First Loss Default Guarantee: Settling the Disquiet in the Fintech Sector

The Reserve Bank of India (“RBI”) issued Guidelines on Default Loss Guarantee in Digital Lending on 8th June 2023, to give a green signal to Default Loss Guarantee or First Loss Default Guarantee (“FLDG”) arrangements between Banks or Non-Banking Financial Companies (“Regulated Entities” or “RE”) and Lending Service Providers (“LSPs”) (typically a Fintech entity). This was a progressive step towards the Fintech sector and guarding the interests of the stakeholders involved in the transaction.

In this blog, the author will discuss the impact of RBI’s guidelines on Fintech’s future and some critical issues involved in the said guidelines.

FLDG Model

Traditionally, banks and other financial institutions were the main source for financing the entities and individuals, but due to the advent of new digital intermediaries such as Fintech companies, the digital lending models have evolved drastically. Since these Fintech companies or LSPs cannot lend money on their own due to want of necessary funds and RBI licenses, they enter into a partnership arrangement with financial institutions and act as an intermediary between the customers and banks.

Banks tend to be cautious while lending because of their biggest fear i.e. Non-performing assets (“NPA”), Fintech companies promise to share risk with the banks when a borrower defaults in loan repayment. Such surety provided is Fintech Companies are known as First Loss Default Guarantees. FLDG is an arrangement between the REs and LSPs or any other FLDG provider, whereby the LSPs agree to absorb the initial financial impact if the borrower makes any default in the repayment of the loan. LSPs guarantee to reimburse the REs for a predetermined percentage of the RE’s loan portfolio. These FLDG models are available in various formats, including funded risk involvements through – cash deposits, or unfunded risk involvement through corporate or bank guarantees, or a combination of both.

Earlier the extent of risk involvement was determined through mutual agreement between LSE and RE, based on factors like lending sectors, LSP’s credibility, market reputation, and more. Although the FLDG was seen as a positive step towards credit penetration, its vulnerability due to its unregulated nature and structural issue raised major credibility concerns.

RBI’s Approach towards FLDG

Due to the contractual nature of the FLDG model, the credit risk guarantees went up to 100% in some cases. This led to a major concern, as the Fintech companies were facing issues related to loan defaults due to limited capital resources and inefficient risk management. Moreover, the swift expansion of instant loan-providing Fintechs led to rise in unethical practices such as imposing high interest rates, data security issues and engaging in harassment of borrowers for repayment of loans. Since Fintechs are not regulated entities, RBI was not comfortable with the FLDG model. The apprehension on the part of RBI pertained to the ‘license rental model’ which involved shifting risk to unregulated Fintech entity in the guise of risk sharing. The regulator considered it as a very high risk model.

FLDG

[Image Sources: Shutterstock]

After analyzing all these issues, RBI in 2021 constituted the Working Group on Digital Lending through Online Platforms and Mobile Apps to delve into the matter. Based on the recommendation of the working group, RBI issued Guidelines on Digital Lending (“Guidelines”) in September 2022, imposing a complete ban on “Loss sharing/structured default guarantee arrangement” (FLDGs) by categorizing them as ‘synthetic securitization’, a prohibited arrangement under Paragraph 6(c) of the Master Direction- RBI (Securitization of Standard Assets) Directions, 2021.

This put the REs and Fintech Companies in a tight spot, many small Fintech companies vanished while others were trying to find alternatives to stay in business. The digital lending market witness the acquisition of various NBFCs by Fintech Companies such as BharatPe secured 51% stake in Trillion loans (NBFC), OHMY Technologies was acquired by Uni-Card (buy-now-pay-later entity). Similarly others came up with a performance guarantee model which was FLDGs dressed in a distinct guise. Hence in the absence of FLDG the digital lending industry was discovering their own construct, which was not acceptable by RBI as most of these alternative models were not in lines with RBI regulations.

Eventually, to clarify its stance on digital lending, RBI further issues an FAQ in February 2023. But FLDG remained a grey area until June 2023, when new guidelines were issued by RBI.

Revamped FLDG- New Guidelines

RBI decided to revisit the stringent Guidelines and tried to manage the balance the regulatory concerns and systemic risks associated with FLDG, while also fostering a strong lending ecosystem that encourages the development of innovative financial products and service.

