Structured Default Guarantees

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Analysing prevalent structures and their capital treatment

– Qasim Saif, Senior Manager | qasim@vinodkothari.com

The term that has been grabbing limelight in the world of finance, specifically for non-banking finance would be First Loss Default Guarantees (FLDGs). The growth of the fintech sector in India may be chiefly credited for making FLDGs as the latest buzzword. However, guarantees are not a new innovation; it has been commonly used in the finance sector since ages.

We are organising a Workshop on Emerging Regulatory Framework for NBFCs and digital lending on 19th, 20th and 21st September 2022. See details here – https://vinodkothari.com/2022/09/workshop-emerging-regulatory-framework-for-nbfcs/
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Workshop on Emerging Regulatory Framework for NBFCs and digital lending

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FAQs on Digital Lending Regulations

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Updated on February 15, 2023

The RBI had constituted a Working Group on digital lending including lending through online platforms and mobile apps on January 13, 2021[1]. The Working Group (‘WG’) submitted its report and the same was published by the RBI on November 18, 2021[2] (‘Report’).

On August 10, 2022, the RBI issued a press release on implementation of the recommendations of the WG. The press release contains three annexures that are either applicable immediately or may be applicable in due course. Through the press release, RBI seeks to implement the recommendations and suggestions of the WG on digital lending.

Further, the RBI has issued the Guidelines on Digital Lending on September 2, 2022 (‘Guidelines’). The text of the Guidelines is largely similar to the press release, with certain modifications and insertions of footnotes.

We have developed a set of FAQs on the press release and updated the same based on the Guidelines issued by RBI, where we intend to answer some of the critical questions relating to the digital lending regulatory framework.

The following FAQs have also been updated in line with the RBI FAQs dated February 14, 2023.

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RBI Regulations on Digital Lending:

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FLDGs come under regulatory ambit

– Team Financial Services | finserv@vinodkothari.com

The RBI had constituted a Working Group on digital lending including lending through online platforms and mobile apps on January 13, 20211. The Working Group (‘WG’) submitted its report and the same was published by the RBI on November 18, 20212 (‘Report’).

On August 10, 2022, the RBI has issued a press release3 dealing with implementation of the recommendations of the working group on digital lending (‘Press Release’). Through the press release, RBI seeks to implement the recommendations and suggestions of the WG on digital lending. The press release contains three annexures, each of which deal with the following –

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Lending without risk and risk without lending:

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The new paradigm of lending partnerships in India

– Vinod Kothari | finserv@vinodkothari.com

In the world of lending, there is a new buzzword – sourcing partnership. This partnership entails the coming together of two entities, both which, let us presume, are financial entities. The one which has strong origination abilities partners with the one which has strong funding abilities, such that credit assets are sourced, serviced and risk-absorbed by the first one (say, Originating Partner), and are housed on the balance sheet of the latter (say, Funding Partner). The Originating Partner takes the credit risk, to a degree sufficient to absorb the expected losses and unexpected losses of the credit assets, continues to service the assets, and eats the entire excess spread, being the difference between the actual portfolio rate of return and the Funding Partner’s expected yield. The Funding Partner puts the loans on its balance sheet, gets only the expected yield, and essentially takes the risk in the Originating Partner, often collateralised by a funding deposit. Thus, the lender has loans with practically no risk, and the originator has risks with no loans.

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The Law of Co-lending

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Financial Services Division | finserv@vinodkothari.com

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The future of Loan-loaded Prepaid Payment Instruments

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Financial Services Division | finserv@vinodkothari.com

The latest communication from the Reserve Bank of India (‘RBI’), barring issuers of prepaid payment instruments (PPIs) from having the same loaded by credit lines, has created a substantial flutter in the financial sector, particularly among the Fintech lenders. Based on the feedback received from market participants it seems that the RBI has been trying to remove any regulatory arbitrage that a non-bank PPI issuer may have as compared to a bank. Considering the gravity of the matter even the Payment Council of India has approached the Government of India to intervene in this matter[1]. There are reports[2] that many of the issuers of PPIs have reportedly stopped issuing PPIs post receiving the RBI circular.

