[By Dhaval Bothra & Rajdeep Bhattacharjee]
The authors are student of Symbiosis Law School, Pune.
Introduction
The verbiage related to loss-sharing models has been a predicament for a substantial period now for the Reserve Bank of India (RBI). Post its Guidelines on Digital Lending (DL Guidelines) on 2 September 2022, a certain conundrum prevailed across the regulatory landscape concerning the validity of the same as it did not explicitly bar the arrangements of loss sharing but suggested that the Reserve Bank of India‘s (Securitization of Standard Assets) Directions 2021 (Securitization Directions), paragraph 6(c), be adhered to for financial products involving contractual loss sharing modalities. However, under the recent Guidelines on Default Loss Guarantee in Digital Lending (DLG Guidelines), the air has been cleared by the regulator. Express permission has been granted to DLG arrangements subject to specific conditions, taking cognizance of all the stakeholders involved.
The DLG Guidelines aim to boost confidence and growth in digital lending by allowing fintech companies to expand their customer base while lowering default risk. Prudent lending approaches, thorough credit evaluations, and modern data analytics should be prioritized for long-term lending practices. To limit risks, borrowers’ creditworthiness, income security, and repayment capacity must be carefully evaluated. This article compares the guidelines to past RBI norms, addresses industry issues, considers alternate options for addressing the stated concerns and suggests a way forward.
Analysis and Interplay with Securitization Directions
Under the guaranteeing ambit, two entities exist:
- Regulated Entities (REs) are permitted to retain the loans and associated credit risk of loans on their balance sheet, under Section 5(b) of the Banking Regulation Act 1949.
- The Lending Service Providers (LSPs) function either in liaising with the credit facilities provided by the REs or the acquisition of borrowers thereof, in a digital landscape.
To provide access to the loan exposures for investors of different classes, a RE repackages the credit risk in a securitization structure into tradable securities with varying levels of risk. This enables a lender to share the risk of a loan with those third parties who might not have otherwise been able to access a loan exposure directly. These transactions that involve the redistribution of credit risk in assets by RE lenders are governed under paragraph 4 of the RBI‘s Securitization Directions.
The DL Guidelines required REs participating in First Loss Default Guarantee (FLDG) arrangements to follow the RBI Securitization Directions, particularly its clause 6(c) about synthetic securitization. Therefore, the three possible interpretations were:
- An arrangement that is specifically related to the credit risk underpinning a pool of loans is called synthetic securitization. Herein, fintech companies could offer loan-specific guarantees.
- Only REs are covered by the Securitization Directions. So, if any regulatory flexibility on FLDG is allowed, it will only apply to RBI-recognized REs. Without obtaining a regulatory license, such as one to run an NBFC or small finance bank, the unregulated entities may not be able to offer FLDGs.
- Since synthetic securitisation is prohibited by the Securitisation Directions, any form of risk transfer in a pool of loans to a third party by a lender RE while keeping the pool on its balance sheet is prohibited.
However, this res intergra position was addressed effectively by the Guidelines, hence clearing the air around this interpretative conundrum and it has been laid down that the DLG arrangements which are subjected to the provisions enlisted under Annex I to the circular, shall not be treated under the mandate of synthetic securitisation and/or the loan participation provisions. Thus, the RBI has provided clarity to LSPs regarding the extension of FLDGs.
Industry Concerns
FLDG
To prevent borrower defaults, REs and LSPs must collaborate under the FLDG. FLDG acts as a risk-sharing mechanism in the domain of online lending. However, there can be concerns regarding how FLDG will be implemented under the DLG Guidelines. These include DLG provider eligibility requirements, DLG coverage constraints (capped at 5%), and the need for detailed disclosure guidelines to promote transparency. Additionally, further clarification is needed regarding the relationship between DLG arrangements and the RBI’s Master Direction on Securitization of Standard Assets 2021 to ensure compliance and avoid ambiguity.
Excessive Data Collection and Misuse
The DLG Guidelines and the DL Guidelines have failed to recognize the privacy concerns and exploitation risk when Digital Lending Aggregators (DLAs) and LSPs obtain superfluous data and permissions. These can include personal and financial information.
