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Solving the Conundrum of Default Loss Guarantee in Digital Lending Space: A Great Route for FinTech.

Updated: Feb 9

by Pranav Sethi *


Introduction

On June 8, 2023, the Reserve Bank of India (RBI) released the new ‘DLG Guidelines’ (Guidelines on Default Loss Guarantee in Digital Lending), addressing concerns regarding loss-sharing agreements that arose after the issuance of the ‘Digital Lending Guidelines’ on September 2, 2022. Although the Digital Lending Guidelines did not explicitly prohibit regulated entities (REs) and fintech entities from entering into loss-sharing arrangements, they recommended that REs comply with RBI's securitization norms. This particularly emphasized adherence to securitization norms concerning ‘synthetic securitization’, which was deemed as a complex structure. It's worth noting that synthetic securitization, like any financial technique, comes with certain complexities and risks. It requires a thorough understanding of the underlying assets, careful selection of appropriate credit derivatives or guarantees, and proper risk management practices to ensure the intended risk transfer is achieved effectively.


The RBI expressed its aim to introduce the First Loss Default Guarantee Guidelines (FLDG) in its ‘Statement on Developmental and Regulatory Policies’ issued on June 8, 2023. The objective is to maintain a balance between promoting innovation and ensuring prudent risk management. The FLDG Guidelines establish a framework that allows REs and fintech entities to engage in loss-sharing agreements or default loss guarantees (FLDGs). Compliance with the FLDG Guidelines ensures that such FLDG arrangements are not classified as ‘synthetic securitization’ or regarded as a form of ‘loan transfer/participation’ (which is restricted for non-REs).


What are exactly Regulated Entities ?

Regulated Entities means all banks authorized under Section 22 of the Banking Regulation Act, 1949, including Scheduled Commercial Banks (SCBs), Regional Rural Banks (RRBs), Local Area Banks (LABs), all Primary (Urban) Co-operative Banks (UCBs), State and Central Co-operative Banks (StCBs/CCBs), and any other licensed banking entities will be collectively referred to as banks. Also, it includes pre-paid instruments issuers and non-banking financial corporations (NBFCs).


Justification and Eligibility Criteria to be met


A Default Loss Guarantees (DLG) refers to a contractual agreement between a RE and another party, wherein the latter assures to provide compensation to the RE for losses incurred due to defaults, up to a predetermined percentage of the RE's loan portfolio. Such an arrangement explicitly covers any implicit guarantees associated with the performance of the RE's loan portfolio, as long as they are specified upfront.


The Guidelines apply to all DLG agreements established in connection with Digital Lending operations (as defined in the DL Guidelines) conducted by Commercial Banks, Primary (Urban) Co-Operative Banks, State Co-operative Banks, District Central Co-operative Banks, and even on Non-Banking Financial Companies.


Maintaining a Balance of Risk

The DLG Guidelines set specific guidelines for the duration and extent of DLG arrangements. The duration of a DLG contract should be equal to or greater than the longest period of the loans in the original loan portfolio. Furthermore, the overall DLG coverage for any outstanding portfolio should not surpass 5% of the loan portfolio's value. When it comes to implied DLG arrangements, the qualified DLG Provider should avoid taking on a performance risk that goes beyond 5% of the underlying loan portfolio. These requirements aim to achieve a balance by providing REs with a reasonable level of assurance through the parallel duration of DLG and ensuring that the highest credit risk associated with the loan portfolio remains with the REs.


Invocation of DLG and Categorization of Non-Performing Assets

The DLG Guidelines necessitate financial institutions to activate a DLG within a maximum duration of 120 days once the loan becomes outstanding. This requirement remains unchanged even if the institution categorizes the loan as a non-performing asset (NPA) according to existing regulations within the specified time frames. The institution bears the responsibility of identifying individual loans within the portfolio as NPAs and adequately making provisions for them, regardless of the presence or activation of a DLG. It is also stipulated that if the borrower repays the loan subsequent to the activation of the DLG by the institution, the repaid amount may be shared with the DLG provider.


Benefit of Guarantee Arrangements

Capital relief can be obtained for loans covered by guarantee arrangements under the existing regulations for calculating regulatory capital. Under capital relief, banks can utilize the capital markets to mitigate certain risks by purchasing credit protection for a bundle of loans. This transaction effectively safeguards a portion of the risk linked to the loans, consequently decreasing the mandatory regulatory capital that banks need to reserve for these loans.


Certain financial institutions are eligible to claim this relief when a loan is backed by a guarantee, which is considered a form of credit risk mitigation. The recently issued DLG Guidelines clarify that these regulations will still apply to individual loans in a portfolio. The Reserve Bank of India (RBI) implies that while guarantee arrangements might be able to cover the entire loan portfolio and capital relief can be claimed by rounding off the guarantee cover on a per-loan basis in proportion to the overall portfolio. Provided that the guarantee meets as per the kind of guarantee and coverage been considered as per the requirements outlined in the existing norms.


Due-Diligence Exercise Importance

While entering into a DLG agreement, it is a pre-requisite that the RE must undertake due diligence. Firstly, it involves establishing a policy approved by the Board that outlines the criteria for selecting a DLG provider, the scope of DLG coverage, and the procedures for monitoring and reviewing the DLG arrangement. In the second stage the RE must implement rigorous credit appraisal requirements and credit underwriting standards. At the third stage it is essential to conduct sufficient due diligence on the DLG provider to ensure their capability to fulfil the DLG obligations.


