Digital Lending

Guidelines on Default Loss Guarantee (DLG) in Digital Lending

The Reserve Bank of India, in its press release dated June 8, 2023, issued Statement on Developmental and Regulatory Authority. The statement includes various developmental and regulatory policies and measures relating to the regulation of Default Loss Guarantee (DLG) Arrangements in Digital Lending.
It has been agreed to establish a regulatory framework for allowing Default Loss Guarantee arrangements in Digital Lending on the basis of thorough consultations with various stakeholders and in line with the RBI’s objective of maintaining a balance between innovation and prudent risk management. This Blog will discuss the detailed guidelines on Default Los Guarantee (DLG) in Digital Lending.

Background

Banks, NBFCs, and fintech businesses are still waiting for clarification on a number of issues, including the First Loss Default Guarantee (FLDG) mechanism, after the RBI released guidelines on digital lending.
The first loss guarantee is a system that pays lenders in the event of a borrower default. Lenders are more willing to make loans as long as a third party is covering the losses. It serves as loss protection. The RBI stated in 2022 guidelines that it opposed such agreements because they would tempt lenders to take on excessive risk.
To address this, the Reserve Bank released guidelines on default loss guarantee (DLG) in digital lending, a step intended to ensure the system for distributing credit in an orderly manner.

Scope of the Guideline

The following entities or regulated entities are considered “Digital Lending” operations under the guidelines:

• All commercial banks, including small finance Banks.
• Primary (urban) cooperative Banks, state cooperative Banks, and central cooperative Banks.
• Non-Banking Financial Institutions (including housing finance companies).

Default Loss Guarantee (DLG)

A written agreement between the Regulated Entity (RE) and a company that satisfies the eligibility requirements outlined in the guidelines, whereby the latter agrees to cover the RE’s loss from default up to a predetermined percentage of the RE’s loan portfolio. Any other implicit guarantee of a similar character that is based on the success of the RE’s loan portfolio and is disclosed upfront shall likewise fall within the definition of DLG as per the guideline.

Eligibility for Default Loss Guarantee Provider

A Regulated Entity may only enter into a DLG agreement with a Lending Service Provider (LSP) or another RE with whom it has already entered into an outsourcing agreement (LSP). The lending service provider offering a default loss guarantee must be incorporated as a company per the 2013 Companies Act.

Requirements of Default Loss Guarantee Arrangements

An explicit, legally binding contract between the RE and the DLG provider must support all DLG agreements. The following information must be included in the contract, among other things:

• The extent of DLG coverage.
• The format for maintaining DLG coverage with the RE.
• Timeframe for DLG invocation.
• Disclosure requirements as per Regulation 11 of the guidelines.

Digital Loss Guarantee Forms

A regulated entity may only accept a digital loss guarantee in one or more of the formats listed below:

• Cash is deposited with the regulated entity.
• Cash held in a Scheduled Commercial Bank Fixed Deposits with a lien designated in favor of the RE
• Bank Guarantee in favor of the RE

Digital Loss Guarantee Coverage Cap

• RE must ensure that the total DLG cover on each outstanding portfolio indicated upfront does not exceed 5% of the entire amount of that loan portfolio.
• When implicit guarantees are used, the DLG Provider is not allowed to take on performance risk greater than 5% of the underlying loan portfolio.

Recognition of Non-Performing Assets (NPA)

• Regardless of any DLG coverage offered at the portfolio level, it is the regulated entity’s obligation to identify specific loan assets in the portfolio as NPAs and make the necessary provisions in accordance with the current asset classification and provisioning guidelines.
• The underlying individual loans cannot be set off with the amount of DLG invoked.
• According to the terms of the contract, any money recovered by the RE from the loans on which DLG has been used and realized can be shared with the DLG provider.

Tenor, Invocation, and Treatment of DLG for Regulatory Capital

• Capital computation, that is, computation of exposure and application of Credit Risk Mitigation benefits on specific individual loan assets in the portfolio, should continue to be guided by the existing regulations.
• Invocation- Unless the borrower makes good before that time, the RE must activate DLG within a maximum overdue term of 120 days.
• Tenor – The DLG agreement’s duration cannot be shorter than the loans in the underlying loan portfolio with the longest term.

Disclosure Requirements – The regulated entity must set up a system to make sure that lending service providers with whom they have a DLG agreement should post the total number of portfolios and the amount of each portfolio on which DLG has been offered on their websites.

Due Diligence and other requirements with respect to the DLG provider

• Before making any default loss guarantee arrangements, regulated entities must implement a board-approved policy. Such a policy must, at the very least, outline the following:
  
  a. Requirements for default loss guarantee providers.
  b. The nature and scope of DLG coverage.
  c. The procedure for monitoring and reviewing the DLG arrangement.
  d. The specifics of any payments that may be due to the DLG provider.
• It is emphasized that, regardless of DLG cover, strict credit underwriting standards must be implemented and that any DLG arrangement must not serve as a replacement for credit evaluation requirements.
• Before entering into or renewing a DLG arrangement, a RE must gather sufficient information to confirm that the party extending the DLG would be able to honor it. The statutory auditor’s certification of a declaration from the DLG provider regarding the total amount of outstanding DLG, the number of REs, and the number of relevant portfolios for which DLG has been issued are the very minimum requirements for this information. Past default rates on similar portfolios must also be included in the declaration.

Customer Protection and Grievance Redressal

Our guidelines in the “Guidelines on Digital Lending” dated September 02, 2022, as well as other applicable current norms, should serve as the basis for customer protection measures and grievance redressal concerns pertaining to DLG arrangements. Grievance redressal as per the guidelines on digital lending are:

• Nodal Grievance Redressal Officer – Along with the lending service providers they have hired, Regulated entities must ensure that they have a nodal grievance redressal officer who is qualified to handle any complaints or difficulties borrowers may have about digital lending.
• On the websites of the regulated entities, their lending service providers, and the digital lending application, contact information for grievance redressal authorities must be prominently displayed. Additionally, they should have complaint filing options on the websites.
• The borrower may file a complaint via the Compliant Management System (CMS) online under the Reserve Bank-Integrated Ombudsman Scheme if any complaints made by the borrower against the regulated entity or the lending service provider employed by the regulated entity are not resolved within the specified term (currently 30 days).

Exceptions

The following schemes and entities’ guarantees are not included in the definition of Digital Loss Guarantee:

• Credit Risk Guarantee Fund Trust for Low Income Housing (CRGFTLIH), Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), and individual schemes under National Credit Guarantee Trustee Company Ltd (NCGTC).
• According to the RBI Master Circular on Basel III Capital Regulation dated May 12, 2023, credit guarantees provided by Bank for International Settlements (BIS), the International Monetary Fund (IMF), and multilateral development banks are not included in the definition of DLG.

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Conclusion

The RBI has been actively involved in regulating and overseeing digital lending. It has taken steps to safeguard borrowers’ interests and ensure fair practices in the digital lending market. These directives are taken in accordance with sections 6 of the Factoring Regulation Act, sections 45JA, 45L, and 45M of the Reserve Bank of India Act, 1934, sections 21, 35A, and 56 of the Banking Regulation Act, 1949, and section 30A of the National Housing Bank Act, 1987.