Guidelines on Default Loss Guarantee in Digital Lending

Guidelines on Default Loss Guarantee in Digital Lending

The digital lending sector has received a significant boost from the Reserve Bank of India (“RBI”) through its recently issued Guidelines on Default Loss Guarantee in Digital Lending (“DLG Guidelines”) on June 8, 2023. These guidelines outline the terms and conditions governing the ability of RBI-regulated lending entities (“RE”) to engage in default loss guarantee (“DLG”) agreements with each other or with lending service providers (“LSP”). The DLG Guidelines have been introduced following extensive discussions between RBI and the fintech industry. This follows RBI's earlier decision to categorize guarantee arrangements between LSPs and REs as “synthetic securitisation” , which had raised concerns that DLG arrangements might not be permissible in the digital lending environment. The terminology concerning loss-sharing models has posed a challenge for the Reserve Bank of India (RBI) for quite some time. Following the issuance of the Guidelines on Digital Lending on September 2, 2022 (“September Guidelines”), there was confusion in the regulatory landscape regarding the validity of these models. The September Guidelines did not explicitly prohibit loss-sharing arrangements but hinted at adhering to paragraph 6(c) of the Reserve Bank of India (Securitization of Standard Assets) Directions, 2021 (“Scrutinization Directions”), for financial products involving contractual loss-sharing methods, which could have any of the following interpretations:

a. Synthetic securitization pertains to an agreement closely linked to the credit risk connected with a group of loans, enabling fintech companies to offer guarantees for individual loans.

b. The Securitization Directions only cover REs. Any flexibility in DLG regulations would be applicable solely to REs recognized by the RBI only. Unregulated entities lacking a proper regulatory license, such as an NBFC or small finance bank, may not be permitted to offer DLGs.

c. The Securitization Directions forbid synthetic securitization, indicating that any method of shifting risk in a pool of loans to an external party by an RE while keeping the pool on its balance sheet might not be permissible.

However, the recent introduction of DLG Guidelines has brought clarity. The RBI has now given explicit permission for DLG arrangements, provided certain conditions are met, taking into account the interests of all stakeholders.. To ease concerns within the fintech sector, the RBI has, via the DLG Guidelines, excluded DLG arrangements that comply with these guidelines from being classified as “synthetic securitisation”.

The DLG Guidelines establish DLG as a contractual agreement between the RE and a DLG provider. In this arrangement, the DLG provider commits to reimbursing the RE for any losses resulting from loan defaults. Additionally, the DLG Guidelines make it clear that any other implicit guarantee, resembling this type of arrangement and tied to the RE's loan portfolio performance, would also fall under the DLG's purview and thus be subject to the DLG Guidelines' conditions.

Key take aways from the DLG Guidelines:

• A DLG provider could either be an LSP or an RE. In order for an LSP to offer a DLG, it needs to be registered as a company under the Companies Act, 2013 in India, or it can acquire already established LSPs that are registered companies. Furthermore, the DLG Guidelines acknowledge the existence of DLG agreements between REs, where one of them functions as an LSP. In this scenario, the RE providing the DLG will be subjected to the same requirements that LSPs need to adhere to according to the DLG guidelines. This includes complying with the risk-sharing limit.
   
• b. As per the DLG Guidelines, REs (i) must confine the DLG coverage for outstanding portfolios (stated in advance) to a maximum of 5% of those portfolios, and (ii) must ensure that the LSP doesn't assume a performance risk exceeding an equivalent value of 5% of the underlying loan portfolio in situations involving implicit guarantees. Additionally, these guidelines make it clear that such DLG agreements can't serve as replacements for credit appraisal prerequisites. Regardless of the DLG coverage, REs are obliged to maintain strong credit underwriting standards. However, it is important to note that while the initial 5% limit is set, the DLG Guidelines don't explicitly explain the method for determining the outstanding or underlying loan portfolio and evaluating performance risk.
   
