guarantee ensures that the LSP is capable of satisfying their obligations under the DLG if the default occurs. Situations where guarantees provided by the LSP exceed the net worth of the LSP itself would no longer occur. There can be efficient regulation in this aspect.

Para 7 of the 2023 Guidelines sheds light on another important aspect of recognition of NLA.[22] It states that the responsibility of recognising an individual loan asset in the portfolio as NLA would lie with the RE and not the LSP. This also extends to the further provisioning and taking necessary steps for the occurrence of an NPA. The LSP’s guarantee coverage and availability within the DLG contract would not affect this responsibility. It further states that, the amount of DLG invoked shall not set off against the underlying individual loans in the case of an NPA. However, the 2023 Guidelines allows for the RE, upon the invocation and realisation of the DLG, to share with the LSP any recovery it makes from the loans declared as NPA, as per the terms of the contractual arrangement.

Para 9 of the 2023 Guidelines imposes a cap on the maximum number of overdue days for invoking the DLG at 120 days.[23] This is provided that the borrower does not make good the default. Moreover, para 10 of the 2023 Guidelines provides that the tenor for the DLG arrangement shall not be less than the longest tenor of the loan in the underlying loan portfolio.[24] For ensuring more transparency and a symmetrical distribution of information, para 11 of the 2023 Guidelines require the RE to put in a mechanism to ensure that the LSP with whom the RE has engaged in a DLG arrangement, publishes the total number of portfolios and the respective amount of each portfolio on which the DLG has been offered, on their website.[25] This ensures not only the RE, but also customers are made aware of the DLG’s commitments of the LSP and then proceed with their transactions.

Para 12 of the 2023 Guidelines lays down three additional due diligence requirements with respect to the DLG provider.[26] Firstly, it requires the RE to put in place a board-approved policy before entering into any DLG arrangement. This policy is required to include the eligibility criteria for the LDG provider, the nature and extent of the cover, the monitoring and reviewing process and the details of the fees, if any, payable to the DLG provider. Secondly, it reiterates that the DLG arrangement does not act as a substitute for credit appraisal requirements. Irrespective of the DLG cover, there has to be a robust credit underwriting standards put in place. Thirdly, it mandates the RE, whenever it enters into or renews a DLG requirement, to obtain the adequate information to satisfy itself that the LSP would be able to honour it. Such information includes a declaration from the LSP, certified by the statutory auditor, on the aggregate DLG amount outstanding, the number of REs and the respective number of portfolios against which DLG has been provided. There also needs to be a declaration containing past default rates on similar portfolios.

Lastly, para 4 of the 2023 Guidelines mandates the DLG arrangement to be backed by a legally enforceable contract between the RE and the LSP which has to contain different details such as the extent of the DLG coverage, the forms in which the DLG cover is to be maintained with the RE, the timeline for the DLG invocation and the disclosure requirements, among other things.[27]

Impact Of The New FLDG Model

This move by the RBI is seen to be a big-positive for the finance sector, particularly NFBCs and fintech start-ups and companies as it will strengthen the digital lending ecosystem. Fintech start-ups and companies would be able to extend loans to borrowers with limited credit history (such as blue-collar workers, MSMEs, students and agriculture units) and those with low credit score, all of whom would have had a very difficult time or been refused loans from banks in the traditional way.[28] Moreover, there is greater transparency being brought about due to the different disclosure and due diligence requirements under the 2023 Guidelines. This not only provides greater clarity to the REs with regard to the portfolios of the LSP but also their consumers for their own choices and protection.[29]

This new model also revives the digital lending market which has been dwindling in the past 9 months due to the complete restriction through the 2022 Guidelines. By capping the DLG at 5% along with providing hard guarantees, LSP are also given better options for managing their capital without locking all of it, which would have been extremely difficult with a 100% DLG.[30] It also opens up the market for the early-stage fintech companies and start-ups, as they can partner with REs through FLDG arraignments instead of waiting for an NBFC licence.[31] This will be a positive development which strengthens the credit penetration and boost the digital lending ecosystem. Experts even indicate that funding into the digital lending market, will also see a stark increase as investors get much-needed clarity with regard to the working of the LSPs.[32]

With regard to the REs, there is more security given to them for extending their partnership with LSPs through such DLG arrangements, both in the form of hard guarantees and the increased informational symmetry. Moreover, since it will be the REs who are responsible for drafting the contracts along with their respective policies for engaging in such DLG arrangements, they have a better control over who they engage with and the manner of engagement.[33] All this can be structured in a manner which does not place the REs in a vulnerable position with regard to their exposure to the risk of deflating loans. There is benefit and cost at both ends of the arrangement, and the same is balanced to ensure the safeguard and overall welfare of the digital lending market.