In recent years, co-lending arrangements have emerged as an effective solution for financial inclusion in India.

?With the Reserve Bank of India (RBI) introducing new regulations to govern co-lending partnerships, these collaborations between banks and Non-Banking Financial Companies (NBFCs) have been gaining traction. By combining the strengths of both entities, co-lending models offer mutual benefits while promoting financial access for underserved segments, including rural communities.

In this blog, I want to put a closer look at some of the typical terms involved in a co-lending arrangement as mandated by the RBI and explain how these terms benefit both parties.

1. 80-20 Split: Capital Deployment Ratio

One of the key features of co-lending arrangements is the 80:20 capital deployment ratio. This means that the bank typically contributes 80% of the loan capital, while the NBFC contributes the remaining 20%. The 80-20 split is designed to leverage the strengths of both institutions. Banks, with their access to cheaper sources of capital, are well-positioned to provide the bulk of the funding. This helps to reduce the overall cost of capital. On the other hand, NBFCs, which are closer to the customer and have a better understanding of the market, can perform the crucial role of sourcing loans and managing the customer experience.

This arrangement is mutually beneficial. For banks, it means the bulk of their capital is deployed in a lower-risk environment, and they benefit from the customer acquisition efforts of the NBFC. NBFCs, on the other hand, gain access to larger capital pools, allowing them to extend more loans and reach a wider customer base, especially in underserved areas.

2. Joint Underwriting: A Two-Check Approach

In a co-lending agreement, both the bank and the NBFC jointly underwrite the loans. This collaborative underwriting process ensures that both parties share the responsibility of assessing the creditworthiness of the borrowers. It creates a safety net for both entities, as the risk is divided, and the expertise of both the bank and the NBFC is leveraged in evaluating the loans.

This joint underwriting also brings a higher level of due diligence to the process. The bank, with its deep experience in risk management, and the NBFC, with its strong customer relationships, can effectively identify creditworthy borrowers. This collaborative approach ultimately enhances the quality of the loan book and reduces the risk for both parties.

3. Risk-Return Split: Sharing Both the Risks and Rewards

A critical aspect of a co-lending arrangement is the risk-return split. As mentioned earlier, the capital deployment follows an 80-20 ratio. This split extends to the risk and return associated with the loan as well. In this structure, the bank, which contributes the larger share of the capital, takes on a higher portion of the risk. However, since it is providing the majority of the funding, it also has a larger share of the return. The NBFC, which takes on less risk, also receives a smaller share of the return, but it benefits from its involvement in sourcing and customer management.

The risk-return split is designed to ensure that both parties are incentivized to perform their respective roles effectively. The bank’s large capital contribution and its lower risk exposure give it a steadier return, while the NBFC’s involvement in sourcing and customer service ensures that the arrangement stays customer-centric, benefiting both sides.

4. Final Interest Rate: A Combination of Costs

One of the most important aspects of a co-lending arrangement is the final interest rate charged to the customer. In most cases, banks have access to lower-cost capital compared to NBFCs, who often incur higher costs. As a result, the final interest rate charged to the customer is typically a weighted average of both the bank’s and the NBFC’s respective capital costs. In addition to the cost of capital, the final interest rate is also influenced by the respective commissions earned by both parties. Banks usually charge a lower rate due to their cheaper funding sources, while NBFCs charge a higher rate to cover their operational costs, risk, and customer acquisition efforts.

The combined interest rate is designed to be competitive in the market while ensuring that both the bank and the NBFC achieve a reasonable return on their investments. It also ensures that the end customer receives a fair rate, which is crucial for promoting financial inclusion.

5. Defined Roles: Clear Responsibilities for Both Parties

The roles and responsibilities of the bank and the NBFC are clearly defined in a co-lending arrangement. This clarity ensures smooth operations and minimizes potential conflicts between the two parties. In most cases, the NBFC takes the lead in sourcing customers, managing the customer experience, and handling product innovations. They are also responsible for ensuring quick documentation and faster turnaround times (TAT), which are crucial for customer satisfaction. The NBFC, with its deep understanding of local markets and customer needs, is best positioned to handle these functions. On the other hand, the bank is responsible for providing the capital at a lower cost and for maintaining credibility with customers. The bank also plays a critical role in building trust and ensuring the overall security and stability of the arrangement. By defining these roles clearly, both entities can focus on their strengths, ensuring that the co-lending arrangement operates smoothly and delivers value to the customer.

Co-lending arrangements represent a win-win for both banks and NBFCs. By combining the strengths of both entities like banks with their access to cheap capital and NBFCs with their customer-facing expertise and co-lending models can serve a broader customer base, particularly in underserved markets.

The RBI’s guidelines for co-lending agreements, such as the 80-20 capital split, joint underwriting, and clearly defined roles, provide a solid foundation for these partnerships to thrive. By balancing risk, return, and customer experience, co-lending arrangements can play a crucial role in promoting financial inclusion, driving economic growth, and enhancing access to credit for all. In a rapidly evolving financial landscape, these collaborative models can help both banks and NBFCs expand their reach and build stronger relationships with customers, ultimately making financial services more accessible and affordable.