There has been great excitement and a rush of positive sentiment among members of the fintech community (digital lenders), regulated lenders, and investors about the recently released Guidelines on Default Loss Guarantee (DLG) in Digital Lending which were issued by the Reserve Bank of India (RBI) vide its notification no. RBI/2023-24/41 DOR.CRE.REC.21/21.07.001/2023-24 dated 08th June 2023.
According to stock market reports, the share price of a listed operator of one of the largest fintech firms surged 3% on June 09, a day after the announcement was made, which hints positive potential of the policy development. Fintech lenders in India were dearly yearning for such a regulatory framework since 02 September 2022, after the RBI had released and specifically issued an advisory to the principal (regulated entities) with regards to loss-sharing arrangements with agents (digital lenders) to be considered synthetic securitization.
In the September 2022 guidelines, with regards to the First Loss Default Guarantee (FLDG) arrangements, RBI had advised regulated entities to adhere to the specific clause, after which, the facility of FLDG had suddenly become a taboo for the majority of regulated entities, consequently, Fintech Loan Service Providers(LSP) especially the smaller ones faced a season of funding winter.
What is First Loss Default Guarantee (FLDG) or Default Loss Guarantee (DLG)?
FLDG now referred to as DLG is an industry practice of offering financial products involving contractual agreements in which a third party guarantees to compensate up to a certain percentage of default in a loan portfolio of the Regulated Entity (RE). It is a common way of protecting the interest of lenders who lend money through intermediary organizations (lending fintech- LSPs) and the magnitude of cover depends on risk appetite of regulated entities (Bank/NBFC).
The FLDG acts as a demonstration of the fintech company’s competency in customer sourcing and servicing and ensures the fintech platform’s skin in the game. Guarantees are also used as a tool for a regulated lender to obtain additional credit comfort with respect to its participation in a loan portfolio.
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What does new DLGs mean for the ecosystem and who gains the most?
With the current guidelines, the industry sentiment is generally upbeat. Indian financial sector largely being regulation biased, FLDG facility will particularly encourage small start-up fintech players which were thus far sitting on the fence and waiting to enter into the business of lending.
The guidelines will facilitate the enlargement of the pie and once these small firms grow big enough, they can always move upwards in the regulatory ladder by choosing to adopt an NBFC form factor, making enough room for other small players to enter into the system and the cycle will continue. One way of looking at this transition is how it happened in the microfinance sector, the transition from NGOs to NBFCs to NBFC MFIs and Banks/SFBs.
What difference will DLG Guidelines make?
There are a few who have started asking this question more openly, what difference will DLG guidelines make in the digital lending ecosystem beyond removing entry barriers for fintech firms? To answer this question, one must examine the development from customer’s perspective. This means more credit deployment, especially for segments like MSME, Healthcare finance, funding into the education and into personal loan segments that too on an almost real-time basis.
The biggest benefit of the guidelines would be in terms of more innovative, customized financial products as per the requirements of end customers designed and delivered in a responsible manner. It will encourage more innovation both at the principal and agent levels. Another important change the guidelines will bring is more transparency into the system as now principal regulated entities must disclose publicly details about their partnership with LSPs and portfolios on which the guarantee has been offered.
Some Simmering Questions
The digital lending industry, although has welcomed the guidelines, however, off-late a few have been concerned about the quantum of the portfolio guarantee cap (up to 5%) as a little less for keeping the interest of principal REs intact in the partnership. There also seems some ambiguity regarding how the portfolio has been defined and the applicability of DLG in the case of revolving facility vs cohort facility of the pool.
Finally,
It is an open secret in the digital lending space that in the absence of the DLG guidelines a few regulated entities used to take up to 100% of default guarantee from partner fintech firms, which was a more of risk transfer to lending fintech by the principal regulated entity rather than risk sharing with fintech firm on the ground, which not all fintech firms could afford and it also tilted all due diligence and monitoring responsibilities practically to the partner fintech LSP entity.
However, a large percentage of the market still had the default guarantee in the range between 15-40% depending upon the size of the LSP the user experience, the capabilities of the LSP, and the level of trust, etc. The understanding and arrangements between the principal and the agent were more fluid and depended upon the comfort level of the regulated principal entity.
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With the new DLG guidelines, this subjectivity is expected to vanish and more structured agreements will take place. This will also put more responsibility on the principal lending partner to ensure deeper due diligence, ensure client protection avenues, and recurrent agent and portfolio checks, thus will reduce credit risk in the system.
While a big thanks to RBI for allowing DLGs, it needs to be seen how regulated principal entities uptake and respond to these guidelines and new partnerships are forged. This development brings in a new ray of hope and excitement and on-ground transmission of the policy decision and its impact on the market and customers needs to be seen now.
This column has been written by Prof Neelam Rani, Associate Professor at IIM Shillong, and Jatinder Handoo, a scholar at IIM Shillong.
Disclaimer: The views expressed in this article are that of the respective authors. The facts and opinions expressed here do not reflect the views of www.financialexpress.com.