Default Loss Guarantee – A gamechanger in RE-LSP partnership
A focus on customer convenience should not divert attention from customer protection and safety. The RBI’s guidelines on digital lending and Default Loss Guarantee are a reiteration of the same.
With FLDG being treated akin to synthetic securitization, lending arrangements between Banks/NBFCs and FinTech were in a soup.
Opaque securitizations are risky and can destabilize the financial system. However, well-structured and regulated securitizations can help lenders distribute risk and improve liquidity. RBI’s guidelines for Default Loss Guarantee will act as a much-needed facilitator to boost fintech lending.
What is this Default Loss Guarantee?
It is a contractual arrangement between a Regulated entity (RE) and a Loan Service Provider (LSP), wherein the latter compensates the RE for loss due to default up to a certain percentage of the loan portfolio of the RE, specified upfront. It means LSPs, for the default of loans sourced by them to the RE, will compensate the RE for up to a certain percentage of the default amount. The percentage of compensation is specified in their agreement.
Major highlights of the Default Loss Guarantee are:
- Requirement of an outsourcing agreement
REs can now enter into Default Loss Guarantee arrangements with LSPs/REs, only with those LSPs with which they have an outsourcing arrangement.
- Cap on the DLG cover
REs can accept DLG cover only up to a ceiling of 5% over the agreed loan portfolios. This change particularly worries both REs and LSPs. The existing FLDGs in the market are higher than the current ceiling. REs who were enjoying higher guarantee cover for their portfolio will now have to adjust for a lower guarantee, which will affect their risk-taking capability. REs will need to revisit their existing arrangements with LSPS and will now be extra cautious in both choosing their target customers and evaluating the underwriting capabilities of LSPs before entering into partnerships. LSPs, on the other hand, will need to face the challenge of entering new partnerships with REs, with co-lending being a more sought-after option.
- DLG cover is to be provided upfront
The current practice of offering corporate guarantees is no longer acceptable, and the DLG cover must be provided upfront 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
This will strain the capital of LSPs as it requires the deposit of hard cash with REs, leading to higher capital requirements.
- Recognition of NPAs
REs are responsible for recognizing individual loans in the portfolio as NPAs, and provisioning is to be done as per the extant asset classification and provisioning norms, irrespective of any DLG cover available at the portfolio level. REs will have the huge task of reporting the existing NPAs in the portfolio as individual NPAs from the date of default, and this requires continuous data flow between REs and LSPs.
- Set off against the loan account
Any DLG amount invoked cannot be set off against the individual loans in their portfolio. The total outstanding amount of NPAs that REs report will increase as the current practice of adjusting the invoked guarantee amount to the loan outstanding is no longer permitted. However, there wouldn’t be any effect on the overall profitability as the guarantee amount invoked is reported as income.
- Invocation timeline
REs need to invoke the DLG within a maximum overdue period of 120 days, i.e., REs need to invoke the guarantee on the loans within 30 days of the loan becoming an NPA. It provides less room for LSPs to complete their recovery initiatives.
- Disclosure Requirements
LSPs must publish on their website the total number of portfolios and the respective amount of each portfolio on which DLG has been offered. This will attract higher scrutiny from REs and expose the LSP’s arrangements with another RE, affecting their bargaining power.
The DLG guidelines put the onus on REs over LSPs’ compliance with various disclosures such as data access, storage, privacy, and disclosures. This requires continuous monitoring of LSPs by REs and reporting by LSPs to REs on various fronts.
REs and LSPs will need to revisit their arrangements and target segments. The guidelines may not greatly affect secured credit offerings, but they will surely have a short-term impact on high-risk unsecured credit. For example, REs might be very comfortable accepting 5% DLG on secured credit as housing loans, as they are protected by additional security coverage, but they may not be willing to accept the same 5% on an unsecured personal loan.
The guidelines are, however, not completely in line with what many FinTech lenders have expected, but they provide much-needed direction for the FinTech industry.
In a country with 1.4 billion people, a large untapped credit potential, the highest global digital adoption, and a large middle-class segment, consumer protection will always be at the forefront.
LSPs may adopt the following two strategies to comply with RBI’s DLG guidelines.
- They can acquire NBFC licenses to become REs themselves. However, this would mean they would have to comply with all applicable regulations and will have to invest in technology for Regulatory Reporting, NPA Management, Portfolio Analytics, etc.
- They can adopt best practices and implement data platforms to ensure that their data flows and usage comply with RBI guidelines. This requires investments in data management platform and regular reporting to REs on compliances.
REs would be looking for LSP partners with policies designed to comply with the Digital Lending guidelines of the RBI. The future dynamics of this RE-LSP relationship will be highly dependent on LSPs readiness to compliance with RBI norms.
In the current phase, with rapid innovation in credit delivery, the regulatory response to monitoring the sector also evolves rapidly, and with granular-level reporting requirements, compliance, and reporting become crucial for the players involved to escape the regulatory wrath.
We at Fintellix, with our data management platform, EWS & NPA management solutions, and regulatory reporting solutions combined with our wealth of experience in the regulatory landscape across the globe help REs and LSPs navigate the highly dynamic digital lending landscape.