-Aryan Babele*
Abstract
The credit gap stands at INR 31 lakhs for Indian MSMEs. Timely access to working capital remains a constraint for Indian MSMEs as licensed lenders find comfort in lending to creditworthy large corporate-buyers. The first-loan default guarantee (FLDG) is the prominent arrangement aiding fintech-entities in incentivising for extending loans to unserved. But the recent digital lending guidelines appear to prohibit FLDG. The digital lending ecosystem seeks clarity from the regulator given a complete prohibition on FLDG could hurt RBI’s financial inclusion objectives. While the industry wants risk-based regulation, any further direction from the regulator will require the restructuring of existing digital lending arrangements.
Background
Last year, the Reserve Bank of India (RBI) issued the ‘Guidelines on Digital Lending’ (DL Guidelines) in September. The DL Guidelines are based on the regulatory framework recommended in the report submitted by RBI’s Working Group on Digital Lending (DL Working Group) in November 2021. The foremost reason that RBI constituted the DL Working Group is the untoward consequences of increased reliance on unregulated fintech entities for digital lending, ranging from mis-selling to customers and data breaches to heavy-handed debt recovery. DL Guidelines are noteworthy, particularly, for the fintech entities engaged by RBI-regulated entities (REs), such as banks and non-banking financial companies (NBFCs), for servicing loans digitally.
Within the universe of digital lending, there are two kinds of entities that carry out the business of loans. Firstly, under Section 5(b) of the Banking Regulation (BR) Act 1949, REs that are permitted to retain the loans and associated credit risk of loans on their balance sheet. Secondly, the lending service providers (LSPs) that are lending outside the purview of any regulatory framework or assisting REs as outsourcing partners with the acquisition/identification of borrowers, over the digital platform.
In a prominent form of digital lending, a fintech LSP not only provides a digital lending application (DLA) to recognised lenders (i.e., REs) for servicing loans but also guarantees to compensate up to a percentage of default with respect to a pool of loans serviced over DLA. This entire construct is known as the First Loss Default Guarantee (FLDG). For instance, an LSP facilitates a bank with the origination of a loan pool of Rs 10 crores. The LSP provides the bank with FLDG to compensate up to 10% credit risk associated with the loan pool, i.e., upto Rs 1 crore. This means that the LSP will be covering the risk of loss upto Rs 1 crore for the loan pool, collectively of Rs 10 crore, it serviced for the bank. This incentivises a lender to approve more loans as a portion of the risk of potentially bad loans is covered by the LSP.
It is this FLDG arrangement regarding which fintech entities and REs are still seeking clarity even months after RBI notifying DL Guidelines. This is because para 15 merely states that until any specific instructions are issued on, for FLDGs, REs providing loans under such arrangements have to adhere to the guidelines laid down in Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 (Securitisation Directions) and, in that, particularly, the provisions pertaining to ‘synthetic securitisation’. The vague directions in para 15 of the DL Guidelines have left fintech-RE partnerships in a quandary as to what is permissible and restricted as far as the FLDG arrangements between them are concerned.
The Good and the Bad of FLDG
When the LSPs cover the risk of loss, lenders have additional comfort in sanctioning unsecured loans for small borrowers characterised with asymmetric financial information. Moreover, FLDG arrangements ensure that LSPs have ‘skin’ in the game, thus, adequate underwriting and cash flow assessment to ensure the quality of thin-filed borrowers. Otherwise, traditional lenders prefer lending to large corporate borrowers leaving micro-enterprises or small borrowers unserved. FLDG is a tool to bridge the credit gap and has also been employed by the government in form of credit guarantee schemes to incentivise RE-lenders for extending collateral-free credit flow to small businesses. The arrangement has been integral to continue lending to small businesses even during crisis like COVID-19 pandemic.
The partnership between REs and unregulated LSPs brings out best of both the worlds to enable financial inclusion. REs provide the liquidity for credit supply and fintechs provide the technology for cost-effective last-mile credit delivery. However, RE-fintech arrangements blur the distinction between regulated and unregulated lending institutions/activities. The dependence of REs on unregulated or shadow lenders could create an informal loan market wherein it is difficult for RBI to identify fraudulent activities. Such lending practices pose regulatory challenges for RBI in ensuring consumer protection, and erode public confidence in the financial system.
