By Mr. Amit Shroff, CEO of Arvog
Introduction
The transformative effect of digital lending is bridging the gap between new technology and the banking sector. Fintech companies have simplified the lending and borrowing processes by integrating traditional financial services with cutting-edge digital technologies.
Recently, there has been a surge of optimism and excitement among fintech groups, established lenders, and investors since the Reserve Bank of India (RBI) issued its Recommended Practices on the Default Loss Guarantee (DLG) within the field of digital lending on June 8th, 2023.
But what do these guidelines mean for the digital lending arena? Let’s find out.
Understanding the RBI’s Guidelines
The Reserve Bank of India’s recent attempts to create a regulatory structure for digital lending across the nation have increased accountability and transparency in the industry while also providing some monitoring to guarantee customer safety.
DLG, earlier called First Loss Default Guarantee (FLDG) refers to a common method of delivering financial products in which an external party guarantees compensation for defaults up to a specified proportion of the Regulated Entity’s (RE) loan portfolio.
It is a frequent practice to insure loans made via lending fintech, with the amount of protection depending on the level of risk tolerance of the regulating body like a bank or NBFC.
Key Provisions of DLG Guidelines
Here are the most important points to remember about the DLG guidelines for regulated organizations and financial institutions.
Here are the most important points to remember about the DLG guidelines for regulated organizations and financial institutions.
- Applicable to Financial Institutions that are Regulated Entities (REs), including commercial and cooperative banking institutions and Non-Banking Financial Companies (NBFCs), that engage in digital lending activities.
- DLG is a legally binding contract between RE and an approved third party that ensures RE will be paid back for any losses due to default. Guidelines for Electronic Lending Circular, dated September 2, 2022, shall govern the terminology and meanings.
- DLG agreements may only be made with LSPs or additional REs maintaining an outsourcing agreement. An LSP that provides DLG must be an organization formed under the 2013 Companies Act.
- A legally enforceable RE-DLG provider contract governs DLG agreements. The scope of DLG, the kind of DLG preservation, the timeline for activating DLG, and its disclosure obligations should all be spelled out in the contract.
- REs take DLG in cash, Scheduled Commercial Bank fixed deposits or bank guarantees.
- DLG coverage on all outstanding loans shouldn’t be more than 5% of the overall loan portfolio. Implicit guarantee agreements should not exceed 5% of the loan portfolio’s performance risk.
- Individual loan assets are recognized as NPAs and provisioned by the RE regardless of DLG coverage.
- Current practices, including exposure assessment, credit risk management, and regulatory capital are maintained.
- If the borrower does not make the payment sooner, the RE is required to commence DLG after 120 days following the payment’s due date.
- The DLG agreement’s length shall not be shorter than the underlying loan portfolio’s longest loan tenor.
- Websites belonging to LSPs with DLG agreements must reveal the total number of allocations and the total dollar amount DLG covers.
- REs should implement a board-approved DLG policy that specifies the eligibility criteria, the monitoring process, the costs to be paid to the DLG supplier, etc. Strong credit underwriting rules are necessary; the DLG structure is not a substitute for these.
- DLG arrangements should comply with Digital Lending Regulations and other relevant rules regarding client protection and complaint remedies.
- DLG coverage does not apply to some programs or companies, notably the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE).
Objectives of RBI’s Guidelines
Stakeholders across the digital lending market are hopeful that the new standards will promote development, openness, and cooperation within the sector. Here are a few more observations on what lenders and customers can anticipate from the guidelines.
- The agreement provisions are seen as a good development that will improve credit acceptance and the digital lending ecosystem.
- It is hoped that with the establishment of a legal framework for DLG agreements, the digital lending industry will become more transparent and disciplined.
- The rules will encourage conventional banks, regulated companies, NBFCs, and fintech enterprises to engage and collaborate, democratizing loan availability and boosting growth in unserved and underserved areas.
- The standards would enhance the ecosystem and open the door for novel services like digital escrow solutions, which facilitate safe collections and deals.
Role of Fintech startup
To ease any worries about credit assessment needs, the RBI has also instructed fintech businesses to implement “robust” credit underwriting criteria. Banks and NBFCs must also gather ‘enough information’ to guarantee fintechs can repay loans.
This report from a fintech company and requires confirmation by an authorized auditor on specific points. The company must report the overall DLG amount remaining, the number of authorized companies, and the portfolios upon which the first loss default guarantee was issued.
Fintech companies will also be expected to include safeguards for their customers and channels for resolving complaints, as outlined in the previously announced digital lending rules.
While the RBI deserves praise for enabling DLGs, the success of these rules and the formation of new partnerships will depend on the degree to which regulated major entities adopt and adapt to them. This is encouraging news, and it will be interesting to observe how the policy choice is communicated to the ground and how it affects the market and consumers.
