RBI permits loan default guarantee in digital lending

Context
The Reserve Bank of India (RBI) has allowed default loss guarantee (DLG), a safety-net arrangement among banks, non-banking finance companies, and lending service providers (LSPs) in the digital lending space.
  • DLG is also known as ‘First Loss Default Guarantee (FLDG)’.
Who are lending service providers (LSP)?
  • Lending service providers are new-age players who use technology platforms in the lending space.
  • They are agents of a bank or NBFC who carry out one or more of a lender’s functions (in part or full) in customer acquisition, underwriting support, pricing support, disbursement, servicing, monitoring, recovery of specific loan or loan portfolio on behalf of REs.
First Loss Default Guarantee (FLDG):
  • FLDG is an arrangement whereby a third party such as a financial technology (fintech) player (LSP) compensates lenders if the borrower defaults.
  • The LSP provides certain credit enhancement features such as first loss guarantee up to a pre-decided percentage of loans generated by it.
  • Offering FLDG acts to investors will work as a demonstration of its underwriting skills.
  • From the perspective of the lender, it ensures the platform’s skin in the business.
About RBI’s move:
  • The RBI, after examining FLDG, permitted the arrangements between banks and fintechs or between two regulated entities (REs).
  • The central bank said an RE can enter into DLG arrangements only with an LSP or other REs with which it has entered into an outsourcing (LSP) arrangement.
  • The LSP-providing DLG must be incorporated as a company under the Companies Act, 2013.
Need of the initiative:
  • The RBI issued guidelines on digital lending in September 2022, but it did not provide clarity on the FLDG structure.
  • In the absence of clear directions, regulated entities like banks had stopped entering into such arrangements with fintech players, posing a threat to their business.
  • The fintech industry was demanding that the RBI should allow FLDG arrangements.
Significance:
  • The RBI nod for compensating banks in case of default is expected to boost fintech activity in the financial sector.

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