By Srinath Sridharan
In recent times, banks’ and NBFCs’ work with app-mediated loans has attracted regulatory attention in India’s lending landscape. Concerns have been raised regarding the integrity of lending practices, with allegations of “renting out books” and inadequate risk assessment. The banking sector regulator’s (the Reserve Bank of India’s) worry stems from the potential creation of a large concentration of risk, as well as the lack of control over borrower cohorts.
The arrangement in question involves the Regulated Entities (REs)—NBFCs and banks—‘leasing’ their loan books to fintech companies, who then assume the responsibility of sourcing loans. App-based lending platforms, with their simplified approval processes and quick disbursements, have become popular among those seeking immediate access to credit.
In some cases, the fintech companies bear the losses associated with defaults, while the REs may neglect to thoroughly assess the risks involved. Against this backdrop, ‘first loan default guarantee’, or FLDG, was conceptualised as an arrangement between a fintech company and regulated entity (RE), wherein the fintech compensates the RE to a certain extent if the borrower defaults. Earlier, some of the REs were technically underwriting loans with up to 100% of default risk to fintech partners, leading to an imbalance in risk-sharing dynamics. The guarantees for loan defaults included opaque and illiquid guarantees. This practice had raised concerns regarding the integrity of the lending process, potential risk misalignment, and the absence of proper risk evaluation protocols. It was “lazy banking” in a manner of speaking—REs earning a net interest margin and showcasing higher assets under management without having to slog for it. Some of the smart REs worked with fintechs to learn the digital model for their credit process and rest of the consumer life cycle. For most of the fintech, it was a way to build traction and show increased loan volumes—leading to perhaps a higher platform valuation.
FLDG norms, as introduced by the RBI recently, allow lenders to partner with entities that provide a guarantee for a portion of the first loss on app-mediated loans. This guarantee (basis cash or liquid collaterals) is capped at 5% of the loan amount and serves as a safety net for lenders, mitigating the risks associated with defaults and providing them with a level of assurance. Under the FLDG guidelines, lending transactions are expected to occur directly between borrowers and the REs. This shift reduces the role of fintechs as intermediaries, as the focus shifts towards establishing a direct relationship between borrowers and lenders.
The implications of FLDG are multi-faceted. First, it strengthens the risk management practices of lenders in app-mediated lending, by encouraging them to reassess their consumer credit and collection processes and collaborate with entities that can offer a first loss default guarantee. This move promotes responsible lending and increases the likelihood of sustainable credit growth in the long run.
Furthermore, the introduction of FLDG by the RBI demonstrates the central bank’s commitment to protect the interests of borrowers and promote financial inclusion while maintaining the stability of the financial system. By encouraging lenders to adopt more prudent lending practices and ensuring a safety net against defaults, FLDG aims to safeguard consumers from predatory lending and unsustainable debt burdens.
The FLDG norms also expect the RE boards to be cognisant of their arrangements with fintechs. While many are bullish, one suspects that the anticipated increased credit deployment in areas like MSMEs, healthcare finance, education, amongst others, will happen only to the advantage of the REs. The fintechs will only source such loans with much trepidation. In the next few years, the REs would understand those segments better, own the consumer-connect directly. There lies another challenge for fintechs, as it creates a regulatory-led business-moat in favour of the REs.
For fintechs, FLDG will mean additional cost of loan sourcing, since the FLDG guarantee has to be in the form of cash deposited with the lender, fixed deposits maintained with a scheduled commercial bank with a lien in favour of the lender or a bank guarantee favouring the lender.
Fintechs that do not have their own NBFCs or those acting solely as digital sourcing agents face a diminished level of control over the lending process. This lack of control can limit their ability to offer personalised lending experiences, develop innovative loan products, or adapt quickly to changing market demands. As a result, the value proposition offered by fintechs, primarily centered around loan origination and customer sourcing, will be challenged. This change has concerns about the future viability of the fintech lending model in India. Banks and NBFCs are increasingly entering into co-lending and co-branded card partnerships, leveraging the technical capabilities of fintechs to enhance their service offerings. This strategic approach allows REs to tap into the fintech expertise while retaining a more significant share of the customer relationship. But at whose cost ?
Fintechs must consider alternative paths for their business models. One option to establish their own NBFCs, allowing them to engage directly in lending activities and maintain control over the customer relationship. This would require them to comply with the necessary regulatory requirements and build their lending capabilities, adding a new dimension to their operations. Operating as an NBFC brings with it a set of regulatory requirements that must be fulfilled.
Another viable path is for fintechs to pivot their focus and become standalone digital sourcing agents, serving as intermediaries between borrowers and REs. By leveraging their technological expertise, data analytics capabilities, and consumer networks, fintechs can assist REs in identifying and sourcing suitable borrowers. But, over the next 3-5 years, there would be enormous pricing pressures on such platforms, and their profitability (if not basic survival) might be under stress.
The pace of change in digital finance necessitates regulatory frameworks that can swiftly respond to emerging challenges. The recent introduction of the FLDG norm serves as an example. This rule, which did not require extensive developmental work, could have been implemented much earlier. Moving forward, regulatory bodies must adopt agile thinking to modify existing rules to effectively navigate the evolving landscape of digital finance. Just as technology platforms frequently update their apps, regulators cannot afford to rely solely on annual circulars; instead, they must proactively issue regulatory updates.
The larger message in this FLDG bottle is clear—only the REs will have the licence to lend. Fintechs wanting to lend have to embrace the “RRR”—risk, reward, regulation—framework of the RBI.
About the author: Policy researcher & corporate advisor
Twitter: @ssmumbai