In the history of Reserve Bank of India (RBI) committees and reports, it has always been the case that RBI implements the recommendations of its committees as is. But in a serendipitous moment, RBI has officially anointed 'Default Loss Guarantee' ("DLG"), more commonly known as First Loss Default Guarantee (FLDG) legal (terms and conditions apply). This is the opposite of the recommendations of the Working Group on Digital Lending – Implementation" dated August 10, 2022, which called this model 'Rent an NBFC' in its report and asked for its ban.
What is FLDG?
For those unaware of FLDG, a digital lender can agree with a non-banking finance company (NBFC) that if a digital lender introduces any borrower to the NBFC and the borrower does not pay back a loan, the digital lender pays the NBFC a percentage of the default on the borrower's behalf. Most NBFCs and banks have been commercially demanding such underwriting from digital lenders to allow them to lend through them for quite some time now. After RBI released the committee's report on digital lending, many banks and NBFCs terminated existing FLDG arrangements.
Why was it considered notorious?
Around 3-5 years ago, there were, in fact, many 100% FLDG arrangements in the market where a digital lender paid back whatever the borrower owed, which was the key reason the arrangement got a bad name. As per Section 45-IA of the Reserve Bank of India Act, 1934, only a company with a valid NBFC registration can lend through its balance sheet. But a 100% FLDG allowed digital lenders to piggyback on the balance sheet of NBFCs without obtaining registration and maintaining provisioning or capital adequacy norms. From the perspective of NBFC, it was credit risk-free and earning only because it was maintaining RBI registrations without any skin in the game.
Changing Tides of Regulatory Trend
But since the end of 2022, RBI has given a nod that risk mitigation for regulated entities in India involves a certain amount of risk sharing or, in some cases, even risk transfer. This is evident from the norms on securitisation and transfer of loans and the existence of asset reconstruction companies and NBFC- Factors. What distinguishes these previous guidelines from the current FLDG guidelines is that all the previous guidelines allowed securitisation, transfer or underwriting of lending risks from one regulated entity to the other. But the FLDG guidelines allow the transfer of risks to lending service providers, which, apart from adhering to digital lending guidelines, are not required to maintain a registration with RBI.
Here are the key takeaways from the guidelines:
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Date of effect of guidelines |
Unlike many other guidelines like the IT outsourcing guidelines where a transition period was allowed, these guidelines have come into effect immediately. Although the guidelines do not have a retrospective effect, it is important that any existing FLDG arrangements are evaluated and aligned with the guidelines immediately since a continuing arrangement shall be considered a violation of the RBI directions. |
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Eligible Givers of FLDG |
Only Lending Service Providers, as defined under the Digital Lending Guidelines and incorporated as a company in India. |
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Eligible Receivers of FLDG |
All Commercial Banks (including Small Finance Banks), Primary (Urban) Co-operative Banks, State Co-operative Banks, Central Cooperative Banks; and Non-Banking Financial Companies (including Housing Finance Companies) |
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Types of FLDG allowed |
- Cash deposits with regulated entities - Fixed deposit with a lien marked - Bank guarantee |
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Percentage Cap |
The default cover can now be provided for up to 5% of the total loan portfolio (not the outstanding amount). [During the committee meetings, stakeholders had requested a cap equivalent to capital adequacy to the tune of ~15-20%, but this recommendation has not been accepted.] |
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NPA Recognition and Provisioning |
Until now, any payment made under FLDG was directly set off against the outstanding loan. However, RBI has now made it mandatory for regulated entities to recognise the unpaid loan as a non-performing asset and undertake required provisioning. The book entry for recovery from FLDG shall be similar to any recoveries made from third-party guarantors in secured lending. |
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Timeline for enforcement |
FLDG can be enforced and collected within a maximum overdue period of 120 days (4 months) unless the borrower has repaid the loan amount before that. |
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Disclosure Requirement |
REs to ensure that LSPs providing DLG arrangements to such REs publish the total number of portfolios and the amount of each portfolio on which DLG has been offered on their website. |
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Duration of FLDG |
DLG agreements will only exist for a period which shall not be less than the longest tenor of the loan in the underlying loan portfolio. |
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.
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