Guidelines On Default Loss Guarantee in Digital Lending - First Impressions And Questions

The Reserve Bank of India ("RBI") has issued Guidelines on Default Loss Guarantee in Digital Lending dated June 08, 2023 ("DLG Guidelines") which will come with immediate effect.

Under the DLG Guidelines, RBI has now permitted Commercial Banks, Primary (Urban) Co-operative Banks, State Co-operative Banks, Central Co-operative Banks, Non-Banking Financial Companies and Housing Finance Companies ("REs") to enter into default loss guarantee ("DLG") arrangements with lending service providers ("LSPs") and REs subject to compliance with the DLG Guidelines.

Key highlights

I. DLG arrangements

The DLG Guidelines define DLG as a contractual arrangement between the RE and LSPs pursuant to which LSPs can compensate the RE for any loss due to default up to a certain percentage of the loan portfolio of the RE. Such percentage is required to be identified by the parties upfront in writing. The RBI has clarified that a DLG shall not involve any actual transfer of the underlying loan exposure from the books of the RE to the books of the DLG provider and that any other implicit guarantee of similar nature linked to the performance of the loan portfolio of the RE will also be covered under the definition of DLG.

One of the requirements of DLG arrangements is that the DLG cover and mechanics will have to be specified upfront in the contract between the parties. The REs will have to ensure that the percentage cover is specified clearly in the contractual arrangements. Further, by including implicit guarantees of similar nature which are linked to the performance of the loan portfolio, RBI appears to be covering contractual relationships worded differently but working effectively as a guarantee. This may impact other loss-sharing and indemnity arrangements which require LSPs to hold REs harmless from loan portfolios' default, and accordingly parties will need to carefully evaluate the structure of any existing and future DLG arrangements.

II. Permissible DLG structures

The RBI has permitted the following DLG structures:

1. Cash deposited with the RE;
2. Fixed Deposits maintained with a Scheduled Commercial Bank with a lien marked in favour of the RE;
3. Bank Guarantee in favour of the RE

DLG arrangements in the form of contractual guarantees or third-party guarantees other than bank guarantees are not permitted under the DLG Guidelines. The treatment of cash deposited with the RE for DLG arrangement appears to have been permitted by the RBI only to the extent of the permitted cap (see below) and this could impact any existing structures in the market under which an RE would accept cash collateral in the form of a security deposit from the LSPs as part of the DLG arrangement. This may imply that REs are not permitted to accept cash collateral in excess of the prescribed limits, as any DLG arrangement in violation of the DLG Guidelines may be treated as synthetic securitization by the RBI. Further, the legality of cash collateral will also have to be analysed from the perspective of regulations on acceptance of deposit .

III. Cap on DLG

DLG cover on any outstanding portfolio is not permitted to exceed 5% of the amount of that loan portfolio and the DLG portfolio needs to be specified upfront in the contractual arrangement between REs and LSPs. A similar cap of 5% of the underlying loan portfolio is provided for implicit guarantee arrangements.

The REs will have to ensure that the percentage cover is specified clearly in the contractual arrangements and such cover is line with the commercial arrangement between the parties. REs may need to restructure the existing arrangements to comply with the DLG Guidelines on this aspect.

IV. Eligibility as DLG provider

REs are permitted to enter into DLG arrangements only with an LSP/ other RE with which it has entered into an outsourcing (i.e., LSP) arrangement. Further, the LSP providing DLG must be incorporated as a company under the Companies Act, 2013.

This qualification appears to address the issue of illegal third-party Chinese apps which were operating as LSPs to REs and entering into DLG arrangements. Now, all LSPs will be required to be incorporated as a company under the Companies Act, 2013. Further, the qualification that REs can enter into DLG arrangements only with an LSP/ RE with which it has an outsourcing (i.e., LSP) arrangement may impact existing models in the market where a group NBFC of the LSP (not being the outsourced LSP partner of the RE) would enter into a DLG arrangement on behalf of the LSP.

V. Conditions of DLG arrangements

1. DLG arrangements should be backed by an explicit legally enforceable contract between the RE and the DLG provider. Such contracts should contain the following:
   
   1. Extent of DLG cover;
   2. Form in which DLG cover is to be maintained with the RE; and
   3. Timeline for DLG invocation.

