[By Tanya Verma]
The author is a student of Dr. Ram Manohar Lohiya National Law University.
Introduction
In Digital Lending (DL) context, individuals can conveniently secure loans through online platforms. These platforms, typically accessible as applications or websites, are managed by entities known as Loan Service Providers (LSPs). The digital lending process necessitates borrowers to furnish requisite documentation and request specific financial solutions, including Buy Now Pay Later loans (BNPL), Small Medium Enterprise (SME) loans, Personal loans, Trade loans, and more. These LSPs, duly authorized by Financial Institutions (FIs), evaluate the financial history of applicants along with the submitted documents. Upon thorough assessment, loans are digitally approved through the platform.
Following the guidelines established by the Reserve Bank of India (RBI) for Digital Lending, Financial Institutions (FIs) are designated as Regulated Entities (RE). These REs primarily extend loans to entities deemed to have low risk, thereby safeguarding the return of invested funds. However, there are instances where borrowers cannot fulfill their loan obligations, resulting in potential losses for the REs. To mitigate this scenario, LSPs offer a guarantee to REs through an agreement referred to as a Default Loss Guarantee (DLG). The DLG agreement ensures loan protection up to a specified limit. Yet, before August 2022, LSPs introduced a synthetic securitization process involving transferring credit risk for digitally provided loans using credit derivatives or guarantees while retaining the loan portfolio on their own balance sheet. This process included a 100% risk guarantee. In response, the RBI prohibited this approach due to its adverse impact on bank balance sheets and implications for the risk management commitments made by LSPs. This piece attempts to shed light on the broader implications of the same, starting with that of lenders, then loan service providers, and lastly for borrowers, which eventually turn out to be on the brighter side. Before that, a look at the major terms of the guidelines:
- The LSP providing DLG must be a company incorporated under the Companies Act, 2013.
- DLG agreements must be legally enforceable contracts between the RE and DLG provider.
- The DLG arrangement should not exceed 5% of the loan portfolio.
- The DLG arrangement’s tenor should match the longest tenor of the loan portfolio.
- DLG can be accepted as cash deposits, fixed deposits, or bank guarantees.
- REs can invoke DLG within 120 days of overdue.
- LSPs must publish information about DLG portfolios and amounts on their websites.
- REs are responsible for identifying loan assets as Non-Performing Assets (NPAs).
- REs need a board-approved policy before entering any DLG arrangement, covering selection criteria, guarantee scope, monitoring processes, and fees.
- DLG arrangements are governed by RBI’s Digital Lending Guidelines and other relevant regulations for customer protection and grievance redressal.
Implications
For brevity of expression, I shall analyze the implications in three parts. First, I shall deal with the implications on lenders, second, for loan service providers, and lastly, for borrowers.
- For Lenders:
We see three major implications for the lenders. First, the RBI’s 5% cap on DLG addresses the issue of high guarantee rates, preventing banks from writing off loans through synthetic securitization. In simpler terms, in a synthetic securitization, a bank buys credit protection on a portfolio of loans from an investor, thereby implying that when a loan in the portfolio defaults, the investor reimburses the bank for the losses incurred on loans in that portfolio up to a maximum, which is the amount invested. This suggests that the RBI’s decision to limit the DLG to 5% of the loan portfolio is a strategic move to curb the practice of offering excessively high guarantee rates by LSPs. By imposing this cap, the RBI aims to prevent banks from taking advantage of synthetic securitization, a process where credit risk is transferred through derivatives or guarantees. The implication is that the RBI seeks to ensure a more controlled and realistic financial environment by discouraging risky lending practices that could lead to potential loan write-offs.
Second, it can be seen that the DLG contracts offer security, allowing lenders to enforce terms and impose penalties on breaching LSPs. This highlights the contractual security provided by DLG agreements. Lenders can use these agreements to establish clear terms and conditions with LSPs. In case of any breaches, lenders have the authority to enforce penalties as per the agreement terms. This creates a framework that encourages LSPs to adhere to their commitments, ensuring higher accountability and reducing the risk of non-compliance or misconduct.