• REs are authorized to accept a DLG in the form of (a) cash deposits, or (b) fixed deposits held with a scheduled commercial bank, with a lien in favor of the RE, or (c) bank guarantees.
   
• REs and LSPs are also required to establish a clear contractual agreement outlining the scope of coverage, the invocation timeline, and the duration of the DLG. This duration must be at least as long as the longest tenor of the underlying loan portfolio. Nonetheless, it's important to recognize that the DLG Guidelines also acknowledge that an implicit guarantee can meet the criteria of a DLG and thus be subject to these guidelines.
   
• Given these considerations, entities involved should take note of the following:
   
• Any obligation, whether explicit or implicit, from any party (including third parties) to compensate for loan portfolio defaults or negative performance, such as through indemnities or damages, would be governed by the DLG Guidelines.
   
• Payments arising from guarantee agreements should be limited to cash deposits or collateral in the form of fixed deposits, irrespective of whether the coverage relates to damages or other agreements involving third parties. Given the restricted options for guarantee arrangements, it may be essential to reconsider the practicality of agreements with unlimited or unrestricted coverage.
   
• The risks and liabilities in outsourcing contracts between LSPs and REs need careful organization to match the requirements outlined in the DLG Guidelines accurately.
   
• According to the DLG Guidelines, REs must implement a DLG within a maximum of 120 days from the time a loan becomes outstanding. This rule applies regardless of whether the RE categorizes the loan as a non-performing asset (“NPA”) within the designated timeframes as per existing regulations. The RE is responsible for identifying specific loans in the portfolio as NPAs and making adequate provisions for them, irrespective of any DLG arrangement or its activation. Additionally, if the borrower repays the loan after the RE has invoked the DLG, the amount repaid can be shared with the DLG provider.
   
• The existing regulations concerning the calculation of regulatory capital allow specific REs to receive capital benefits if a particular loan in their portfolio benefits from a guarantee arrangement, which is considered a form of 'credit risk mitigation'. The DLG Guidelines clarify that these current regulations will still be applicable to individual loans within the portfolio. The RBI's explanation implies that although DLG arrangements might cover the entire loan portfolio, the capital benefits can be obtained by averaging the DLG coverage for individual loans in relation to the overall portfolio, provided that the DLG meets the criteria specified in the existing regulations, including the nature of the guarantee and its coverage.
   
• When establishing or renewing a DLG arrangement, lenders must perform due diligence on the DLG provider. This includes obtaining a declaration certified by an auditor regarding the provider's existing DLG obligations. The purpose is to ensure the DLG provider's capability to fulfil its commitments. Additionally, lenders must have a policy approved by their board before entering any DLG arrangement. Customer protection measures and grievance redressal issues pertaining to DLG arrangements shall be guided by the instructions contained in the September Guidelines.
   
• It is pertinent to note that as per the DLG Guidelines, guarantees covered under the following schemes/ entities shall not be regarded as DLG:
   
• Guarantee schemes of Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), Credit Risk Guarantee Fund Trust for Low Income Housing (CRGFTLIH) and individual schemes under National Credit Guarantee Trustee Company Ltd (NCGTC).
   
• Credit guarantee provided by Bank for International Settlements (BIS), International Monetary Fund (IMF) as well as Multilateral Development Banks as referred to in Paragraph 5.5 of RBI Master Circular on Basel III Capital Regulation dated May 12, 2023.

Conclusion:

The DLG Guidelines mark a noteworthy progress for digital lending because the RBI has now allowed unregulated entities to function as LSPs in the lending system and offer DLGs. This enables REs to expand their loan portfolio, cater to a broader range of borrowers, and simultaneously ensures the RBI's regulatory supervision over REs. The cap of 5% will ensure that the unregulated players do not cause risk to the lending ecosystem. However, the requirement of DLG to be in the form of cash deposit or fixed deposit or bank guarantee, thereby losing liquidity, may be problematic for the fintech entities as this may require them to raise funds for such cash requirements in relation to the DLG.