RBI has limited supervision on the activities of LSPs under the outsourcing arrangement. The ultimate obligation to ensure adherence to appropriate credit scoring norms rests with REs according to Para 4.1 of Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Services by banks and Para 3.1 of Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Services by NBFCs. Therefore, RBI expects REs to lend largely by relying on standard underwriting and know-your-customer (KYC) processes. With FLDG provided by LSPs, REs find their credit risk covered and incentivised to lend by relying on flexible LSPs algorithm-based underwriting models. The report of the DL Working Group in its report apprehends such practices as circumvention around RBI’s licensing regime. The report observes that LSPs are indirectly lending on their balance sheet in absence of any regulatory license and compliance with the RBI’s prudential norms. Para 5.3.4.1 of the Report of RBI’s DL Working Group also notes that the cost incurred in extending the FLDGs is passed on to the borrowers in form of higher interests for quicker disbursals.
The excessive reliance on FLDG by LSPs as criteria to sanction a loan could also run afoul of RBI’s outsourcing guidelines. The outsourcing guidelines prevent REs from outsourcing core-banking activities such as underwriting to third parties. To avoid the build-up of operational risks, RBI has maintained that the primary motivation to frame DL Guidelines is to prevent RE lenders’ unchecked reliance on unregulated LSPs. While framing DL Guidelines, RBI has taken note of DL Working Group’s express reservations against FLDGs involving RE-fintech arrangement.
Securitisation Directions
In a securitisation structure, an RE repackages the credit risk into tradeable securities of different level of risks, to give investors of various classes access to the loan exposures. This allows a lender to distribute risk associated with a loan among such third parties that otherwise might have not been able to access a loan exposure directly. RBI’s Securitisation Directions (Para 4) regulate such securitisation transactions which involve the redistribution of credit risk in assets by RE lenders.
The Securitisation Directions, as mentioned in its para 3, are applicable to a list of RBI-regulated REs only, such as banks and small finance banks (excluding RRBs); All India Financing Institutions (AIFIs) such as NABARD, NHB, EXIM Bank, and SIDBI; NBFCs and Housing Finance Companies (HFCs), that are lenders or originators of loans.
Permissible Securitisation Transactions
The para 6 of the Securitisation Directions provides a negative list of the assets that cannot be securitised:
Restricted Securitisation Structures | Meaning |
Re-securitisation exposure | As the name itself suggests, it is the securitisation of an already securitised assets. For instance, securitising mortgage-backed securities would mean re-securitisation. |
Structures in which short-term instruments such as a commercial paper, are periodically issued against long-term assets held by an entity | This could be a note which collateralises future repayments of individual loans, such as credit cards, auto loans, student loans, such as collateralized debt obligations (CDOs) and asset-backed commercial papers. |
Synthetic Securitisation | Under this arrangement, the credit risk underlying a pool of loans is hedged instead of repackaging and transferring a pool of loans. E.g., credit default swaps (CDS) or credit guarantees. |
Securitisation of the following assets as underlying: 1. Revolving credit facilities (RCF); 2. Restructured loans; 3. Exposures to other lending institutions; 4. Refinanced exposures of AIFI; and 5. Loans with bullet re-payments; 6. Loans with residual maturity of less than 365 days. | 1 - RCF is a line of credit as agreed between a bank and a business such that the business can access capped funds at any time required. 2 – Restructured loans are the loans that are repackaged by a creditor by changing the loan terms to make the existing debt more affordable. 3 - The exposures to other lending institutions such as banks and NBFCs; 4 - Refinanced exposures of AIFIs such as the NABARD, SIDBI and NHB. 5 - Loans for which lump-sum repayment is made of both principal and interest as underlying cannot be securitised. 6 - Loans where the actual maturity period (other than the minimum holding period) is less than 12 months. |
Except for the transactions mentioned in the above list, all other loans and advances-related exposures of lenders, which are on its own balance sheet, are permissible securitisation transaction.
