In August 2022, the Reserve Bank of India (RBI) issued a press release announcing the partial implementation of the recommendations of its working group on digital lending. Among the proposals made by the working group that still remained for the RBI’s further consideration was that on first loss default guarantees (FLDG). From the publicity this recommendation generated, it was apparent that the provision of FLDGs is one of the cornerstones of the fintech ecosystem. There was much anxiety within the sector as to how tightly FLDGs would ultimately be regulated.
An FLDG is where a technology platform provider gives a partial guarantee to support the loans referred by it to an RBI-regulated entity (RE). FLDG arrangements can also exist between two REs, and are not limited to those between an RE and a non-RE. There had been some consternation in the fintech and the lending sectors as the RBI’s September 2022 initial guidelines on digital lending equated the providing of an FLDG with a synthetic securitisation. This is a structure whereby the credit risk of a loan or a pool of loans is transferred, in whole or in part, by way of credit guarantees or credit derivatives. The RBI recently issued further guidance on 8 June 2023 on default loss guarantees (DLG) in digital lending.
The June 2023 circular clarifies that DLGs adhering to its provisions will not be treated as either synthetic securitisation or as loan participations. The latter are structures where the economic interest in a loan is transferred without the actual loan being transferred. The circular applies to all commercial banks and all non-banking financial companies. A DLG is now defined in the circular as a contractual arrangement between an RE and any other entity that complies with the criteria prescribed in the circular, where such entity agrees to compensate the RE for any losses in a loan portfolio up to a pre-agreed limit. An RE may enter into a DLG only with another RE or a lending service provider (LSP) incorporated under the Companies Act, 2013, with which it has entered into a lending services outsourcing arrangement.
A DLG must be backed by an explicit, legally enforceable contract between the RE and the DLG provider. The DLG contract must specify the form of the DLG, how the DLG cover is maintained by the RE, the extent of the DLG cover, the timeline for invoking the DLG and the further disclosure requirements specified in the June 2023 circular. DLG can only be provided in the form of cash deposited with the RE; fixed deposits maintained with a scheduled commercial bank marked with a lien in favour of the RE, or a bank guarantee in favour of the RE.
The term of a DLG must not be shorter than the maturity of the loan portfolio for which the DLG has been provided. The cover provided under a DLG must not exceed 5% of the loan portfolio in respect of which the DLG has been provided. An RE must invoke a DLG within a maximum period of 120 days from the date the loan becomes overdue, unless the amount due has been discharged by the borrower.
An RE retains the responsibility for recognising individual loans underlying a DLG in accordance with the prudential requirements applicable to them, such as non-performing assets, and for providing for such loans. Recovery from any loan for which a DLG has been invoked may be shared with the LSP in accordance with the contractual arrangement between the RE and the LSP. Interestingly, the June 2023 circular specifies that the amount of a DLG invoked “shall not be set off against the underlying individual loans”. The reason behind this provision is not clear, considering that the amounts invoked in respect of a DLG for a loan would reduce the outstanding balance in respect of such loan.
That the RBI has provided guidance on DLG arrangements is welcome, and provides much-needed clarity on the validity of such arrangements. Prior to the issue of this guidance, DLG arrangements that REs entered into were subject to uncertainty and speculation. It is interesting to note that the tone of the guidance provided by the RBI implies it has set out what it believes is an initial level of regulation. It would seem that for the time being, the regulator has decided to encourage and to foster the industry rather than to shackle it with cumbersome regulation.
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