Impact of 'Revamped FLDG' on lenders, borrowers & fintechs

Post relentless persuasion from industry players , experts and associations of App based lenders like Fintech Association for Consumer Empowerment (FACE) , Reserve Bank of India (RBI) has now allowed the use of Digital Lending Guarantees (DLG) or FLDGs as they are popularly known, for commercial banks, co-operative banks, NBFCs and HFCs. This means they can work with fintechs to lend to customers they have not reached so far.

Why did RBI stop FLDG earlier?

When the FLDG scheme was launched, there were issues around the guarantee arrangement limit that fintechs (mostly non-regulated) provide to banks, some even going up to as high as 100%, in the absence of RBI supervision, as per the outsourcing arrangement.?

Hence,RBI imposed a complete restriction on FLDGs in August 2022, calling them 'synthetic securitisation’. However, less than a year later, RBI has revived the FLDG model with a new framework and stricter restrictions on how banks and fintechs can partner.?

The revived FLDG model, which came into effect from June 8, 2023, comes with a new set of rules and stringent dos and don'ts for fintechs and banks and will have a significant impact on all stakeholders, including the end borrower.

Major Features of Revamped FLDG Guidelines :

A first loan default guarantee, or FLDG, is a legally-enforceable contract, typically between an?RBI-regulated entity (RE) and a fintech. The fintech promises to compensate the lender for a pre-determined loss incurred in the event of a loan default.

• The RBI has capped this guarantee at 5%.
• The exposure will have to be secured by the fintech through a cash deposit—a fixed deposit (FD) maintained with a scheduled commercial bank with a lien (security interest over a property) or a bank guarantee marked in favour of the RE. This ensures that the fintech company backing the guarantee is financially capable of fulfilling its obligations if a default occurs.

The RBI has mandated fintechs to make strict disclosures:

• For instance, LSPs will have to publish, on their website, the total number of portfolios and the respective amount of each portfolio on which FLDG has been offered.
• Any other similar implicit guarantee linked to the performance of the loan portfolio of the RE and specified upfront, would also be covered under the definition of DLG.
• An RE can enter into such an agreement only with a LSP or another RE with which it has entered into an outsourcing arrangement; the LSP providing the DLG must be incorporated as a company under the Companies Act, 2013.

Some of the due diligence requirements are:?

• REs shall put in place a board-approved policy before entering into any FLDG arrangement. Such a policy shall include the eligibility criteria for the FLDG provider, the nature and extent of the cover, the monitoring and reviewing process, and the details of the fees, if any, payable to the default loss guarantee (DLG) provider.
• Robust credit underwriting standards need to be put in place irrespective of DLG cover.?
• Every time an RE enters into or renews an FLDG arrangement, it shall obtain adequate information to satisfy itself that the entity extending DLG would be able to honour it. This includes a declaration from the DLG provider, certified by the statutory auditor on the aggregate FLDG amount outstanding, the number of REs, and the number of portfolios against which the DLG has been provided. The declaration shall also contain past default rates on similar portfolios.
• Lenders are accountable for identifying individual loan assets as NPAs or loans that are not paid on time, irrespective of the DLG cover.?Industry experts
• Non-regulated entities can also be a part of FLDG arrangements.FLDG arrangement can be between -RE and LSP (unregulated) or Two regulated entities
• Regulated entities include commercial banks, small finance banks, cooperative banks, and NBFCs (including housing finance companies).
• The duration should be at least as long as the longest tenor of the loans in the underlying loan portfolio.
• Fintech lenders will be able to serve borrowers with lower credit scores or limited credit histories (such as blue-collar workforce, MSMEs, students, and agriculture units) via this arrangement with banks.
• Further, the new guidelines mandate stronger customer protection measures, along with high transparency (lenders will have to disclose their portfolios on their websites).?
• Low FLDG is also good as fintechs have always struggled with capital that would get locked in.
• Fintechs with low credit losses accumulated over the last 24 months will benefit the most. Serious supply partners will be happy to partner while it may be a little difficult for smaller fintechs due to the hard guarantee (cash, FD etc.) condition.?
• The arrangement opens up the market for early-stage fintechs, which can partner with banks and NBFCs and source loans for them without having to wait for an NBFC licence.?

On the flip side, the scrutiny of fintech business is set to increase as REs will be underwriting the arrangement. They can attempt to have a greater squeeze over revenue share between them and the partner fintech.?

Will lenders be content with a 5% FLDG?

The 5% cap on guarantee for the loan portfolio is probably smaller than lenders might have wished for even though they earn high yields on these loans and adding customers. They would be compelled to do careful appraisals as the risks of disbursing unsecured loans to borrowers, who otherwise are not well-rated, are high.

Before the regulator banned FLDGs last year, when it felt lenders were taking on too much risk on their balance sheets, some fintechs were offering huge guarantees that, on occasion, were 100% of the loan value.

On average, however, the size of the guarantee was 25-30%. Much will depend on how the Account Aggregator mechanism takes off; with high-quality data at their disposal, helping them to appraise borrowers better, NBFCs and banks may be content to lend with only a 5% FLDG.

Will unrated borrowers gain?

Yes, the move will spur lending to those borrowers who are currently not reached by the organised?lenders.This is because the ecos-system will get a lot more transparent.

At the same time, RBI will have a lot less to worry about. Earlier, it was concerned that many NBFCs were “renting out their balance-sheets.”

Will interest rates come down?

The new regulations, together with the Account Aggregator mechanism, could bring in more lenders who team up with fintechs. While demand for credit is high, which is the reason for very high loan rates, more lenders and greater competition might soften the loan rates. However, for loan rates to come off, the default rates too need to be low; for this to happen, the quality of the data and loan appraisal must be good.

How will a smaller FLDG help the borrower?

For fintechs, providing an FLDG will mean incurring a cost since the guarantee must be provided by way of cash deposited with the lender, fixed deposits maintained with a scheduled commercial bank with a lien in favour of the lender or a bank guarantee favouring the lender.

These costs incurred by the fintech are built into the interest rate charged to the borrowers, who already pay very high rates.

Had the FLDG cap been higher than what the RBI has fixed, the cost for the fintechs and, in turn, the customers would have been driven up.

How do the rules help lenders?

The new guidelines from RBI are aimed at protecting NBFCs and banks that are disbursing unsecured credit. These are expected to usher in discipline. Lenders must do a fresh appraisal of the loans each time they enter into or renew a contract for an FLDG.

Fintechs providing the FLDG must furnish an audited statement on the total value of guarantees provided, the numbers of entities to which they have been provided as also the respective loan portfolios. They must also declare the historical default rates on similar loan portfolios.

( Excerpts from RBI Circular, news reports and various reports on the subject)