Digital Lending

Guidelines on Default Loss Guarantee by RBI in Digital Lending

On June 08, 2023, the Reserve Bank of India issued guidelines on default loss guarantee on their official websites. With technological advancement, digital lending platforms have increased extensively among the public to fulfil their day-to-day business transactions. This digitalization has changed the framework of the financial industry; companies like Fintech have replaced the traditional lending method by easing the process of loan lending and borrowing.

Therefore, RBI has issued this guideline on default loss guarantee to secure and develop the digital lending procedure, promote the fintech industries, and subsequently protect the interests of regulated entities.

Guidelines on Default Loss Guarantee specifically mention the criteria for how digital lending companies shall function whenever there is a default in the loan repayment to a regulated entity, i.e., banks or NBFC. However, these guidelines on Default Loss Guarantee provide an arrangement of the regulatory framework for digital lending platforms.

A Default Loss Guarantee (DLG) is a contractual agreement between a Regulated Entity (RE) and lending service providers or between two REs (Regulated Entities) involving DLG, under which the latter guarantees to compensate for the loss that occurred due to default loan repayment. It is also commonly known as a first Loss Default Guarantee or FLDG.

What is Digital lending?

Unlike traditional banks, digital lending is an online platform that facilitates loans to customers. It involves technology-based systems such as mobile applications, websites, and data analytics, thus eliminating the traditional loan procedures. These loans are streamlined to meet the needs of borrowers, ensuring flexibility and convenience in the lending service.

Through digital lending borrowers can directly apply for personal loans from the comfort of their own house through their smartphones or computers, unlike traditional & hustle and bustle banking.    

Guidelines on Default Loss Guarantee Key Insights

 Here are the key insights mentioned in the guidelines on default loss guarantee by RBI in digital lending:

1. The guidelines apply to banks and NBFCs entered into the DLG arrangements for digital lending operations.
2. The Lending Service Provider basically acts as an agent of lenders (banks and NBFCs) to carry out functions like customer acquisition, pricing support, recovery loans, etc., aligning with the RBI guidelines on outsourcing arrangements.
3. The total number of portfolios and the respective amount of each portfolio where DLG has been offered shall be published on the official website of the respective LSPs.
4. This guideline applies to Regulated Entities engaged in digital lending business operations, such as Commercial Banks, Cooperative Banks, and Non-Banking Financial Companies.
5. It has specifically laid down criteria for compensating the Regulated Entity and qualified entity for Default Losses on loans. Hence, the terms and conditions mentioned in the RBI guidelines on default loss guarantee are applied to such agreements.
6. Default Loss Guarantee (DLG) are only permitted with lending service provider or other Regulated Entities with whom RE has an outsourcing arrangement. Further, the LSP providing Default Loss Guarantee (DLG) must be incorporated under the Companies Act 2013.

What are the Structures, Forms, & Cap under the DLG RBI guidelines?

 In its guidelines on default loss guarantee, RBI has specifically mentioned para-wise the structure of DLG arrangements, forms of DLG, and Cap on DLG. Given below is the breakdown for the same:

1. DLG arrangements must be accompanied by a legally enforceable contract between the RE and the DLG provider. According to the RBI guidelines on default loss guarantee, the contract must contain the extent of DLG cover, a form in which DLG cover is maintained, DLG invocation timeframe, and disclosure requirements.
2. RE shall accept DLG forms in cash deposits, fixed deposits with Scheduled Commercial Bank, or a Bank Guarantee in favour of RE.
3. RE (Regulated Entities) shall ensure that the total amount of DLG covered on loan outstanding shall not exceed five per cent of the loan portfolio amount.

What are the Powers of Regulated Entities (RE)?

Regulated Entities (RE), as per the guidelines on default loss guarantee, shall be responsible for identifying and making provision for an individual loan asset as an NPA (Non-Performing Asset) irrespective of any DLG cover available at the portfolio level. Moreover, RE shall maintain robust creditworthiness, and such insurance cannot replace its standard, i.e., the amount of DLG invoked shall not be set off against underlying individual loans.

However, if any loan amount against which the guarantee has been invoked and realized is subsequently recovered by Regulated Entities (RE), then RE shall share such loan recovered with the DLG provider according to the contractual agreement.

According to the guidelines on default loss guarantee, RE shall invoke the Default Loan Guarantee (DLG) within 120 days of the default loan amount unless made good by the borrower before that.

What are the Tenor and DLG Renewal Guidelines?

The Default Loan Guarantee agreement shall remain in force till the tenor of the longest period of the loan portfolio.

The Regulated Entities (RE) shall obtain adequate details and information regarding the LSP (Lending Service Provider) before entering or renewing the DLG agreement with the LSP (Lending Service Provider) to ensure that the LSP is capable of meeting the obligations. For instance, RE shall ask the LSP for a declaration on its financial statements certified by its concerned auditor addressing the existing obligations and past defaults connected to DLG.

What are the Due Diligence and other Requirements for DLG Providers?

According to guidelines on default loss guarantee, REs or Regulated Entities must go through the following due diligence connected to the DLG provider:

1. REs shall obtain Board approval before entering into a DLG arrangement; for instance, such policy shall include eligibility criteria for selecting the DLG provider, nature and extent of DLG cover, monitoring procedure and reviewing the DLG arrangements, and fees payable to DLG provider.
2. It is indeed crucial for REs to maintain a credit assessment standard in addition to the DLG arrangements. It says that the DLG arrangement shall not replace the need for credit assessment.
3. In case the RE enters into new DLG arrangements or renews them, it shall obtain adequate detailed information on the capability of DLG providers to meet the obligations. The statutory auditor shall certify such information collected from the DLG providers, who will provide details of portfolios and past default rates on similar portfolios.

What are the Exceptions under DLG Arrangements?

RBI Guidelines on Default Loss Guarantee on Digital Lending

has also mentioned exceptions under the DLG arrangements.

1. A credit guarantee is provided by BIS, the Bank for International Settlement, the IMF (the International Monetary Fund and Multilateral Development Banks), and the Multilateral Development Bank.
2. CGTMSE (Credit Guarantee Fund Trust for Micro and Small Enterprises), CRGFTLIH (Credit Risk Guarantee Fund Trust for Low-Income Housing) and NCGTC (Individual Schemes Under the National Credit Guarantee Trustee Company Ltd).

Conclusion

Hence, due to the surge of Fintech players in the financial markets, the government of India, through RBI, has issued guidelines on default loss guarantee, especially in digital lending. This guideline on default loss guarantee has struck a balance between the requirement for innovation and an inclusive system of lending provisions ensuring a customer’s experience and protection. However, three main areas are covered under this guideline on default loss guarantee such as customer protection, technology and data requirement and regulatory framework.