How to Lend? | Fintech Inside Edition #71 - 27th Feb, 2023

Hi Insiders, I'm Osborne Saldanha , Principal at Emphasis Ventures (EMVC) .

Welcome to the 71st edition of Fintech Inside. Fintech Inside is the front page of Fintech in emerging markets.

Ability to lend is important for the fintech sector's growth and success. There are several structures to launch lending products with varying levels of control, balance sheet exposure and risk. More importantly, India's central bank is not shy to intervene when it comes to customer protection, given the spate of regulations, guidelines and recommendations introduced in just the past year.

The question then is, given the regulatory framework, what are the lending structures at a fintech startups disposal? In this edition, I attempt to give a very high level view of the various structures ranging for risk off marketplaces to risk on NBFC's and many more.

Raising funding for your early stage fintech startup? reach out to me?[email protected]

Enjoy another week in fintech!

?? One Big Thought

The regulatory structures available to build a lending business

Note:

1. Special thanks to Satyam Kumar , co founder of LoanTap Financial Technologies and co founder of Fintech Association for Consumer Empowerment (FACE) for helping me understand a few concepts of these structures.
2. This edition aims to provide a very high level understanding of the structures to launch lending products. There is a *lot* more nuance and details that I've skipped for the purpose of this edition.

If you've been a long time subscriber of Fintech Inside, you know I've written a lot about lending (Edition #16, 16th Jan, 2021), why lending products are top of mind for every founder (Edition #65, 16th Aug, 2022), why building a large lending startup is tough (Edition #56, 28th Feb, 2021) and why banks seem to be winning at fintech and lending (Edition #36, 5th Sept, 2021). There are a lot more articles on lending in the Fintech Inside archive.

All this to say, lending products are crucial to fintech sector's growth and success in India.

The sector has been in a state of flux lately given the several recent RBI regulations. Most folks (founders, investors, employees and others) are still trying to keep up with RBI's regulations to identify where the opportunities lie and what products can be launched. In this post, I've tried assimilating my own thoughts on the various structures that regulation allows for to launch lending products. I've skipped mentioning about credit cards and consequently UPI on credit cards - you can find more details on that in Edition #63 13th Jun, 2022.

How should a founder think about structuring lending products? There are 5 (well, 6 if you have a banking license) structures to launch lending products. Each of these structures comes with varying levels of control, balance sheet exposure and risk.

Structure 1: Marketplace

1. Participating entities: customer acquirer (e.g. fintech startup or consumer app), lender (regulated entity) and borrower.
2. How does it work: In a marketplace, the customer acquisition platform aggregates lending partners on the customer app. The customer can choose (typically based on lowest interest rates) which lender they want the loan from and the loan application can be submitted via the app. More recently, to give the customer a seamless experience, fintech startups are integrating the lenders credit policy on the app so that when the borrower submits the loan application, the borrower gets a shown only one lender's offer - typically where the borrower profile meets the lenders credit policy and where the interest rate is lowest.
3. Typical economics: The customer acquirer typically gets paid 2-4% of the loan value for successful loan disbursal.
4. Entity underwriting the borrower: Lender
5. Risk participation: No risk participation for the customer acquirer.

Structure 2: First Loss Default Guarantee (FLDG)

1. Participating entities: customer acquirer (fintech startup or consumer app, not regulated), lender (regulated entity) and borrower.
2. How does it work: The customer acquirer deposits a certain amount of capital with the lender before lending. The amount of capital to be deposited with the lender is determined as a % of total loan value the customer acquirer expects to disburse. If there is a default in the loan portfolio (assessed monthly), the lender dips into/collects equivalent amount from the capital deposited with the lender - hence the name first loss default guarantee. The customer acquirer then has to replenish the capital to maintain lending at the levels it previously did.
3. Typical economics:

• Deposit capital: the customer acquirer has to deposit between 5-50% of the lending it expects to do. It's typically between 10-20%.
• Loan economics: The customer acquirer typically keeps the entire net interest margin (interest charged to customer minus interest cost paid to the lender).

1. Entity underwriting the borrower: Customer acquirer in consultation with and approval of the lender. When the customer acquirer wants to launch more experimental products and wants more control on the underwriting process and customer experience, it chooses FLDG structure.
2. Risk participation: Customer acquirer is full risk on, as in, all loss is borne by the customer acquirer.

Structure 3: Non-banking financial company (NBFC)

1. Participating entities: customer acquirer (regulated entity) and lender (regulated entity, banks or other NBFCs).
2. How does it work: The customer acquirer (regulated entity) borrows capital from the lender against the equity capital on the balance sheet of the acquirer. The debt capital borrowed is typically 2x to 5x of the customer acquirers equity capital. Hey, look at you - you just learned what financial leverage is! The customer acquirer then lends this total capital (borrowed capital + equity capital) to its borrowers (customers). If the customer acquirer needs to lend more, it raises more equity capital and borrows more debt capital against that equity.
3. Typical economics: The customer acquirer typically lends to the borrower at 12-15% but borrows the debt capital at 6-9%, effectively earning a net interest margin of 3-7%. The net interest margin is slightly higher than the straight-forward formula of interest income (charged to borrower) minus interest cost (paid to the lender), because the customer acquirer also lends its own equity capital, on which it is not paying any interest.
4. Entity underwriting the borrower: Customer acquirer develops and maintains its own credit policies.
5. Risk participation: customer acquirer is full risk on and bears the cost of defaults from the net interest margin it earns.

