(I) BACKGROUND
The Reserve Bank of India ("RBI") had, basis the recommendations of the Working Group on 'digital lending including lending through online platforms and mobile apps' ("Working Group Report"), issued a press release on August 10, 2022 ("Press Release") followed by the "Guidelines on Digital Lending" on September 2, 2022 (the "DL Guidelines"). Our detailed articles on the Press Release and Guidelines are available here and here.
One of the key changes introduced in the DL Guidelines was the restriction imposed on Regulated Entities ("REs") with respect to the acceptance of first loss default guarantees by REs, commonly known as 'FLDG' and to adhere to the provisions of Master Direction – Reserve Bank of India (Securitization of Standard Assets) Directions, 2021 dated September 24, 2021, especially, synthetic securitization contained in Para (6)(c).
This had created a lot of concerns owing to the prevalent nature of use of FLDGs issued by business correspondents to REs.
On June 8, 2023, the RBI issued the Guidelines on Default Loss Guarantees (DLG) in Digital Lending ("Guidelines") and in this update, we discuss the implications and restrictions set down by the recommendations which are being implemented immediately.
(II) APPLICABILITY & EFFECTIVE DATE
- The Guidelines are applicable to all DLG arrangements entered in relation to Digital Lending operations (as defined in the DL Guidelines) undertaken by (a) all commercial banks; (b) Primary (Urban) Co-Operative Banks, State Co-operative Banks, District Central Co-operative Banks; (c) Non-Banking Financial Companies (including Housing Finance Companies).
- The Guidelines are effective from the date of the circular i.e., June 8, 2023.
(III) KEY COMPLIANCES
Definition
A DLG would mean a contractual arrangement between an RE and any entity where such entity is guaranteeing to compensate the RE for any loss due to default of up to a certain percentage of the loan portfolio of the RE, which is specified upfront. This would also include any implicit guarantee of a similar nature linked to the performance of the loan portfolio of the RE and specified upfront will also be considered as a DLG.
Eligibility
It has been clarified that REs can enter into DLG arrangements only with their outsourcing partners whether LSPs or REs. The LSP who is providing a DLG would need to be incorporated as a company under the Companies Act, 2013.
Structure and Limits of DLG
An RE can accept DLG in one or more of the following forms:
- Cash deposited with RE
- Fixed deposits maintained with a scheduled commercial bank with a lien marked in favour of RE.
- Bank guarantee in favour of RE.
The total amount of DLG cover on any outstanding portfolio which is specified upfront should not exceed 5% (five percent) of the amount of that loan portfolio.
For implicit guarantee arrangements, the DLG provider should not bear performance risk of more than the equivalent amount of 5% of the underlying loan portfolio.
The time period for the DLG cannot be less than the longest tenor of the loans in the underlying loan portfolio.
DLG Arrangements
The Guidelines require that all DLG structures be backed with explicit legally enforceable contract, which should contain certain specific details like (a) extent of DLG cover; (b) form in which DLG cover which is required to be maintained; (c) timeline for DLG invocation; and (d) necessary disclosures as set out in the Guidelines.
Invocation of DLG
The RE can invoke the DLG within a maximum overdue period of 120 days, unless made good by the borrower prior to such date. The amount of DLG invoked cannot be set off against underlying individual loans. In case of recovery by RE of any amounts of the underlying loans which have been invoked and realized, such amounts can be shared with the DLG provider, basis the DLG arrangement.
The NPA classification and consequent provisioning would continue to be the responsibility of the RE as per the relevant RBI regulations. The intent of this is not clear as to whether the underlying loan classification and provisioning obligation will continue irrespective of invocation of DLG.
Disclosures and other requirements.
The following disclosures and other compliance requirements would need to be adhered to by the REs:
- RE would be required to ensure that the LSP publish on their website the total number of portfolios and respective amount of each portfolio on which DLG has been offered.
- RE would need to have a board approved policy which should include (a) eligibility criteria; (b) nature and extent of DLG cover; (c) process of monitoring and reviewing of DLG arrangement; and (d) details of fees payable to the DLG provider. This policy is required to be in place before entering into any DLG arrangement.
- RE should ensure that when a DLG arrangement is being entered into/ renewed, RE obtains adequate information to satisfy themselves on the ability of the DLG provider to honour the same. For this, the RE should obtain a declaration from the DLG provider duly certified by the statutory auditor regarding (a) aggregate DLG amount outstanding; (b) number of REs and number of portfolios against which the DLG has been provided; (c) past default rates on similar portfolios.
Continued responsibility of REs
The Guidelines clarify that availing DLG cover by REs would not be construed as a substitute for credit appraisal requirements and credit underwriting standards, which requirements need to be continued to be complied with by the REs. Also, the capital computation on individual loan assets in the portfolio would continue to be governed by existing RBI norms.
(IV) CONCLUSION
The introduction of the Guidelines has come as a welcome relief to the fintech players and REs offering clarity and concrete guidance on the eligibility and terms of the FLDGs.
Having said that, the devil is always in the detail – the manner of operationalizing and interpreting the 5% threshold limit is going to be critical for the REs.
The intent, however, of the RBI has been put forth eloquently – primarily that unregulated entities providing balance sheet leverage, which is not backed up with an identified pool of assets is untenable and not permitted. On a macro level, this is also to ensure the economic stability of the markets and safeguard that all liabilities of an unregulated entity are crystallized and identifiable.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