From past scenarios, it is imperative to protect borrower data. This is crucial to prevent fraud and maintain trust in digital lending. DLAs and LSPs must prioritize strong data security measures like multi-factor authentication and upgraded encryption. The erosion of consumer trust hampers the growth of digital lending, so a comprehensive regulatory framework is needed. The framework should include explicit permission procedures, clear data retention and sharing policies, and strict penalties for noncompliance. To resolve this, a model akin to the European Banking Authority (EBA) Guidelines on the Security of Internet Payments can be adopted which comprehensively addresses the bottleneck and mitigates the concerns.
‘Buy Now Pay Later’ (BNPL)Applications
These Guidelines will have a substantial impact on BNPL applications, particularly in terms of credit levels and operations. The effects of the DLG Guidelines on credit lines on BNPL platforms include the prohibition on loading non-bank Prepaid Payment Instruments (PPIs) through credit lines, changes to operational procedures, and the challenges faced by BNPL enterprises.
The DLG Guidelines will impact the credit limitations of BNPL platforms. Specific conditions and new rules will be imposed on REs offering BNPL services, necessitating an evaluation of credit line practices and structures for regulatory compliance. BNPL companies must adjust their credit line policies accordingly. Additionally, DLG arrangements for BNPL platforms need to be reviewed to ensure adherence to the guidelines. This requires the development of clear and binding contracts between the RE and the DLG supplier, specifying the scope, categories, timeframe, and disclosure requirements of DLG coverage. Meeting these standards may involve investments in infrastructure, technology, and changes in business practices for BNPL companies.
Mitigating Industry Concerns
We propose the following alternative FLDG Design Models to mitigate the current industry concerns:
Risk Pooling
Herein, various lenders contribute to a single pool that compensates for early default losses. This model decreases individual lenders’ exposure to default loss by sharing the risk among lenders. It encourages collaboration and risk-sharing in the online lending ecosystem. A prime example of the same is the United States of America. Platforms such as LendingClub and Prosper Marketplace have embraced a risk pooling strategy in the peer-to-peer (P2P) lending business. These platforms make loans possible by connecting borrowers with independent investors who fund the loans. They have devised risk pooling systems to alleviate default risks, in which investors contribute funds to a pool that covers possible losses from borrower defaults. To implement risk-pooling solutions in India, we suggest the following:
- Peer-to-peer lending platforms should build alliances with various lenders, such as banks or NBFCs, to share the risk of default. These platforms can distribute risk by allowing different lenders to participate in funding a single loan.
- Lenders can also form syndicates to fund loans and disperse risks per RBI regulations.
- Loan guarantee schemes offered by the RBI can also be used, in which lenders pool their resources to take advantage of loan guarantees.
- Lenders can also consider securitization, which involves grouping loans and selling them as securities to investors to diversify risk.
Third-Party Guarantee Providers
Another alternative is to collaborate with third-party guarantee providers that are experts in identifying and managing default risks. These providers would give lenders guarantees covering a predetermined percentage of losses in the event of borrower defaults. This methodology capitalizes on the knowledge of specialized organizations in credit risk management and boosts lender confidence. A cross-jurisdictional example of the proposed alternative model for FLDG arrangements can be observed in China. Platforms like Lufax and CreditEase in the Chinese PSP lending business have taken a similar strategy by utilizing third-party guarantee providers. They provide lenders with guarantees, guaranteeing a predetermined percentage of losses in the event of borrower default.
To implement this in India, it is imperative to identify and collaborate with existing entities that have been authorized or registered by the RBI or other regulatory bodies. Post authorization, collaboration agreements should be established between lenders and these guarantee providers, including the terms and conditions, as well as the percentage of damages covered in the event of a default. Lastly, a standardized risk assessment process should be created that integrates guarantee providers’ expertise while remaining consistent with existing lending practices.
Conclusion
The DLG Guidelines addressed industry concerns and offered clarity for the digital lending sector. The directions define how synthetic securitization and loan participation laws should be interpreted. However, there are still worries about FLDG implementation, data privacy, and BNPL applications. To limit these challenges, strong data security measures and appropriate lending practices are required. Alternative FLDG design models promote collaboration and responsible lending, such as risk sharing and partnership with third-party guarantee providers. Addressing these challenges and establishing alternative approaches will ensure the digital lending industry’s long-term growth and borrower trust.