(this is where it starts getting complicated, for me at least. Buckle up!)

Structure 4: Co-lending (launched by RBI in Sept 2018 and then updated in Nov 2020)

1. Participating entities: customer acquirer (e.g. NBFC, regulated entity), lender (e.g. bank, regulated entity) and borrower (priority sector borrower only).
2. How does it work: Customer acquirer acquires a borrower to lend to. Once the loan is approved, the customer acquirer and the lender split/disburse the loan value at a certain ratio to bring down the effective interest charged to the borrower. Customer acquirer then manages the collections and other acquirer duties.
3. Typical economics: Co-lending arrangements typically happen at an 80:20 or 70:30 split or others i.e. 70% or 80% of the loan value is disbursed by the lender (bank) and 20% or 30% of the value is disbursed by the customer acquirer (NBFC). The bank's interest income is typically 6-7% and the NBFC's interest income is typically 12-15%. The combined interest payable by the borrower is effectively lower because of the ratio in which the loan was disbursed.
4. Entity underwriting the borrower: both customer acquirer and lender have their own credit policies, but they have to come to an arrangement to successfully co-lend.
5. Risk participation: Both entities share the cost of defaults to the extent of their participation in the ratio of lending.

Structure 5: Securitisation

1. Participating entities: customer acquirer (originator, regulated entity), Special Purpose Entity (SPE) and investors (typically large institutions).
2. How does it work: The customer acquirer carves out a section of their loan portfolio (that meets RBI's securitisation norms) and transfers it to a SPE which investors can buy into via securitisation notes. The customer acquirer has to continue to maintain a minimum of 5% performance stake in the SPE.
3. Typical economics: Securitisation investors earn continuing interest up to their stake in the SPE, assessed on a monthly rolling basis.
4. Entity underwriting the borrower: customer acquirer.
5. Risk participation: Post securitisation, the customer acquirer and investors have a pro rata participation in the risk.

Securitisation doesn't sound like a structure to lend. What's the scene? You're right, securitisation is not a direct structure to lend. It's a structure to off load a section of the lenders portfolio and raise some capital to further leverage and raise debt capital to lend to more borrowers.

Securitisation as a structure is important to know of, thanks to RBI's Working Group on Digital Lending and its recommendations. In this Aug, 2022 recommendation (specifically Annex II), the RBI said that it is examining the FLDG structure and that any regulated entity engaging in such a contractual agreement before the RBI makes up its mind, should adhere to the securitisation norms dated Sept, 2021. As you noted above, the FLDG structure is not the same as the securitisation structure for lending. This has caused chaos in the fintech sector with lenders (banks and NBFC's) largely stopping all such FLDG arrangements. Fintech startups are reportedly holding several consultations with RBI to find some middle ground.

What does the future hold for the FLDG structure and what does it mean for fintech startups? In short, the future of FLDG structure looks bleak. It's very easy to see how the FLDG structure can create disincentives to protect the borrower rights. IMO, that's what RBI is focused on. On the other hand, I believe FLDG is an ideal structure to launch lending products with low upfront capital requirements, foster innovation in lending and credit policies and create incentives to target borrower types that incumbents are wary to lend to. The biggest rebuttal to this argument is that lending startups are not regulated and pose a systemic risk and hence should not be allowed to operate. There are many ways to tackle that problem including for example, putting a limit of, say, INR 50crs ($6mm) on total disbursements via the FLDG structure.

I believe that FLDG is an ideal structure for early stage startups while the other structures are more suited for growth stage startups that have the capital to apply for licenses and maintain minimum capital requirements. It's left to be seen what the RBI finally decides on lending.

Have I missed out on any other structures? What approach/structure do you use to launch lending products? Are you still figuring out how to hit the market with your lending product? Let's talk!

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?? International

Stripe launched an "enhanced issuer network": a set of partnerships with US card issuers designed to help businesses rescue fraud and boost authorisation rates. DataMesh, an Australian payments company, raised $30mm. US nominated former Mastercard CEO Ajay Banga for World Bank CEO position. JPMorgan Chase is restricting employee use of the ChatGPT for internal memos. Block reported Q4 revenue up 15% YoY to $4.65B; Square gross profit up 22% YoY to $801M, and Cash App gross profit up 64% YoY to $848M. Coinbase launched Base, a Layer 2 network built on Optimism's OP Stack, offering access to Ethereum, Solana, and others. South American e-commerce giant MercadoLibre reported a fourth-quarter net profit of $164.7 million buoyed by its fintech business.

??? Other Notable Nuggets

1. PE/VC in Financial Services and Fintech, Report by RBIH
2. Software 2.0
3. The Paypers Global Fintech Investments Analysis: Q4 2022
4. State of Fintech 2023 - by FPrime Capital

?? Song on loop

Fintech updates can get boring, so here's an earworm: Drip Check by D’Evil (Youtube / Spotify). If you like hindi rap, you will love this song. Thanks to Azhar Hemani for the recommendation.

???? That's all Folks

If you’ve made it this far - thanks! As always, you can always reach me at [email protected]. I’d genuinely appreciate any and all feedback. If you liked what you read, please consider sharing or subscribing.

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See you in the next edition.