The trigger for all this is a June 20, 2022 communication from the RBI, addressed to certain NBFCs and Fintech lenders, who have been extending credit facilities for loading prepaid cards, stating that prepaid payment instruments (PPIs) must not be loaded through credit lines. The aforesaid communication has raised questions on the existing business model of several fintech entities and threatens their existence. The relevant extract of the said communication states that:

“A reference is invited to the provisions contained in the paragraph 7.5 of the Master Direction on PPI (PPI-MD) dated August 27, 2021 (updated as on November 12, 2021) – “PPIs shall be permitted to be loaded /reloaded by cash debit to a bank account, credit and debit cards, PPIs (as permitted from time to time) and other payment instruments issued by regulated entities in India and shall be in INR only”

The PPI-MD does not permit loading of PPIs from credit lines. Such practices, if followed, should be stopped immediately. Any non-compliance in this regard may attract penal action under provisions contained in the Payment and Settlement Systems Act, 2007”

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Exploring Core Financial Services Solution for NBFCs

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Applicability, Features, Modules & Challenges

– Subhojit Shome, Executive and Parth Ved, Executive | finserv@vinodkothari.com

Background

As a part of the overhaul for the NBFC Sector, the Reserve Bank of India (‘RBI’) had, on October 22, 2021, introduced the Scale Based Regulations (SBR): ‘A Revised Regulatory Framework for NBFCs’. Upon application of SBR, NBFCs will now be divided into four major categories starting from base layer, followed by middle and upper layers and a top layer. The categories can be briefly summarised through the below chart (visit https://vinodkothari.com/sbr/ to read our write-ups on SBR and related topics).

Overview of the Scalar Approach for Classifying NBFCs

Through SBR, various governance guidelines have been newly introduced while the existing guidelines have been modified to keep up with the current market practices. One of the requirements is the introduction of Core Financial Services Solution (CFSS) for NBFCs vide RBI circular dated February 23, 2022 (‘CFSS Circular’).

In this article, we discuss the applicability of CFSS on NBFCs, explore the current core banking systems of banks, highlight the necessary modules which can be adopted by NBFCs along with the issues that may arise during implementation.

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FAQs on Large Exposures Framework (‘LEF’) for NBFCs under Scale Based Regulatory Framework

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Financial Services Division | (finserv@vinodkothari.com)

1. Applicability –

1.1. What is the intent behind the LEF?

Response: Regulation and control of “large exposures” is a part of financial sector regulations globally to control concentration of exposures (thus, risks) to a few individuals/entities/groups. The Basel Committee of Banking Standards has been having recommendatory pieces on this topic since 1991, if not earlier.  The Basel standard subsequently became a part of the Basel capital adequacy framework. 

There is a large exposures framework in case of banks as well. 

The intent behind the large exposure framework, which essentially limits the exposures to a single entity or group or group of economically interdependent entities is to strengthen the capital regulations. Capital regulations prescribe minimum capital in case of financial entities. The adequacy of capital is obviously connected with the risks on the asset side – hence, if the assets represent exposure in a single borrower or economically connected group of borrowers, a credit event with respect to such borrower may deplete the adequacy of capital very quickly.  Hence, regulators limit the exposure to a single entity or a group.

There might be other forms of credit concentrations – for example, sectoral or geographical concentrations – these are not captured by the Framework.

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Differential Standard Asset Provisioning for NBFC-UL

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-RBI issues new guidelines on provisioning for standard assets

-Kumari Kirti | finserv@vinodkothari.com

The function of NBFCs as a supplemental route of credit intermediation alongside banks and its contribution to supporting real economic activity are well known. Within the financial sector, the NBFCs have grown significantly in terms of scale, complexity, and interconnectedness over time. Many companies have expanded to the point where they are systemically significant, necessitating the alignment of the regulatory framework for NBFCs in light of their shifting risk profile.

To address the same, RBI vide its circular dated October 22, 2021[1] has introduced Scale Based Regulation (SBR) for all NBFCs and has classified NBFCs in four layers- Base, Middle, Upper and Top layer.

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