Digital Lending

Default Loss Guarantee

Recent instructions about Default Loss Guarantee (DLG) in Digital Lending were released by the Reserve Bank of India (RBI). These rules are meant to apply to contracts, including DLG, also known as First Loss Default Guarantee, between Regulated Entities and Lending Service Providers (LSPs) or between two REs. The immediate application of the circular’s instructions is a requirement for the RBI’s decision to approve such arrangements. These regulations are issued under various sections of the Banking Regulation Act, Reserve Bank of India Act, National Housing Bank Act, and Factoring Regulation Act.

The Reserve Bank of India was inspired to establish guidelines on Default Loss Guarantee in Digital Lending by the recommendations of the Working Group on Digital Lending. On August 10, 2022, the RBI released a press release outlining the working group’s proposals, which included a review of the First Loss Default Guarantee. The RBI then examined DLG agreements between REs, LSPs, or between two REs. These rules offer a framework for the regulation of DLG digital lending agreements.

 

Default Loss Guarantee (DLG)

A written agreement between a business that complies with the guidelines’ eligibility conditions and the Regulated Entity, whereby the latter promises to pay for the RE’s loss from default up to a specific proportion of the RE’s loan portfolio. According to the recommendation, any other implicit guarantee of a comparable nature that is dependent on the performance of the RE’s loan portfolio and is stated upfront will also be included in the definition of DLG.

Eligibility for Default Loss Guarantee Provider

Only a Lending Service Provider (LSP) or another RE with whom it has already signed an outsourcing arrangement may a Regulated Entity enter into a DLG agreement. According to the 2013 Companies Act, the loan service provider providing a default loss guarantee must be incorporated as a company.

Default Loss Guarantee Agreement Requirements

All Default Loss Guarantee agreements must be supported by an express, binding contract between the RE and the DLG provider. The contract must, among other things, contain the following details:

• The coverage area of DLG.
• The structure used to keep DLG coverage with the RE.
• Duration of DLG invocation.
• Disclosure requirements in accordance with Guideline.

Principal Aspects of the Directive

The application’s Purpose, Definitions, and Eligibility of default loss guarantee are:

• Applicable to regulated entities, including commercial banks, cooperative banks, and non-bank financial companies, that carry out digital lending operations.
• A default loss guarantee is a contract between RE and a qualified entity that ensures payment for losses caused by default.
• Only LSPs and other REs with whom the RE has an outsourced agreement are eligible to enter into DLG agreements. An LSP that provides DLG must be a business incorporated in accordance with the 2013 Companies Act.

Default Loss Guarantee’s structure, forms, and cap

• A legal contract between the RE and the DLG provider must govern DLG agreements. The scope of DLG coverage, the kind of DLG maintenance, the window for using DLG, and the disclosure criteria should all be included in the contract.
• Cash, fixed deposits with a Scheduled Commercial Bank, or a bank guarantee in the RE’s favour are all acceptable forms of DLG that are accepted by REs.
• The total DLG coverage for the portfolio of outstanding loans should not be greater than 5%. The implicit guarantee agreements’ performance risk shouldn’t be higher than 5% of the underlying loan portfolio.

Digital Loss Guarantee Coverage Cap

• The total default loss guarantee cover on any outstanding portfolio that is indicated upfront must not be greater than 5% of the total value of that loan portfolio, according to the Digital Loss Guarantee Coverage Cap.
• The DLG Provider may not assume performance risk that exceeds 5% of the underlying loan portfolio when implicit guarantees are employed.

How do you handle regulatory capital and other crucial deadlines?

• Regardless of DLG coverage, the RE is still in charge of identifying individual loan assets as Non-Performing Assets (NPAs) and making provisions. The underlying individual loans cannot be subtracted from the DLG sum.
• The requirements for calculating exposure, reducing credit risk, and allocating regulatory capital remain in place.
• RE must start DLG within 120 days of the payment due date unless the borrower pays the balance in advance.
• The default loss guarantee agreement’s length should not be less than the underlying loan portfolio’s longest loan tenor.

Industry Observations on the Guidelines

• Positive for Credit Penetration – Positive Industry Reactions to the Guidelines for Credit Penetration First Loss Default Guarantee arrangements are being implemented in digital lending, which is seen as a positive trend that will increase credit penetration and the ecosystem surrounding digital lending.
• Transparency and Discipline: The regulatory framework for FLDG arrangements is expected to promote more transparency and discipline in the world of online lending.
• Clarity and Harmonisation: The proposed regulatory framework will provide the regulated firms in the digital lending sector with clarity and harmonisation.
• Partnership and Collaboration: The rules have received positive feedback for promoting more collaboration and partnerships between traditional banks, regulated organisations, NBFCs, and fintech companies. This will democratise access to finance and spur economic growth for underserved and unserved markets.
• Enhanced Ecosystem: The rules are seen as a move in the right direction that will strengthen the ecosystem and open doors for novel solutions like digital escrow services that allow for secure collecting and transactions.

In general, industry participants are upbeat about the recommendations and believe they will encourage expansion, transparency, and cooperation in the digital lending sector while also maintaining proper protections and oversight.

Customer Protection and Grievance Redressal

Customer protection policies and grievance redressal concerns pertaining to default loss guarantee arrangements should be based on the guidelines as well as other applicable current rules. According to the standards of digital lending, complaints can be resolved as follows:

Conclusion

In order to encourage transparency, discipline, and credit penetration while addressing regulatory concerns, the RBI has created a legal framework for LDG arrangements in digital lending. The rules, which were developed with consultation from a number of stakeholders, are meant to encourage the orderly expansion of credit distribution through digital lending techniques. The framework emphasises that lending must be carried out by organisations under RBI regulation or permitted by relevant legislation. The industry has reacted favourably to these rules, and stakeholders have been upbeat about the prospect of improved credit access, more cooperation, and a general development of the digital lending ecosystem.

FAQs: –

1. https://www.rbi.org.in/commonperson/English/scripts/RBICMS.aspx