Thirdly, REs must still identify NPAs for asset classification, excluding guaranteed amounts from LSPs. This point emphasizes that while Digital Lending Guarantee (DLG) agreements provide assurance for loan repayment, it’s still the responsibility of the Regulated Entities (REs) to identify Non-Performing Assets (NPAs) for proper asset classification. The guaranteed amounts from LSPs are excluded from this classification process, indicating that the guarantees do not affect the overall assessment of the financial health of the loans. This separation maintains asset quality and risk assessment transparency, regardless of the guarantees provided.
Adding onto the above, it can be seen that board-approved policies and auditor-certified disclosures enhance credit standards and reliability. Here, the focus is on robust credit underwriting standards and transparency in the DLG arrangement process. The requirement for board-approved policies ensures that the entire DLG process adheres to specific criteria, from selecting providers to monitoring and review mechanisms. Auditor-certified disclosures add another layer of reliability by ensuring that the financial information provided by the DLG provider is accurate and trustworthy. This enhancement in credit standards and transparency improves the overall credibility and effectiveness of the DLG arrangements.
- For Loan Service Providers
The situation of LSPs is not the same too, for they can no longer offer exorbitant DLG rates, affecting their risk exposure and credit management. This highlights a significant change for LSPs resulting from implementing the RBI’s DLG guidelines. The guidelines impose a maximum cap on the rates at which DLG arrangements can be offered by LSPs. This cap effectively curtails the ability of LSPs to provide excessively high guarantee rates to borrowers. As a result, LSPs face limitations on how much risk they can cover through DLG agreements. The implication is that LSPs must reevaluate their risk management strategies and credit practices since they can no longer rely on exorbitant DLG rates to offset potential defaults.
Secondly, it is contended that guidelines bring LSPs under better control and compliance by REs, establishing a regulated system. This underscores the regulatory nature of the guidelines in terms of LSPs and their relationship with Regulated Entities (REs). The guidelines create a framework that enhances control and compliance over LSPs by the REs. This means that the REs, which are typically financial institutions responsible for licensing LSPs, now have clearer guidelines to oversee the activities of LSPs more effectively. By establishing this regulated system, the RBI aims to ensure that LSPs operate within defined boundaries, adhere to specific practices, and maintain accountability in digital lending.
- For Borrowers
Dealing with the same in a three-pronged manner, it can be seen that DLG arrangements involve REs or LSPs as companies, safeguarding borrowers from malicious third-party LSPs and unauthorized data gathering. This statement highlights a significant benefit for borrowers resulting from DLG arrangements. These arrangements involve either Regulated Entities (REs) or Loan Service Providers (LSPs) that are formally incorporated as companies. This safeguard protects borrowers from potential fraudulent activities by malicious third-party LSPs. It also prevents unauthorized data gathering, ensuring borrowers’ sensitive financial information remains secure. The implication is that borrowers can have greater confidence in engaging with DLG arrangements, as the involvement of legitimate and regulated entities adds a layer of security and trust to the process.
Secondly, the cap on the guarantee amount reduces costs for LSPs, indirectly leading to lower interest rates. This point highlights a positive outcome of the cap imposed on the guarantee amount in DLG agreements. With the maximum guarantee amount limited, LSPs experience reduced costs associated with maintaining these guarantees. As a result, LSPs can manage their operational expenses more efficiently. The implication for borrowers is that this cost reduction for LSPs may indirectly lead to lower interest rates on loans provided under the DLG arrangements. Borrowers benefit from more competitive and reasonable lending terms, making the borrowing experience more favorable.
Finally, the grievance redressal provisions protect borrower interests and maintain regulatory standards. This emphasizes the importance of grievance redressal provisions in DLG arrangements. These provisions ensure that borrowers’ concerns and complaints are addressed promptly and effectively. By establishing a mechanism for resolving issues, the guidelines prioritize borrower interests and provide a means for borrowers to seek remedies for any disputes that may arise. Furthermore, this commitment to grievance redressal helps maintain regulatory standards and reinforces the transparency and accountability of the DLG process.
Concluding Thoughts
The RBI’s Guidelines on DLG reshape the lending landscape and reaffirm the commitment to a secure and transparent digital borrowing experience. By striking a balance between the interests of lenders, LSPs, these guidelines pave the way for a regulated and reliable digital lending ecosystem that thrives on integrity, fairness, and customer protection. As the digital lending realm continues to evolve, these guidelines are poised to serve as a cornerstone for a healthier, more accessible, and safer lending environment for all stakeholders involved.