The Reserve Bank of India (RBI)‘s circular on first loss default guarantee (FLDG) can help expand the digital lending ecosystem, according to an India Ratings and Research report. The FLDG norms will also increase participation of potential players in digital lending, which could increase the business sustainability of these lending service providers, and increase competition within the segment.
The credit agency expects the profitability of originators to improve by 5-15% of the portfolio subject to originator-partner relationship. However, this would depend on the nature of the relationship.
The RBI earlier this month issued a circular permitting FLDG agreements between lending service providers and regulated entities. Under such an agreement, a third party guarantees to compensate up to a certain percentage of default in the loan portfolio of regulated entities. It has also recommended a 5% cap on explicit and implicit guarantees.
“The circular provides clarity on the shape and form of FLDG that the digital lenders/originators can provide to its partners/co-lenders and can improve the economics and working capital management of the business for originators,” the report said.
While the RBI had not explicitly asked regulated entities to provide or accept FLDG, it was frowned upon by the central bank. The central bank’s move will enable digital lenders to participate in the lending ecosystem as loan originators even if they do not have an NBFC licence.
While many banks had stayed away from partnerships with digital lenders due to a lack of clarity on default loss guarantee, they can now partner with originators and this will help widen competition in the digital lending ecosystem. Hence, the pool of willing partners would also expand, the report said.
The onus of assessing the originator and its ability to honour the guarantees would be proportional to the portfolio attributed between the originator and the partner. This implies that originators would want to prove themselves credit-worthy and hence need equity and could tweak their business model to deliver material profitability for themselves.
“If the originators and partners chose to move to a loss default guarantee model, they may need time to rework the contracts,” the report said. “At the same time, there could be some players who may need to strengthen their balance sheets, etc, so that they are in a position to provide guarantees. This could result in a slowdown in disbursements of such entities in the intermediate period.”