Additional Explanation and Clarity Required on Other Aspects

Although the FLDG Guidelines offer a certain level of clarity, certain aspects might necessitate additional examination by stakeholders in the industry.

i. Invocation Duration

The rationale for the 120-day duration for invoking remains ambiguous. Additional guidance from REs is required to determine if the invocation process from the FLDG will align with the REs' established standards for categorizing assets. Specifically, it is important to comprehend how the invocation triggers will function in relation to the REs' practices and policies regarding the resolution of distressed assets.

ii. Possibility of Loan Transfer Structure

The FLDG Guidelines explicitly state that FLDG arrangements cannot be used to shift the loan exposure from the books of the RE to the lending service provider (LSP). To put it differently, there should be no escaping from the loan exposure transfer regulations established by the RBI. However, if fintech players have their own REs (such as a wholly-owned NBFC), there might be some opportunity to structure FLDG arrangements in combination with a loan transfer framework that complies with RBI regulations. This would involve the fintech players' RE in the loan transfer structure.

iii. Fintech Companies Must Ensure Adequate Cash Reserves

In the past, FLDG structures could be established through contractual corporate guarantees. A corporate guarantee is an agreement between a corporate entity or an individual and a borrower. In this agreement, the guarantor agrees to assume liability for the borrower's commitments, such as repaying a debt. When a company guarantees the repayment of a loan given to one of its subsidiaries, the individual who signed the contract ensures that the loan will be paid back in case the subsidiary fails to do so.

However, due to the implementation of the FLDG Guidelines, the options for providing FLDGs are now limited to actual cash deposits, fixed deposits with a lien, and bank guarantees. These options require fintech players to invest cash up-front and continually add more funds as the portfolio size grows. For fintech companies, which are typically technology-focused entities with minimal assets, the FLDG Guidelines will increase the strain on their limited cash resources. Additionally, complying with the guidelines and maintaining sufficient reserves will create additional compliance and accounting challenges. Fintech players, especially newer ones, may not currently have the necessary financial controls in place, and these arrangements will undoubtedly attract scrutiny from regulatory entities and investors.

iv. FLDG Coverage Potential

The maximum limit of 5% of the overall loan portfolio might hinder the efforts of LSPs aiming to promote lending products extensively to their users. It is possible that the more watchful and alert REs may be careful when it comes to establishing relationships with customers acquired through LSPs / DLAs. However, this could also promote improved methods of assessing credit risk and encourage LSPs / DLAs to create more effective criteria for selecting and identifying potential customers. This, in turn, could benefit the long-term stability of the financial services sector.


Critical Analysis and Opinion Elaborated

The FLDG Guidelines offer much-needed clarity to the fintech sector, which has been struggling with uncertainty regarding FLDG measures since the introduction of the Digital Lending Guidelines. The RBI's objective is to strike a balance between fostering innovation and managing financial risks. Consequently, the FLDG Guidelines have separated the responsibilities of the RE and the LSP, emphasizing that the RE is accountable for maintaining a robust customer verification and credit risk underwriting system. The guidelines also prevent the RE from evading prudential norms and Credit Risk Mitigation (CRM) measures. Additionally, this ensures that LSPs cannot indirectly participate in loan exposures and engage in off-balance sheet lending. Essentially, while FLDGs are permanent fixtures, they are not permitted to assume the credit risk of the RE.


However, the aspect where the FLDG Guidelines lack clarity is in identifying the appropriate entity that would meet the requirements to become an FLDG provider. While the responsibility of determining eligibility criteria has been delegated to the REs, there is a high probability that REs may adopt a cautious approach when forming partnerships with fintech companies, taking into account FLDG considerations. Furthermore, it is probable that the RBI will also promote a robust selection process for fintech partners by the REs, ensuring a rigorous verification process. In the future, we anticipate a growing consensus on how REs will establish eligibility criteria for LSPs to offer FLDGs, as well as the structure of FLDG contracts. It is essential to avoid excluding new and innovative LSPs, including early-stage ventures, due to technical barriers.


Conclusion

The introduction of the DLG Guidelines is a positive move in allowing FLDG agreements by LSPs, addressing many concerns about the future of this sector. While the maximum limit set for FLDG exposure seems to be lower than the industry norm, it demonstrates the RBI's efforts to maintain a balance. In its role as a regulator in the financial sector, the RBI has made efforts to strengthen measures against certain exploitative arbitrage, aiming to maintain transparent management and safeguard the digital lending ecosystem from potential risks. However, despite these efforts, certain ambiguous aspects still exist, and it remains to be seen if the RBI will release some frequently asked questions or any detailed notification to provide clarity on various operational matters.


The RBI aims to ensure that the REs bear the systemic risks associated with these arrangements while placing the primary responsibility on the REs to comply with regulations, provision assets, protect customers, and implement protective measures related to credit underwriting.


*Pranav Sethi is a fourth year student at SVKM NMIMS School of Law , Navi Mumbai at the time of publication of this blog.

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