Regulating digital lending

Implementing the recommendations in the recent report of the RBI working group on digital lending could lead to consolidation in the space. Technology intermediaries and smaller platforms will likely be more affected than the licensed larger NBFC players

The report makes the important point that the digital lending sector has evolved to a point where there is now a regulatory gap that needs to be plugged with laws that address issues specific to digital lending.
The report makes the important point that the digital lending sector has evolved to a point where there is now a regulatory gap that needs to be plugged with laws that address issues specific to digital lending.

By Shilpa Mankar Ahluwalia

Certain “bad practices” in the digital lending ecosystem linked to unauthorised use of data and intrusive recovery practices prompted RBI to constitute a Working Group on Digital Lending that recently released its report. While lending in India is closely regulated, digital lending is not. The report makes the important point that the digital lending sector has evolved to a point where there is now a regulatory gap that needs to be plugged with laws that address issues specific to digital lending. A central theme has been consumer protection.

Only licensed players can lend: The report outlines a clear road map of how to regulate the sector. The market can broadly be categorised into two sets of players—the licensed entities (mostly NBFCs) that have the regulatory capability of lending on their balance sheets; and the non-regulated technology intermediaries that assist with customer acquisition, credit risk analytics and developing customised credit solutions. The report highlights “renting an NBFC” or off-balance sheet lending models as an area of concern. Several digital lending products today are based on models where non-licensed entities provide some form of credit support such as first loan default guarantees and assume part of the credit risk of the loan without having to comply with any regulations that would typically apply to lenders (such as allocation of regulatory capital and exposure norms). It asserts that all lending (such as several of the buy now pay later products) must be done only “on balance sheet” by licensed entities. This will be a game changer for the digital lending ecosystem and trigger a “re-invention” of several credit products modelled on credit underwriting by non-licensed technology platform which essentially gives licensed lenders the confidence to lend to some of these segments.

Credit risk analytics: One of the key strengths of digital lending apps is that they use alternative datasets to generate credit scores and make credit decisions. While credit scoring by bureaus relying on historical financial data is a highly regulated activity, data analytics and credit assessment by digital lending applications is largely unregulated. Several loan models rely on AI and algorithms to analyse and price credit risk. Such algorithms, the report notes, should disclose their underlying rationale, embed ethical AI and be auditable. This will not only give consumers access to their credit underwriting data and analysis but also require technology platforms to disclose and defend credit underwriting strategies.

Are we headed towards interest rate caps: Transparency in process and pricing should be mandated in the interest of consumer protection. It is in this context that the report discusses the concept of an annual percentage rate (APR) that includes interest rates and all other costs associated with a loan to prevent over-charging by way of “hidden costs”. The digital lending industry has been concerned about possible interest rate regulation. The report recognises that RBI has generally tried to stay away from interest rate caps, which can tend to exclude certain sections of high-risk borrowers. However, it does talk about the “need to bring in” interest rate regulation. Generally, transparency in pricing is a preferred methodology to interest rate regulation which could have serious
implications for the sector.

SRO will play a central role: The constitution of a self-regulatory organisation (SRO) among digital lending players is a key recommendation in the Report. This is likely linked to the fact that in a sector where technological changes are rapid, an SRO is well-positioned to understand the risks of newer business models, develop best practice codes that are aligned with market practice and assist with soft enforcement. The report notes that the SRO should evolve codes of conduct for all participants, develop standardised contracts, build a model to calculate APR, prescribe and monitor technology standards that ensures security of mobile based apps, and institutionalise a consumer redressal mechanism.

Separating the good from the bad: One of the most challenging aspects of regulating the digital lending sector will be to effectively filter out illegal digital lending apps. Partnerships with application stores will be critical. RBI may not be equipped to monitor this which is probably why the report has recommended the constitution of a nodal agency to verify a digital lending app before it can go live. Processing delays, however, could be a serious risk with this approach.

What next?
The sector will need to “wait and watch” to see what form the final law takes, but the report gives useful insights into the kinds of areas that are likely to be regulated. The technology intermediaries and smaller platforms will likely be more affected than the licensed larger NBFC players. As costs of compliance increase and certain business models become unviable, the sector may see some consolidation. The new regulatory framework will certainly improve standards of transparency & disclosure, prevent unfair lending practices and give borrowers greater control over their data. The key question will be whether the law is able to strike the right balance between promoting innovation and protecting consumer interest.

The author is Partner & Head (Fintech), Shardul Amarchand Mangaldas & Co

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