by Bhavesh Ambadkar and Naman Kothari *
Introduction
As per the concept of Digital Lending (“DL”), a borrower can acquire a loan through an online platform flexibly. These online platforms are usually apps or websites which are operated by a Loan Service Provider (“LSP”). The process of digital lending requires the borrower to submit the necessary documents and apply for the desired financial facility such as Buy Now Pay Later loans (“BNPL”), Small Medium Enterprise (“SME”) loans, Personal loans, Trade loans etc. The LSPs, who are licensed by the Financial Institutions (“FIs”), assess the applicant’s financial footprint, and the submitted documents. After thorough scrutiny, the loan is sanctioned through their platform digitally.
As per the Digital Lending Guidelines released by the Reserve Bank of India (“RBI”), the FIs are known as Regulated Entities (“RE”). The REs primarily provide loans to low-risk entities to ensure the return of their funds. Despite such practice, there are still instances where the borrower is unable to pay the loan amount provided by the LSPs, due to which the REs end up facing a loss. To tackle this situation, the LSPs provide a guarantee to the REs in the form of an agreement which is known as a Default Loss Guarantee (“DLG”). The DLG agreement provides loan assurance up to a certain amount. However, prior to August 2022, LSPs initiated a synthetic securitization process (in this the credit risk of a portfolio is transferred, either partially or entirely, using credit derivatives or credit guarantees, while the original lender retains the portfolio on their balance sheet) whereby they offered a 100% risk guarantee on digitally provided loans. Following this, the RBI banned the operation of such facility as this method not only affected the balance sheets of the banks to write off the loan amount but also had implications for the risk management commitments made by the LSPs.
Overview of RBI's Guidelines on DLG :
To address the above-stated problems the RBI released Guidelines on DLG on June 8th, 2023. These guidelines aim to regulate the execution of the DLG agreement between the REs and the LSPs or between two REs. As per the guidelines, the following are the statutory provisions applicable to the DLG Agreement:
●The LSP providing the DLG arrangement must be incorporated as a company under the Companies Act, 2013.
●The DLG agreements must be entered in a form of a legally enforceable contract between the RE and the DLG provider.
●RE needs to ensure that the DLG arrangement does not go beyond the maximum cap of 5% on the loan portfolio.
● The tenor of the DLG arrangement shall be not less than the longest tenor of the loan portfolio.
● The RE will accept DLG only through cash which is deposited with the RE, Fixed Deposits maintained with Scheduled Commercials bank in favour of the RE, or Bank Guarantee in favour of the RE.
● The RE can invoke the DLG within a maximum overdue period of 120 days.
●It is the duty of REs to ensure that the LSP publishes information on their website with respect to the total number of portfolios and the respective amount of each portfolio on which DLG has been offered.
●The REs would be accountable for identifying which loan assets to be declared as Non-Performing Assets (NPAs).
●REs must establish a board-approved policy prior to entering any DLG arrangement. This policy should outline criteria for selecting DLG providers, guarantee scope and coverage, monitoring and review processes, and applicable fees. Robust credit underwriting standards are crucial regardless of DLG cover. When entering or renewing a DLG arrangement, REs must gather sufficient information, including a certified declaration from the DLG provider stating the outstanding FLDG amount, RE and portfolio coverage, and historical default rates for similar portfolios certified by the statutory auditor.
●The ‘Guidelines on Digital Lending’ along with the other regulations will govern the customer protection measures and grievance redressal matters pertaining to DLG arrangements.
Implications
Considering the development in the DLG arrangements and with respect to the above-mentioned provisions of the DLG guidelines, there will be significant implications on future arrangements in the digital lending space, impacting the lenders (REs), the LSPs and the borrowers. These implications are listed hereunder:
A. Implication for the Lenders
The introduction of the maximum cap of 5% on the DLG arrangement by the RBI serves the purpose of addressing the issue of excessively high guarantee rates promised by the LSPs on loan portfolios. This practice led to banks writing off loan amounts through synthetic securitization. Now, with the rate capped, REs are refrained from writing off amounts through synthetic securitization.
