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The First Loss Default Guarantee (FLDG) Model in India

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Last Updated on February 6, 2024 by Kanakkupillai

The Reserve Bank of India (RBI) recently issued a regulatory framework on digital lending arrangements that provides banks with a safeguard arrangement against non-banking finance companies (NBFCs) and fintech lending service providers, commonly referred to as fintechs. Under its FLDG model, fintechs will assume initial default hits up to an agreed percentage threshold.

First Loss Default Guarantee (FLDG)

The Reserve Bank of India (RBI) recently authorized an alternative form of safety net between banks, non-banking financial companies (NBFC), lending service providers (LSP or fintechs), and lending default guarantee guarantees (FLDG) among lenders who will lose up to a pre-decided percentage if their borrowers default. FLDG arrangements ensure lenders won’t incur losses up to this percentage if any loans default and increase access to mainstream credit for people without it or with limited access.

FLDGs are often provided by LSPs in the form of cash deposits with them, fixed deposits maintained at scheduled commercial banks, or bank guarantees in their favour; their costs are then built into interest rates charged to borrowers. This allows LSPs to take riskier positions, encouraging more lending. Furthermore, it simplifies lending processes for NBFCs and banks that may need more technology or resources.

Before the RBI banned such arrangements last year, some fintechs offered FLDG guarantees of up to 100% of their loan portfolio. However, their new guidelines limit this to 5% of total loans, which reduces fintech’s skin in the game and hinders their ability to reach unbanked borrowers.

Crisil Ratings indicates that these new guidelines call for fintechs to increase data transparency to underwrite their borrowers properly. Crisil suggests this may slow the co-lending market as lenders adjust their models to comply with these new regulations.

These rules are essential to make India’s fintech ecosystem credible and responsible. They should encourage digital lending growth in India while making more people eligible to access credit. Furthermore, these regulations will assist fintech in building more robust ecosystems while improving the economics of business – particularly the originator’s financials – to provide higher quality loans that are safer and more reliable to borrowers.

Structured Guarantees

Structured guarantees are financial instruments designed to transfer credit risk within a pool of loans by offering guarantees to lenders. A structured guarantee may be limited or unlimited and cover only part of an outstanding debt; when this occurs, it’s known as a partial guarantee – often used for international business transactions. Different kinds of bank guarantees are available, each with its advantages; unconditional guarantees are the most widely used type, typically used with large-scale transactions like imports/exports.

The Reserve Bank of India (RBI) recently issued guidelines allowing structured guarantees in digital lending, subject to strict norms. Fintechs may use such arrangements to offer loans directly to consumers while taking on any default risk rather than passing it off onto banks or other financial institutions – although these arrangements should not be seen as an alternative solution to whole securitization.

RBI’s guidelines prohibit selling structured guarantees more than once to protect purchasers from moral hazard and opportunistic behaviour, ensuring they will not take on additional risks while trying to profit from the first loss protection offered by structured guarantee sellers. In addition, they must have an exit strategy when their current ones expire and plan for renewal as needed.

An essential requirement under the new guidelines is for structured guarantees to be purchased from an NBFC or HFC that has been granted full licensing by RBI, helping protect against distressed sales from non-licensed entities. Furthermore, performance targets and operating expenses (such as interest payments) must be met consistently by each NBFC/HFC to comply with its standards.

Guidelines stipulate that structures backed by an AMC or ARC-rated asset pool and free from non-performing assets diversify and have low correlation with one another; the purchase of guaranteed assets must occur at fair value to protect NBFCs or HFCs against selling their assets at discounted prices and incurring higher losses.

Partial Guarantees

Partial bank guarantees are designed to safeguard guarantors against potential loss due to non-performance of an obligation but do not cover its total amount; instead, they rely on third parties (in this instance, the host government) as sources of creditworthiness.

A partial guarantee can provide developing countries access to international capital markets and increase investment, lowering borrowing costs by eliminating collateral requirements. The World Bank uses partial guarantees as part of its lending portfolio strategy for projects with high social and environmental returns that require commercial financing backed by a sovereign counter-indemnity guarantee.

Partial guarantees can be offered for various projects, such as infrastructure and energy investments. Still, governments must refrain from oversubsidizing these guarantees, eroding profitability and discouraging banks from providing similar loans. To keep up with changing market trends and add more excellent value to its products, the World Bank collaborates regularly with financial market participants.

Recently, the government expanded its Partial Credit Guarantee Scheme 2.0 (PCGS) to cover bonds and commercial papers issued by HFCs, NBFCs and MFIs with low credit ratings – providing much-needed liquidity to this critical economic sector and helping it continue its role.

It will reduce the risk of default on debt issued by NBFCs and MFIs while permitting longer-term debt issuance by these companies and making loans available to more businesses so they can expand.

Partial credit guarantees can also be helpful in projects with low levels of political and economic risk, and this type of guarantee is sometimes referred to as “financial insurance” since it protects principal and interest payments in case of borrower default. They can also finance infrastructure projects with minimal political and economic risks.

Variations

After several years of inaction, the Reserve Bank (RB) recently responded to concerns over credit underwriting practices in fintech by issuing revised default loss guarantee guidelines. These revised rules have brought much-needed clarity to the lending industry and included significant amendments such as forcing banks that acquire NBFCs to recognize loans acquired as non-performing assets (NPA) regardless of First Loss Default Guarantee coverage; this requirement will have an immediate and profound effect on co-lending portfolios of these banks by increasing reported asset quality metrics and gross credit costs.