These contractual prescriptions are in addition to the requirements prescribed under RBI guidelines on outsourcing of financial services by REs. The existing outsourcing policy of the REs may be required to be revised to include the above specifics in relation to outsourcing arrangements involving DLG arrangements.

2. REs are not permitted to invoke DLG for loan accounts overdue for more than 120 days, unless made good by the borrower before that.
   
   
3. Tenor of DLG arrangement should not be less than the longest tenor of the loan in the underlying loan portfolio.

By providing an outer limit in terms of the number of days for which a loan account is delinquent and within which the DLG must be invoked, the RBI appears to create some accountability and discipline for the RE's giving loans on the basis of such DLG's and taking recourse to DLG's in a timely manner. Also, by prescribing that the minimum tenor of the DLG arrangement shall not be less than the longest tenure of the loan in the underlying portfolio, RBI seems to have pre-emptively prohibit any DLG arrangements which may be sliced up in multiple parts by the parties to circumvent the aggregate caps on DLG cover..

4. DLG providers are required to publish on their website the total number of portfolios and the respective amount of each portfolio on which DLG has been offered. This is also required to be captured in the DLG contractual arrangement between RE and DLG provider.

VI. Due diligence of DLG provider

1. REs are required to put in place a board approved policy before entering into any DLG arrangement which should include, at the minimum, the eligibility criteria for DLG provider, nature and extent of DLG cover, process of monitoring and reviewing the DLG arrangement, etc.
2. DLG arrangement should not act as a substitute for credit appraisal requirements and robust credit underwriting standards need to be put in place irrespective of DLG cover.
3. Every time an RE enters into or renews a DLG arrangement, REs should obtain adequate information to satisfy itself that the entity extending DLG would be able to honour it. Such information shall, at a minimum, include a declaration from the DLG provider, certified by the statutory auditor, on the aggregate DLG amount outstanding, the number of REs and the respective number of portfolios against which DLG has been provided. The declaration shall also contain past default rates on similar portfolios.

RBI has introduced due diligence requirements to ensure that REs enter into DLG arrangement with entities of good standing and which are capable of honouring the guarantee obligations and are not overleveraged with existing DLG arrangements. REs will be required to ensure that in addition to having a board policy, the REs will have to ensure continuous monitoring and review of the DLG arrangement. Further, REs will have to ensure that independent robust credit checks are put in place irrespective of reliance on the credit checks done by the LSP. For each DLG arrangement entered, the DLG provider will be required to issue a certificate from its statutory auditor confirming details of aggregate exposure of the LSP to all DLG arrangements.

VII. Account classification, provisioning and regulatory capital

1. REs shall continue to be bound by the extant account classification and provisioning norms for the individual loans irrespective of any DLG cover available at the portfolio level.
2. The amount of DLG invoked is not permitted to be set off against the underlying individual loans.
3. Recovery by the RE, if any, from the loans on which DLG has been invoked and realised, can be shared with the DLG provider in terms of the contractual arrangement.
4. Capital computation of exposure and application of Credit Risk Mitigation benefits on individual loan assets in the portfolio shall continue to be governed by the extant norms.

The existing practices of some Res of classifying the loan portfolios as standard assets upon invocation of the DLG arrangements will have to be discontinued. Further even post invocation of DLG arrangements, the exposure of the RE for the defaulted loans cannot be set-off against the amount recovered from the DLG provider.

Concluding remarks

With issuance of DLG Guidelines, the RBI seems to have taken a balanced approach by permitting DLG arrangements in a calibrated manner while not completely derailing existing FLDG arrangements and business models adopted by many fintech companies and given the importance of digital lending and access of credit. With the DLG Guidelines coming into effect, REs will be required to revisit and restructure their existing DLG arrangements to ensure compliance with the DLG Guidelines as non-compliant structures could be treated as 'synthetic securitisations', which are not permitted under the Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 dated September 24, 2021 and/or may also not attract the provisions of 'loan participation' in terms of the Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021 dated September 24, 2021.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.