The inclusion of DLG in a legally enforceable contract provides lenders with a sense of security. In the event of an LSP breaching any term of the DLG agreement, lenders have the right to enforce the contract and impose additional penalties on the LSP as per the agreed arrangement. An additional layer of security is offered through the method of claiming the DLG amount. As the amount is deposited in the form of cash deposit, fixed deposit, or bank guarantee, the REs have the liberty to claim such funds upon the expiration of the agreed tenor.
It has been made clear that despite there being a particular guarantee on the outstanding loan amount. The REs are obligated to identify the NPAs with respect to their individual loan portfolio. This particular provision not only aims for asset classification but also aims to address the issue of allocation of funds for such NPAs, excluding the guaranteed loan amount provided by the LSPs.
The REs are required to establish a board-approved policy outlining criteria for selecting DLG providers as pointed out above. It will ensure robust credit underwriting standards regardless of DLG cover. Additional information-gathering requirements and a statutory auditor-certified disclosure given by the DLG provider will enhance the reliability of such DLG arrangements, providing REs with a safer and more robust mechanism for approving and entering into DLG arrangements.
B. Implications for the Loan Service Providers
LSPs operate under the license and financial backing provided by REs. Previously, these LSPs were offering DLG arrangements at exorbitant rates, even reaching as high as 100% of the loan portfolio amount. However, with the introduction of a maximum cap of 5%, LSPs can no longer attract the financial backing of REs based on such unrealistic rates. This change also affects the risk exposure and credit management of LSPs. They are now obligated to display information about loan portfolios and DLG cover on their websites, following the directions of the REs.
These guidelines aim to bring LSPs under better control of REs and impose additional compliance requirements on the REs. From the perspective of LSPs, these provisions may appear to limit their actions and options in terms of DLG arrangements. However, taking a broader perspective, these guidelines aim to establish a more regulated and improved system for DLG arrangements.
C. Implications for the Borrowers
The guidelines outline that parties involved under DLG arrangements can be either REs or LSPs incorporated as companies under the Companies Act, 2013, the objective behind such arrangement is to safeguard borrowers’ interests by preventing malicious third-party LSPs engaging or participating in DLG arrangements or operating as LSPs in digital lending, to restrict any unlawful gathering of borrowers’ financial records in digital lending. This ensures the protection of borrowers’ personal data and privacy.
Additionally, the guidelines set a maximum cap on FLDG, which reduces the costs borne by LSPs in maintaining guarantees in the form of deposits for REs. Principally, these costs are passed on to the borrowers through higher interest rates. However, by limiting the FLDG cap, the interest rates indirectly decrease for loans provided under the FLDG.
The guidelines also emphasize the protection of borrowers' interests by ensuring grievance redressal in line with the "Guidelines on Digital Lending" and other regulatory provisions. These include regulations for fair practices codes, such as the "Master Circular on 'Loans and Advances" for banks, and the "Ombudsman Scheme for Digital Lending, 2019," which establishes an effective and responsive framework for the Ombudsman system.
Both the REs and LSPs are responsible for adhering to these guidelines. These guidelines not only provide banks with a framework for issuing bank guarantees and determining conditions for specific institution advances, but they also establish regulatory restrictions and procedures for implementing a grievance redressal mechanism.
Conclusion
The RBI’s Guidelines on DLG bring positive changes to the regulatory landscape of DLG arrangements. With a maximum cap on guarantee rates, legally enforceable contracts, and stringent compliance requirements, the guidelines enhance the security and transparency of DLG arrangements for lenders, Loan Service Providers (LSPs), and borrowers. Lenders benefit from better risk management and asset classification, while LSPs are regulated and provided with a more realistic framework. Borrowers, on the other hand, gain protection against malicious LSPs and enjoy reduced costs through capped guarantee amounts. Although the guidelines limit the arrangements entered for the purpose of guarantee in the digital lending sector, they overall establish a regulated and improved system, safeguarding the interests of all stakeholders in the digital lending space.
*Bhavesh Ambadkar and Naman Kothari are fourth year students at Government Law College, Mumbai at the time of publication of this blog.
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