The interplay between Securitisation Directions and DL Guidelines: Takeaway for FLDG structures
DL Guidelines require REs engaged in FLDG arrangement to adhere to the Securitisation Directions, especially its clause 6(c) related to synthetic securitisation. Para 15 of the DL Guidelines and paras 5(y) and 6(c) of the Securitisation Directions define ‘synthetic securitisation’ as:
“a structure where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of credit derivatives or credit guarantees that serve to hedge the credit risk of the portfolio which remains on the balance sheet of the lender”
As per the definition of ‘synthetic securitisation’ above, the traditional instrument of credit guarantees have also been included. Therefore, the FLDG arrangements being credit guarantees could also be said to fall in the category of synthetic securitisation.
Thus, DL Guidelines read with Securitisation Directions provide three possible observations:
As synthetic securitisation is impermissible under Securitisation Directions, any form (through credit guarantee or credit swaps) of risk transfer in a pool of loans to a third party by a lender RE, while retaining the pool on its own balance sheet, is not permitted.
The Securitisation Directions are applicable to REs only. Thus, the regulatory accommodation on FLDG, if any permitted, will remain for RBI REs only. The unregulated entities may not be able to offer FLDGs now without getting a feasible regulatory license, such as license to operate an NBFC or small finance bank. Although, DL Guidelines do not restrict REs from extending FLDG arrangement to unregulated LSPs, as expressly as recommended by DL Working Group.
Synthetic securitisation is an arrangement that is specifically related to credit risk underlying a pool of loans. This could possibly mean that fintech entities may provide guarantees specific to individual loans.
Conclusive Remarks
The restrictions on synthetic securitisation stem from the predominant role CDS played in the 2008 Financial Crisis. Credit guarantees by fintechs are similar to CDS such that a third-party LSP agrees to protect a RE lender against the risk of loss with respect to a loan pool. The guarantee is not cash and an unregulated LSP’s standing cannot be relied upon. This creates a bubble, which any financial regulator seeks to avoid.
If an unregulated entity is able to provide material guarantee i.e., in cash, within the bounds of outsourcing guidelines, there should not be any objections to such FLDG arrangement. However, any kind of securitisation arrangement between fintech LSPs and RE lenders now appears to be difficult with the inclusion of loans with maturity periods upto 12 months within the list of impermissible securitisation structures. The majority of fintech entities facilitate loans (either consumer finance or business finance) to solve the immediate short-term credit needs of small borrowers. These loans are of shorter maturity periods (typically 3-6 months) and small ticket sizes. This will adversely affect the existing RE-fintech arrangements that have extended short-term working capital loans to unserved segments (such as micro-enterprises) and discourage progress witnessed in pursuing RBI’s goal of financial inclusion.
RBI has valid concerns in relation to increased reliance on unregulated fintech entities of RE lenders for extending loans to diverse pockets of borrowers. Barring fintech LSPs absolutely from existing FLDG arrangements not only take away the comfort that RE lenders now find in extending credit to unserved segments but also make LSPs dispassionate about solving the huge need of quicker or immediate disbursals of loans in India. RBI may rather consider introducing the regulatory cap on FLDG extended by LSPs to RE lenders. For effective monitoring of loans disbursed under such arrangements, a comprehensive framework may be adopted for registering partnerships between LSPs and REs. The registration framework may allow only those FLDG arrangements wherein LSP is complying with a set of net-worth and background check norms along with the fair practices code.
From the current regulatory prescriptions by RBI, it is clear that the intent of the RBI is to ensure that the one who holds the pool of loans in its balance sheet must hold the underlying credit risk in a pool as well. However, the LSPs need clarity from RBI to ascertain whether going forward only REs (or an entity regulated by another financial-sector regulator such as SEBI) will be able to extend FLDGs. In such a scenario, the existing FLDG-based lending models will need to be restructured.
*Aryan Babele is the Legal Counsel (Fintech) at FloBiz - a Neobank for SMBs.