The major highlights of the new guidelines are as follows;

  1. Cap of 5% – RBI introduced a risk sharing cap on total FLDG i.e. 5% of the amount of loan portfolio. The RE will be taking the hit beyond it. The LSP will have to secure its guarantee through cash deposit- fixed deposit or with bank guarantee in favor of RE.

(Issue)– RBI still needs to clarify whether the cap would be computed on total outstanding loan or unpaid amount or defaulted loan. This would help the statutory auditor while going through the financial report of the REs and LSPs.

Further, the cap of 5% does not align with the stance undertaken by the industry associations and other players in the Working Group Report of 2021. They suggested cap on FLDG to be around 15-20%. The current FLDG cap would not be beneficial for small LSPs. There is a scope of a ‘graded approach’ based on risk taking abilities and credit availability of the LSPs, to regulate the FLDG model efficiently.

  1. Legally enforceable contract– the arrangement between RE and LSP has to be a legally enforceable, and it shall explicitly lay down essential terms and structure of FLDG arrangement. Moreover the duration of the contract must be at least as long as the longest tenure of any loan with the underlying loan portfolio.

(Issue)– The current guidelines imposes strict disclosure mandates on LSPs by requiring them to reveal their FLDG involvements in all portfolios. Every time they want to create a default guarantee with a new financial institution, they must provide audited information on the guaranteed amount and default rates at other places. This would be a cumbersome procedure and would potentially influence competition among them.

  1. FLDG only limited to RE and LSP– the guidelines only permit REs and LSPs to enter into FLDG arrangements and LSP which is involved in digital lending has to be incorporated as a company.

(Issue)– The guidelines however do not address the issue of ‘co-lending’ between two regulated entities, where there can be a FLDG arrangement between a Fintech company with NBFC license and a bigger NBFC. Since such transactions are not prohibited by RBI, it remains as a grey area which needs clarification.

Further according to CRISIL report, the co-lending market is expected to witness a decline in sectors where FLDG is ‘relatively high’, as the industry adapts to new regulations. Lenders who provide funding may have to modify their business strategies to conform to the updated guidelines, which could involve setting higher minimum return rates for specific types of assets to counter the effects of FLDG cap.

Since FLDG enables Fintech (non-regulated entities) to collaborate with an RE in the lending program, this may be an issue as it allows NBFCs to expand their reach with non-regulated Fintech entities, which may not necessarily represent sound lending practices.

  1. No escape from Non-performing assets– The REs cannot exploit FLDG for covering up their NPAs. This means that when there is a default, the LSP will take the first hit and can pay off the outstanding loan. However, the account still remain an NPA until RE write-off the money or attempts to recover it in some other way. If recovery is successful, the RE must share the amount with the LSP.

(Issue)– The smaller NBFC will potentially face difficulties due to the NPA rule and the 5% risk cap. This would lead to increase of NPA accounts in the financial books of the REs which would eventually affect their position in lending as well as non-lending business. This could further pose a serious issue with the stock prices of listed NBFCs and banks. Although this can significantly boost the digital lending, where losses are relatively low. The banks and NBFCs must be vigilant about “evergreening”, i.e. borrowers repeatedly taking out additional loans to avoid being classified as NPAs.

Conclusion

According to State of The Indian Fintech Report 2023, the Fintech market in India is expected to reach around $2.1 Trillion by 2030 along with 18% compound annual growth rate from 2022. Since the Fintech market is expanding, it is necessary to regulate it, and FLDG guidelines is a much appreciated step taken by RBI. In comparison to its previous stance, RBI decided to regulate and control the Fintech industry with the help of FLDG guidelines. It comes as a breather for the Fintech industry as it offers clear guidance on interaction between REs and LSPs. RBI has definitely made efforts to regulate and strengthen its control over certain ‘opportunistic arbitrage practices’ in order to strengthen credit penetration and safeguard the interests of different players in the digital lending sphere. The aforementioned issues still remains in the black box, where clarity is required either by FAQs or notification issued by RBI.

Author: Arya Sharma, in case of any queries please contact/write back to us via email chhavi@khuranaandkhurana.com or at Khurana & Khurana, Advocates and IP Attorney.

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