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Loan Default Guarantee : A Potential Catalyst for Digital lending

Digital lending in India might still be a small sliver in the overall financial pie, but its potential can't be ignored. The ease of access, game-changing technological innovations, and cost-effective models are priming digital lending to explode into an influential sector in India's credit financial landscape.

What makes these digital lending platforms tick? Their secret lies in their agile nature and their prowess in leveraging technology to revolutionise the way we perceive and manage credit. However, as adept as they may be in this new-age tech, they still lack the monetary muscle to compete with traditional financial institutions.

These financial powerhouses have deep pockets, but are often held back by bureaucratic hurdles and rigid regulations. They also struggle to innovate and diversify their credit offerings at a pace that can keep up with the changing times. Hence, an alliance between the nimble digital lenders and the financially potent traditional institutions seems not just plausible but also mutually beneficial.

However, while the digital lender can provide an easier access and bridge between people who need credit and the traditional lender, underwriting the risk of default amongst the parties is asymmetrical. This has led to mushrooming of practices that has given rise to increasing uncertainty and unclarity in this space.

FLDG - An illusive ‘safety net’ To make traditional lenders feel safer, digital lenders offered ‘First Loss Default Guarantee’ (FLDG). This is essentially a promise from the digital lender to cover some of the money lost if a borrower doesn't pay back their loan.

Imagine a traditional lender that gives out 1000 loans through a digital lender. The digital lender might promise to cover the cost if up to 50 of those loans aren't paid back. This means the traditional lender won't lose money as long as no more than 5% of the loans go bad. Even though this sounds like a good deal, there are 2 key problems.

One, digital lenders were making these promises to cover losses all over the place, and there were no rules about it. For example, a digital lender with INR 10 Crores in assets might have made promises to cover up to INR 100 Crores in loan losses. This could put banks and big financial companies, who are important parts of our financial system, at risk should the loans turn bad.

Second, the regulated lenders were treating such digital loans as securitized and hence not creating adequate provisions for any doubtful loans which they otherwise would require to do.

RBI’s Role The RBI issued guidelines on digital lending in September 2022 but did not provide clarity on the FLDG structure. In the absence of clear directions, regulated entities like banks had discontinued / stopped entering into arrangements with fintech / digital loan service providers, posing a threat to the nascent digital lending system. The fintech industry was demanding that the RBI should allow FLDG arrangements.

Heeding to the demand from the industry, the RBI has in early June 2023 issued guidelines on loan default guarantees. Now, digital lenders can still make these promises, but with certain safeguards. Banks can only accept a FLDG if it's backed up with real money. This could be a cash deposit, or a fixed deposit in a bank that the bank can claim if needed, or a bank guarantee that favours the bank. This makes sure that digital lenders can only make promises they can keep and hence act as a natural guard rail against unbridled optimism.

The RBI also made some extra rules to make sure that banks and big financial companies check things out for themselves and don't just rely on digital lenders: the amount of money a digital lender can promise to cover is limited to 5% of the loan. If a loan goes bad, it will still count as a bad loan for the lender, even if there's a FLDG. The lender can use the FLDG to get their money back, but the bad loan would still count against them.

Implications for the future

The RBI's guidelines for digital lending companies is a constructive step towards providing clarity and certainty in the area and making lending safer. By letting digital lenders make promises to cover losses and assume the underwriting risk in a clear and measurable manner, the RBI has sought to make the lending world safer for both lenders and borrowers. This is likely to avoid unintended fallouts and foster people’s trust in digital lenders and thereby help catalyse the growth of this extremely promising industry.

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