Posted by : Ashi Atre FIRST LOSS DEFAULT GUARANTEE GUIDELINES
Several years ago, when India’s fintech boom started, companies rapidly understood that lending was the only way they would generate money. Interest and late fines were both quite profitable. But before they could lend, they needed approval from the RBI and RBI has a high level of conservatism, a “license to lend” was hard to come by.
As a result, fin-techs decided to simply enter partnerships with established players. They became an agent of sorts). These fintech startups would do the hard work of acquiring or sourcing potential customers, run checks and use technology to scan through the customers’ transaction history to determine if they’re creditworthy. And then, they’d pass along the details to the partner NBFC or bank. In return, they’d pocket a nice commission.
Some fin-techs offered to guarantee default rates of up to 100% when they referred consumers to banks or NBFCs. The fintech would bear the loss for up the entire or significant amount of defaults if they obtained loans from the NBFC. That was the ‘first loss’ that was guaranteed. They wished to convey to the NBFCs that they had carried out their due diligence and had faith in their procedure.
But what happens when things don’t go well? What if banks and NBFCs turn lax when lending, considering the FLDG protection? What if the fintech company goes bust? And what happens when fin-techs begin losing money and try to compensate for it by passing on most of their costs to the customers? Who bears responsibility then? The RBI realised that it would struggle because these fintech companies aren’t regulated by them. And, the fintechs were sidestepping the regulatory scrutiny by not taking an NBFC license themselves but still operating in the lending business. So, you can see why the central bank was skeptical of the whole scenario.
FLDGS have since been examined by the Bank and it has been decided to permit such arrangements subject to the guidelines laid down in the recent notification of the RBI, dated 8th June, 2023.
The RBI, in its recent notification, has defined a Default Loss Guarantee (DLG) as a contractual arrangement between the Regulated Entity (RE) and an entity meeting the criteria laid down for it qualify as an LSP or other RE with which it has entered into an outsourcing (LSP) arrangement, under which the latter guarantees to compensate the RE, the loss due to default up to a certain percentage of the loan portfolio of the RE, specified upfront. Any other implicit guarantee of similar nature linked to the performance of the loan portfolio of the RE and specified upfront, shall also be covered under the definition of DLG.
RBI also provides that the DLG arrangements must be backed by an explicit legally enforceable contract between the RE and the DLG provider. Such contract, among other things, must contain the following details:
- Extent of DLG cover
- Form in which DLG cover is to be maintained with the RE
- Timeline for DLG invocation
- Disclosure requirements wherein the RE shall ensure that LSPs with whom they have a DLG arrangement shall publish on their website the total number of portfolios and the respective amount of each portfolio on which DLG has been offered.
Further, RE shall accept DLG only in one or more of the following forms:
- Cash deposited with the RE
- Fixed Deposits maintained with a Scheduled Commercial Bank with a lien marked in favour of the RE
- Bank Guarantee in favour of the RE
One of the critical changes implemented by the RBI is the application of a cap on the percentage of FLDGs. As per the notification, RE shall ensure that total amount of DLG cover on any outstanding portfolio which is specified upfront shall not exceed 5% of the amount of that loan portfolio, including a situation of an implicit guarantee arrangement.
Also, Recognition of NPA and consequent provisioning shall be the responsibility of the RE irrespective of any DLG cover available at the portfolio level. The amount of DLG invoked shall not be set off against the underlying individual loans. Recovery by the RE, if any, from the loans on which DLG has been invoked and realised, can be shared with the DLG provider in terms of the contractual arrangement.
The RBI has also explained that the RE shall invoke DLG within a maximum overdue period of 120 days, unless made good by the borrower before that and the period for which the DLG agreement will remain in force shall not be less than the longest tenor of the loan in the underlying loan portfolio. Furthermore, REs shall perform a proper due diligence before entering a DLG arrangement, for instance, they shall put in place a Board approved policy before entering any DLG arrangement and obtain adequate information to satisfy itself that the entity extending DLG would be able to honour it. It is reiterated that any DLG arrangement shall not act as a substitute for credit appraisal requirements and robust credit underwriting standards need to be put in place irrespective of DLG cover.
It has further been clarified that guarantees covered under Guarantee schemes of Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), Credit Risk Guarantee Fund Trust for Low Income Housing (CRGFTLIH) and individual schemes under National Credit Guarantee Trustee Company Ltd (NCGTC) as well as Credit guarantee provided by Bank for International Settlements (BIS), International Monetary Fund (IMF) and Multilateral Development Banks shall not be covered within the definition of DLG.
As far as the portfolio of Caspian is concerned, we currently have a relatively small group of loans in the category wherein FLDGs have been agreed upon, however, we are working on expanding this portfolio in the coming years. It is pertinent that we ensure that the current as well as upcoming arrangements are complying with the above guidelines while also keeping mind the enormous opportunities it shall bring in for us and expand our expertise in another different horizon of the business.
All the aforesaid goes to prove that the RBI has understood the risk being posed on the economy in absence of proper FLDG guidelines, while recognising and promoting the growth of the fin-tech industry. The new FLDG framework comes as a breather for the fintech industry and provides clarity on the relationship between REs and LSPs. The new guidelines are expected to give a well-deserved boost to the fintech industry.
Nevertheless, the fact that FinTech has opened avenues for banking and financial institutions to innovate cannot be ignored. This will allow them to stand ahead of their competition as technology’s prowess to anticipate future trends and client expectations can create extraordinary experiences. In the present digitally driven world, consumers expect tailored offerings that are safer and more efficient. Using advanced analytical tools, fintech players can enhance customer services by decreasing the cost and time of the lending process.