Another critical change involves setting the Daily Loan Growth Cap at five per cent of the loan portfolio to ensure lenders exercise caution when underwriting credit risk and promote responsible borrowing practices. Furthermore, under the guidelines, defaults must be resolved within 120 days or less from being overdue, encouraging borrowers to take immediate corrective actions and foster a healthier lending environment.

Benefits of Default Loss Guarantee in India

Recent moves by the Reserve Bank of India (RBI) were a welcome relief, as they addressed issues surrounding loss-sharing structures while maintaining standards. FLDG arrangements now play a vital role in digital lending.

The DLG Guidelines permit regulated entities (banks and NBFCs) to enter into FLDG arrangements with unregulated fintechs or other REs that meet specific norms, compensating REs proportionately for their losses incurred.

  1. It Boosts Credit Penetration

The Reserve Bank of India’s (RBI) decision to allow fintech lenders to offer first-loss default guarantee arrangements is a significant boon for the industry. It should help create a secure and sustainable lending ecosystem, expanding credit access for MSMEs while contributing to economic development.

Before this change, the RBI had advised that arrangements between regulated entities and lending service providers should be treated as synthetic securitization transactions that may trigger loan participation provisions, prompting many fintech lenders to discontinue offering DLG partnerships. As a result, many have had to stop offering them.

With these new guidelines in place, there is more clarity and discipline for regulated entities, which should facilitate deeper partnerships among banks, NBFCs, and fintech companies, leading to faster growth for the sector overall.

  1. It Reduces Risk

The Reserve Bank’s revised guidelines regarding DLG arrangements have clarified this subject. These stricter rules ensure fintech companies provide a partial default loss guarantee to their banking and NBFC partners, compensating them up to an agreed-upon percentage in case a bad loan occurs.

Banks and NBFCs can utilize this arrangement as a cost-cutting measure by outsourcing functions like customer acquisition, risk assessment and management, servicing and collection, thereby lowering costs while expanding loan portfolios.

Synthetic securitization requires entities to maintain regulatory capital for their cover pool; by contrast, DLG arrangements serve as an indirect form of collateralized lending and thus reduce the credit risks for these loans. Furthermore, the RBI has set a cap of 5%, which helps curb any unnecessary risk build-up within this sector.

  1. It Boosts Revenue

Crisil says the DLG guidelines bring much-needed clarity and regulatory sanctity, though short-term business volume could be affected.

DLG arrangements are agreements between banks or non-banking financial companies (NBFC) and fintech lending service providers (LSP). Under this arrangement, initial losses for defaulted loans will be covered by LSP, with compensation being offered up to an agreed percentage of portfolio size.

Banks and NBFCs can partner with heritage institutions to level the playing field and compete on innovation and effectiveness rather than price alone, helping diversify lending portfolios, access new markets and strengthen credit assessment systems by working closely with data providers and credit bureaus. This provides banks and NBFCs an additional benefit by levelling competition based on innovation, effectiveness and cost rather than solely cost considerations. This can then enable banks and NBFCs to partner more easily. This has the added advantage of helping banks and NBFCs work more closely together while levelling playing fields between competitors who might otherwise compete solely on price – helping banks and NBFCs find ways of competing for more innovation while competing effectively without solely cost considerations compared with heritage institutions collaborating through data providers or credit bureaus.

  1. It Strengthens the Ecosystem

The new guidelines aim to strengthen the digital lending ecosystem and lending partnerships between fintech and banks or NBFCs, thus helping reduce operational costs and increase profitability.

The Reserve Bank of India (RBI) recently approved and released the First Loss Default Guarantee guidelines, which ensure that guarantors compensate lenders up to a set percentage of loans generated by them if defaults occur within that predetermined percentage limit, improving the economics of fintech lenders/originators while decreasing operational risks, according to Ind-Ra Ratings in their report.

The RBI has approved FLDG structures between regulated fintechs but has issued stringent guidelines and expectations. These include making arrangements within 120 days of becoming overdue for loans and capping default loss guarantees at 5% as an adequate safeguard.

  1. It Strengthens the Banks

These guidelines could hurt NBFCs that have recently acquired lenders as the Federal Deposit Guarantee Liability Guarantee coverage is now limited to only five per cent of the loan portfolio. This change could significantly lower asset quality metrics and gross credit costs reported by acquired banks.

It will force NBFCs to explore alternative funding methods, such as fund-raising, debt restructuring or mergers and acquisitions; non-cash forms of FDLG, like corporate guarantees, have now been prohibited.

India Ratings and Research reported that these new rules will also help expand the digital lending ecosystem by encouraging heritage institutions to partner with fintech originators, providing more competition. But until that occurs, these guidelines provide much-needed momentum for this sector.

Conclusion

The move is also seen as a boost for the digital lending ecosystem and outsourcing industry, which were threatened with collapse following RBI’s ban last year. Under these guidelines, collaboration among regulated entities and fintech firms will increase, providing an ideal setting for innovation and growth of fintech firms in this sector.

Before the ban was enforced, some fintech companies were boasting about their ability to guarantee up to 20% of loans sourced through them, providing a positive indicator for potential borrowers and increasing business. It was an act of pride in their underwriting processes while simultaneously growing the business.

However, with such a mechanism, NBFCs and banks would thrive from lending to creditworthy borrowers, further worsening India’s household debt/ GDP ratio and hindering financial inclusion efforts. With the new guidelines in place, both NBFCs and banks will need to pay closer attention to the credit quality of those they source from fintechs, possibly adding their input into the underwriting process to improve overall credit underwriting systems for all. This will ultimately benefit everyone.

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