Digital lenders seek cap on default loss guarantee models from RBI

They suggested that the central bank could look at a reasonable cap to the FLDG models, given RBI's concerns of around build-up of systemic risk and 100% risk transfer rather than banning it outright

At a meeting with the Reserve Bank of India (RBI) governor earlier this week, Digital Lenders Association of India (DLAI) – the industry association for digital lenders – raised the issue of first loss default guarantee (FLDG).

They suggested that the central bank could look at a reasonable cap to the FLDG models, given RBI’s concerns of around build-up of systemic risk and 100 per cent risk transfer rather than banning it outright, sources aware of the development said.

In a note to its members, DLAI said it apprised the RBI of the importance of FLDG as such risk-sharing models have played a critical role in scaling up capital deployment to customers. They should be considered key tools in advancing financial inclusion.

The DLAI also highlighted that the majority of digital lending players serve ‘new-to-credit’ customers and underserved customers such as micro, small and medium enterprises (MSMEs) and consumers.

Expanding supply of liquidity from larger banks and non-banking financial companies (NBFCs) to these customers has prompted players to innovate hybrid on-and-off balance sheet funding models, particularly co-lending.

FLDG is one of the issues where digital lenders are awaiting clarity from the RBI as there is interpretational ambiguity on this front.

In its September guidelines on digital lending, RBI said with regard to the industry practice of offering financial products involving contractual agreements such as FLDG, it is advised that regulated entities (REs) adhere to the provisions of the Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 dated September 24, 2021, especially, synthetic securitisation.

The RBI has defined ‘synthetic securitisation’ as a structure where the credit risk of an underlying pool of exposures is transferred, in whole or in part. It is through the use of credit derivatives or credit guarantees that serve to hedge the credit risk of the portfolio, which remains on the balance sheet of the lender. According to experts, the RBI’s stance on FLDG says that any form of risk transfer in a pool of loans by any lender to a third party is not permitted.

Essentially, FLDG is a lending model whereby third-party guarantees, which can be a Lending Service Provider (LSP), compensate up to a certain percentage of default in a loan portfolio of the RE.

From the LSP’s perspective, offering FLDG acts as a demonstration of its underwriting skills, whereas from the lender’s perspective, it ensures the platform’s skin in the game.

DLAI is also said to have apprised the RBI that the LSP would benefit from clarity and recognition in unlocking last-mile credit. This includes the ability to manage pooled accounts.

Those LSPs that wish to convert to NBFCs would benefit from a clear and predictable application process.

They have also suggested to the RBI that digital NBFCs would willingly comply with higher compliance requirements if they could apply for credit card issuing licences and/or a pathway to convert to small finance banks down the line.