A Framework for Productizing RBI's Default Loss Guarantee Guidelines

Background

Reserve Bank of India (RBI) has quite recently issued guidelines on "Default Loss Guarantee (DLG) in Digital Lending". This would prove to be a game changer for both banks and lending service providers (Fintech) in terms of establishing a strong ecosystem based on partnership.

In simple terms, DLGs are guarantees, provided to banks/NBFCs, by entities (called Loan Service Providers or LSP) involved in sourcing loan customers. Though sourcing happens through LSPs, on account of regulatory guidelines, the loan is provided by the bank/NBFC. In effect, banks/NBFCs underwrite the risk.

Such guarantees are considered as LSP's skin-in-the-game; they could be invoked by the banks/NBFCs when the quality of the portfolio originated by LSPs fall below expected levels.

On the flip side, on account of such DLGs which act as a safety net, banks tend to take a laid-back approach in assessing the risk while sanctioning the loans; which could prove detrimental to the overall asset quality. Ultimately, as the banks/NBFCs are underwriting the risk, they have a responsibility of assessing the risk as well. Consequently, such DLGs were proving to be contentious.

In terms of the above-referred guidelines, RBI has formalized such DLG based lending, subject to various checks and balances mentioned in the guideline. Such checks included a 5% cap on the overall quantum of DLG and governance measures such as putting in place a board-approved policy to determine the eligibility of the DLG provider.

Need for a product-based approach to manage LSPs/DLGs

As the guidelines have been formalized, banks/NBFCs and LSPs would be in a position to get into many-to-many contractual LSP relationships. For example, a bank could enter into independent tie-ups with different LSPs specializing in say, SME Segment and Retail Segment. Going forward, a significant proportion of the loans are expected to the sourced/managed through LSPs on account of the unit economics involved.

In order to streamline the management of the lifecycle of LSPs/DLGs, a product-led approach is best suited. This will ensure process efficiency, cost efficiency, and regulatory compliance, at all levels.

Key reasons why a product-led approach is advocated in this regard include:

1. Onboarding the right LSP: RBI Guideline on DLG prescribes that there needs to be a board-approved policy in determining the eligibility of LSPs who issue the Default Loss Guarantees (DLG). As per best practices, such eligibility conditions must cover adherence to standard due diligence norms such as KYC, KY3P (Know Your Third Party), or AML norms. In addition, the selection criteria include sound track record, technical capabilities, good financial standing, creditworthiness, and market standing. All these would involve performing the required checks using in-house/third-party data and eventually scoring/rating the LSP to objectify the decision-making process.
2. Ensuring Regulatory Compliance: LSPs come within the ambit of 'Guidelines on Digital Lending' issued by Reserve Bank of India, during September 2022. In terms of the said guidelines, banks have an onerous responsibility of ensuring regulatory compliance such as conducting due diligence and ensuring LSP's compliance with requirements such as data storage and privacy. Such compliance needs to be ensured not only at the time of onboarding the LSP but on an ongoing basis as well. Unless the process is streamlined, it will become burdensome for the banks to always ensure regulatory compliance.
3. Fulfillment of contractual obligations: Both parties must fulfill certain contractual obligations such as documentation, payouts, and contract renewal. Such obligations have to be tracked till fulfillment.
4. Performance Measurement: LSPs are directly responsible for the quality of portfolios sourced by them. In addition, they may have other responsibilities such as collections/recovery being managed by them as part of the contractual terms. Such business obligations have to be measured against defined Key Performance Indicators (KPIs)/OKRs as part of the performance measurement of LSPs. Typical KPIs/OKRs could be in the nature of portfolio default rates, cost of sourcing, risk-adjusted rate of return, and collection efficiency. Such performance metrics can be tracked through near real-time dashboards and BI tools, in order that corrective actions may be initiated against any slippage as compared to targets.

Illustrative Framework

An illustrative product framework that caters to the requirements of managing the lifecycle of Loan Service Providers and their Default Loss Guarantee is depicted below:

I. Loan Service Provider Lifecycle Module

1. Onboarding: Facilitating onboarding processes such as entity registration, correspondence details, and invoicing-related details such as GST, and authorized signatories.
2. Due Diligence: Conducting due diligence as per regulatory/internal guidelines such as KYC, KY3P, Negative watchlist, etc.
3. Scoring/Rating: Evaluating an LSP based on various paraments such as track record, financials, and creditworthiness and assessing eligibility as per board-approved policy.
4. Corporate Info: Maintaining the LSP's corporate information such as directors' names, external ratings, and financials.
5. Documentation: Various aspects related to maintaining documentation related to the contract such as versioning and maintaining copies of approval notes, board resolutions, and contacts.

II. Default Loss Guarantee Lifecycle Module

1. Terms & Conditions: Managing terms and conditions pertaining to DLG such as revocations and notices.
2. DLG Details: Maintaining details pertaining to DLG such as type of guarantee (cash margin/FD/bank guarantee) and bank details.
3. Expiry/Renewal Dates: Maintaining calendars pertaining to the expiry/renewal of various contracts.
4. DLG Risk Limits: Such risk limits could pertain to credit risk limits for each of the LSP, portfolio-wise risk limits, or even risk-adjusted limits based on Expected Loss.

III. LSP Payout Module

This module maintains details pertaining to the commercial arrangement between Bank/NBFC and LSP such as fee details, clawback arrangements, frequency of payout, and methodology for computation of payouts.

IV. KPI Monitoring

Eventually, the performance of the LSPs has to be tracked in terms of metrics such as TAT, quality of assets originated, profitability, and collection efficiency. KPIs/OKRs need to be agreed upon in advance against which near real-time monitoring can happen. Any signs of deterioration could be captured through targeted Early Warning Signals, in order that corrective measures may be triggered.

Given the vast underserved credit needs in our country, LSPs would be an important channel for credit delivery, especially for the last mile segments such as rural/MFI segment, self-employed and gig workers. LSPs, with their innovation and unit economics, could play a significant complementing role in this regard, along with the ultimate providers of credit: banks/NBFCs. A product-led approach in managing this ecosystem could provide to be a game-changer in scaling it up, in an efficient manner.

References:

1. Reserve Bank of India Guidelines on Digital Lending dated September 02, 2022
2. Reserve Bank of India Guidelines on Default Loss Guarantees dated June 08, 2023
3. Economic Times on"RBI’s proposals restrict e-loans to regulated companies" dated November 20, 2021

#digitallending #fintech #fintechinnovation #fintechindustry #digitalbank

Digital Lenders Association of India (DLAI)

Fintech Convergence Council

ProductNation/iSPIRT