The Reserve Bank of India ("RBI") has provided a much-needed fillip to the digital lending sector with its latest Guidelines on Default Loss Guarantee ("DLG") in Digital Lending ("Guidelines") on June 8, 2023. The Guidelines regulate DLG arrangements, commonly known as FLDG (First Loss Default Guarantee) in the industry.
A regulated entity, i.e., bank or NBFC ("RE") is now allowed to enter into arrangements with a lending service provider (an unregulated fintech, with whom the RE has an outsourcing arrangement) or another RE, to obtain a guarantee to compensate the RE on account of default in the loans provided by the RE, for a percentage of the loss.
The key fetters placed on such DLG arrangements are as follows:
Cap on DLG
The total amount of DLG cover on any outstanding portfolio specified upfront is capped at 5% of the amount of such loan portfolio. This also includes arrangements involving implicit guarantee linked to performance of the RE's loan portfolio specified upfront.
Form
DLGs can only be collateralized in the form of cash deposited with the RE, fixed deposits (with scheduled commercial banks) with lien in RE's favour or bank guarantees in RE's favour.
Invocation
The RE is required to invoke the DLG within a maximum overdue period of 120 days, unless the borrower itself makes good the default before invocation.
Tenor
The DLG agreement must remain in force for a time period at least as much as the longest tenor of the loan in the underlying loan portfolio.
Disclosures
REs are required to establish a mechanism to ensure that LSPs providing DLG publish: (a) total number of portfolios, and (b) respective amount of each portfolio on which DLG has been offered, on their websites.
Due diligence
REs must put in place a Board approved policy for entering into any DLG arrangement, which must deal with aspects such as eligibility criteria for DLG provider, nature and extent of DLG cover, monitoring and review process, etc.
The RBI has expressly clarified that DLG arrangements should not be a substitute for credit appraisal requirements and robust credit underwriting standards.
The guidelines are definitely a step towards an orderly development of the digital lending space and enhancement of credit penetration through digital lending. It remains to be seen whether the limited ability of REs to rely on DLG owing to the 5% cap will bolster the space and to what extent.
Originally published 9 June 2023
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