By Sameer Shetty
Last month, RBI’s working group on digital lending released a set of recommendations and suggestions that lay down principles for regulation of the digital financial services sector. The digital lending space has grown 12X between FY17 and FY20, as per RBI data. A slew of digital lending apps that have emerged are not regulated by RBI. They typically partner with banks or NBFCs to offer loans, but in some cases, offer it through their own balance sheets. Today, consumers can get a loan on almost any app that they use—e-commerce, food delivery, cab aggregators, etc. Further, the loans are available instantly, on three clicks. While the ubiquitous availability and ease of availing the loans have dramatically increased penetration of these loans, they pose several challenges. These include overleveraging of customers, usurious rates, collection methods not in line with regulatory prescriptions, regulatory arbitrage, etc.
The working group’s report addresses these and other issues in a holistic manner and establishes a framework for growth of the sector. While there is a large list of recommendations and many nuances, eight areas stand out:
First, the report creates a clear distinction between Balance Sheet Lenders (BSLs) and Loan Service Providers (LSPs). BSLs are entities that can give out loans and take credit risk; only regulated entities can be BSLs. LSPs may be digital apps or other ecosystem players, who offer borrowing options to customers. LSPs need not be regulated entities, but they cannot lend on their own and need to necessarily partner with regulated entities. LSPs manage the customer front-end and experience, BSLs book the loans and manage risk and regulatory compliance. This segregation of roles allows the industry to innovate and evolve and at the same time ensure regulatory compliance and oversight.
Second, the report recommends against allowing backdoor entry into regulated activities, via a ban on the First Loss Default Guarantee (FLDG) instrument, which allowed unregulated entities to take credit risk and offer loans to customers. Equally important, it holds that credit risk taking can only be allowed with regulated entities. This will pose existential challenges for a number of new age lenders, whose business models were built on shadow lending. In addition to FLDGs, the report calls for checks on lend-a-balance-sheet models, and also asks to set clear direction via regulations for neo-banking and decentralised finance(DeFi) models as well.
Third, the report calls for eliminating regulatory arbitrage. The key recommendation here is that all products with credit risk involved are recognised as lending products. As an example, many Buy Now Pay Later (BNPL) providers do not treat BNPL as a loan. As a result, they do not follow KYC procedures while onboarding customers, do not check with the credit bureau and do not report to the bureau. The report calls for such products to be identified as lending products and following necessary checks.
Fourth, the report calls for several actions to be taken to ensure consumer protection. The report asks institutions to include all interest and charges paid as Annual Percentage Rate (APR), which needs to be communicated to the customer transparently. Currently, lending rates and charges on digital apps can cumulatively add to over 100% in some cases. Rates of 40-45% are quite normal. A large portion of this is charged as fees, which makes the interest rate look more palatable. The report recommends that Short Term Consumer Credit (STCC) be brought under appropriate guidelines similar to that of governing MFIs, to prevent usurious rates. In fact, for certain categories of very short term and non-instalment loans, the report suggests that RBI should restrict such products. There are other recommendations on reducing over-indebtedness, restricting refinancing etc, all of which will significantly add to consumer protection.
Fifth, the fair treatment of borrowers takes centre-stage. The working group has recommended that the regulated entity associated with the LSP should ensure that the LSP follows a set of criteria that ensure fair treatment of borrowers, particularly around practices in collections. Given the instances of coercive behaviour shown in collections by digital apps, this will come as a confidence booster to customers and the ecosystem.
Sixth, the working group has laid out some fundamental principles around data and data privacy. The broad approach is to identify the consumer as the owner of the data, and not the entity. One of the areas identified is the need to get explicit consent from customers before using their data for making lending decisions. So, if you bought something on your favourite e-commerce platform, the platform will need to take your explicit consent before using this data to make an underwriting decision. Similarly, today unregulated entities can get access to customers’ credit bureau information by asking them to check their scores via their apps. The report makes it clear that such access can only be provided to regulated entities. It also lays out the need to create rules on what data can be used for which purpose and for what time duration. These recommendations will help enhance overall security of data and consumer trust.
Seventh, the report calls for the creation of a Self-Regulatory Organisation (SRO) to frame standards and govern activities in the space. It also recommends creating the Digital Trust of India Agency (DIGITA), which will inter alia set up the minimum technical standards and verify compliance. Apps not carrying a verified signature by DIGITA will be considered non-compliant from a law enforcement perspective. The report also calls for a law banning unregulated lending activities. There is a recommendation for RBI to introduce an Agency Financial Service Regulation (AFSR) that will set a framework for all customer-facing and fully outsourced activities of regulated entities. These formal mechanisms will give teeth to the intent of the report.
Last, the report highlights few areas that need to be further looked into from a regulatory perspective. One such area is the role of Big Tech in financial services and the risk, regulatory and compliance challenge that it brings. Overall, the report takes a balanced view of this sector, while calling for specific regulatory interventions to reduce concentration risk and eliminate regulatory arbitrage. It also calls out issues such as unfair competitive advantage through access to data, potential for cross-subsidisation etc. Moreover, the report highlights neo-banking and DeFi. These two areas are witnessing activities similar to digital lending, but do not fall under any specific regulatory framework. Finally and critically, the report also talks about introducing digital-only banks and NBFCs.
In summary, the digital lending report provides a balanced framework encouraging innovation, protecting consumers and minimising risks to the financial system. A framework of this nature is critical for the industry to grow and thrive at scale. There are many nuances that will get debated and clarified over time; however, this report is a seminal one and will likely lay the groundwork for the future of digital financial services in India.
The author is President & head (Digital Business & Transformation), Axis Bank. Views are personal