What is RBI's 5% Default Loss Cover for Banks and Fintechs?

The Non-Banking Financial Companies (NBFCs) and fintech firms are applauding Reserve Bank of India’s (RBI’s) decision to approve First Loss Default Guarantees (FLDG) between regulated and unregulated entities. This move, however, comes with a cap of 5 percent of the loan portfolio value.

What Does RBI’s New Guidelines Say?

The RBI has issued new guidelines allowing the use of First Loss Default Guarantee (FLDG) arrangements in digital lending. This comes after the FLDG model was banned by the regulator last year, leaving fintech firms waiting for clarity on their lending arrangements with banks. 

The FLDG model involves a lending partnership between a bank/NBFC (regulated entity) and a fintech or lending service provider (mostly unregulated), where the latter guarantees to compensate for a certain percentage of defaults in the loan portfolio. 

What Changed?

Under the new framework, the default cover can be provided for up to 5% of the loan portfolio and must be invoked within a maximum overdue period of 120 days. 

This is a significant change from the previous practice of offering almost 100% FLDG, which exposed banks and NBFCs to high risk. The RBI also stated that any other implicit guarantee linked to the loan portfolio's performance must be covered under the definition of DLG. 

Lenders are required to ensure that lending service providers disclose the number of portfolios and the respective amounts covered by the guarantee arrangement on their website. Additionally, fintechs must provide a tangible guarantee in the form of cash deposits, fixed deposits, or a bank guarantee in favor of the lender.

Adequate Risk Coverage with the 5 Percent Cap

Experts in the industry believe that the 5 percent cap is more than sufficient to address the risk concerns of regulated entities (REs). This decision by the RBI provides much-needed clarity on digital lending. The new guideline enables REs to collaborate with non-REs in sourcing loans, a development that will significantly contribute to financial inclusion. If an RE expects more than 5 percent cover, it may be worth reconsidering their lending strategy altogether.

A Shift in RBI's Stance

Back in September 2022, the RBI prohibited REs from engaging in FLDG arrangements with unregulated entities. At that time, the RBI asserted that the loan offered to a consumer was strictly between the lender and the consumer, with the fintech partner serving as a loan originator, akin to an agent.

However, the central bank has now revised its stance and permitted REs to enter into FLDG arrangements with unregulated entities, albeit within the confines of a 5 percent cap. According to the new framework, the default cover can be provided for up to 5 percent of the loan portfolio and must be invoked within a maximum overdue period of 120 days.

What Are The Key Points from the Circular?

The circular issued by the RBI on June 8 outlines important details regarding this development. It states, "The RE shall ensure that the total DLG cover on any portfolio which is specified upfront shall not exceed 5 percent of that loan portfolio. In case of implicit guarantee arrangements, the DLG provider shall not bear performance risk of more than five percent of the underlying loan portfolio."

Understanding Regulated Entities and Lending Service Partners (LSPs)

The circular also clarifies the definition of regulated entities and lending service partners (LSPs). Regulated entities include commercial banks (including Small Finance Banks), primary (Urban) cooperative banks, state cooperative banks, central cooperative banks, and Non-Banking Financial Companies (NBFCs), including Housing Finance Companies. 

LSPs, on the other hand, are agents of a Regulated Entity who perform one or more of the lender's functions, such as customer acquisition, underwriting support, pricing support, servicing, monitoring, and recovery of specific loans or loan portfolios on behalf of REs. These functions must align with the outsourcing guidelines issued by the Reserve Bank.

The RBI's decision to allow First Loss Default Guarantees between regulated and unregulated entities, with a 5 percent cap, has generated enthusiasm among NBFCs and fintech firms. This development not only offers clarity on digital lending but also opens up opportunities for collaboration between REs and non-REs, ultimately contributing to financial inclusion. 

As the industry embraces these changes, it becomes essential for REs to re-evaluate their lending strategies and consider the risk coverage provided within the 5 percent limit.