Lenders’ piggybacking: NBFCs lending on Fintech platforms’ guarantees

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-Vinod Kothari

(vinod@vinodkothari.com)

Among the disruptive Fintech practices, app-based lending is certainly notable. The scenario of an app-based lending is somewhat like this – a prospective borrower goes to an app platform, fills up some information. At the background, the app collects and collates the information including credit scores of the individual, may be the individual’s contact bases in social networks, etc. Finally, the loan is sanctioned in a jiffy, mostly within minutes.

The borrower interacts with the platform, but does the borrower know that the loan is actually not coming from the platform but from some NBFC? Whether the borrower knows or cares for who the lender is, the fact is that mostly, the technology provider (platform) and the funding provider (lender) are not the same. It may be two entities within the same group, but more often than not, the lender is an NBFC which is simply originating the loan based on the credit comfort provided by the platform.

The relation between the platform and the lender may take one of the following forms: (a) platform simply is procuring or referring the credit; the platform has no credit exposure at all; (b) the platform is acting as a sourcing agent, and is also providing a credit support, say in form of a first-loss guarantee for a certain proportion of the pool of loans originated through the platform; (c ) the platform provides full credit support for all the loans originated through the platform, and in return, the lender allows the platform to retain all the actual returns realised through the pool of loans, over an and above a certain “portfolio IRR”.

Option (a) is pure sourcing arrangement; however, it is quite unlikely that the lender will be willing to trust the platform’s credit scoring, unless there is significant skin-in-the-game on the part of the platform.

If it is a case of option (c ) [which, incidentally, seems quite common, the loan is actually put on the books of the lender, but the credit exposure is on the platform. The lender’s exposure is, in fact, on the platform, and not the borrower. The situation seems to be quite close to a “total rate of return swap”, a form of a credit derivative, whereby parties synthetically replace the exposure and the actual rate of return in a portfolio of loans by a pre-agreed “total rate of return”.

Our objective in this article is to examine whether there are any regulatory concerns on the practice as in case of option (c ) . Option c is an exaggeration; there may be a case such as option (b). But since option (b) is also a first loss guarantee with a substantial thickness, it is almost akin to the platform absorbing virtually all the risks of the credit pool originated through the platform.

Before we get into the regulatory concerns, it is important to understand what are the motivations of each of the parties in this bargain.

Platform’s motivations

The motivation on the part of the platform is clear – the platform makes the spreads between the agreed portfolio IRR with the lender, and the actual rate of return on the loan pool, after absorbing all the risk of defaults. Assume, the small-ticket personal loan is being given at an interest rate of 30%, and the agreed portfolio IRR with the lender is 14%, the platform is entitled to the spread of 16%. If some of the loans go bad, as they indeed do, the platform is still left with enough of juice to be a compensation for the risks taken by it.

The readiness on the part of the platform is also explained by the fact that the credibility of the platform’s scoring is best evidenced by the platform agreeing to take the risk – it is like walking the talk.

Lender’s motivations

The lender’s motivations are also easy to understand – the lender is able to disburse fast, and at a decent rate of return for itself, while taking the risk in the platform.  In fact, several NBFCs and banks have been motivated by the attractiveness of this structure.

Are there any regulatory concerns?

The potential regulatory concerns may be as follows:

  • De-facto, synthetic lending by an entity that is not a regulated NBFC
  • Undercapitalised entity taking credit risk
  • Skin-in-the-game issue
  • A CDS, but not regulated as a CDS
  • Financial reporting issues
  • Any issues of conflict of interest or misalignment of incentives
  • Good borrowers pay for bad borrowers
  • KYC or outsourcing related issues.

Each of these issues are examined below.

Synthetic lending by an unregulated entity

It is common knowledge that NBFCs in India require registration. The platform in the instant case is not giving a loan. The platform is facilitating a loan – right from origination to credit risk absorption. Correspondingly, the platform is earning a spread, but the activity is technically not a “financial activity”, and the spread not a “financial income”; hence, the platform does not require regulatory registration.

Per contra, it could be argued that the platform is essentially doing a synthetic lending. The position of the platform is economically similar to an entity that is lending money at 30% rate of interest, and refinancing itself at 14%. There will be a regulatory arbitrage being exploited, if such synthetic lending is not treated at par with formal lending.

But then, there are whole lot of equity-linked or property-linked swaps, where the returns of an investment in equities, properties or commodities, are swapped through a total rate of return swaps, and in regulatory parlance, the floating income recipient is not regarded as investor in equities, properties or commodities. Derivatives do transform one asset into another by using synthetic technology – in fact, insurance-linked securities allow capital market investors to participate in insurance risk, but it cannot be argued that such investors become insurance companies.

Undercapitalised entities taking credit risk

It may be argued that the platform is not a regulated entity; yet, that is where the actual credit risk is residing.  Unlike NBFCs, the platform does not require any minimum capitalisation norms or risk-weighted capital asset requirements. Therefore, there is a strong potential for risk accumulation at the platform’s level, with no relevant capital requirements. This may lead to a systemic stability issue, if the platforms become large.

There is a merit in the issue. If fintech-based lending becomes big, the exposure taken by fintech entities on the loans originated through them, on which they have exposure, may be treated at par with loans actually held on the balance sheet of the fintech. As in case of financial entities, there are norms for converting off-balance sheet assets into their on-balance sheet equivalents, the same system may be adopted in this case.

Skin-in-the game issue

Post the Global Financial Crisis, one of the regulatory concerns was skin-in-the-game. In light of this, the RBI has imposed minimum holding period, and minimum risk retention requirements in case of direct assignments as well as securitisation.

The transaction of guarantee discussed above may seem like the exposure being shifted by the platform to the NBFC. However, the transaction is not at all comparable with an assignment of a loan. Here, the lending itself is originated on the books of the NBFC/lender. The lender has the ultimate discretion to agree to lend or not. The credit decision is that of the lender; hence, the loan is originated by the lender, and not acquired. The lender is mitigating the risk by backing it up with the guarantee of the platform – but this is not a case of an assignment.

There is a skin-in-the-game on either side. For the platform, the guarantee is the skin-in-the-game; for the NBFC, the exposure in the platform becomes its stake.

A CDS, but not regulated as a CDS

The transaction has an elusive similarity to a credit default swap (CDS) contract. It may be argued that the guarantee construct is actually a way to execute a derivative contract, without following CDS guidelines provided by the RBI.

In response, it may be noted that a derivative is a synthetic trading in an exposure, and is not linked with an actual exposure. For example, a protection buyer in a CDS may not be having the exposure for which he is buying protection, in the same way as a person acquiring a put option on 100 gms of gold at a certain strike price may not be having 100 gms of gold at all. Both the persons above are trying to create a synthetic position on the underlying.

Unlike derivatives, in the example of the guarantee above, the platform is giving guarantee against an actual exposure. The losses of the guarantor are limited to actual losses suffered by the lender. Hence, the contract is one of indemnity (see discussion below), and cannot be construed or compared to a derivative contract. There is no intent of synthetic trading in credit exposure in the present case.

Financial reporting issues:

It may be argued that the platform is taking same exposure as that of an actual lender; whereas the exposure is not appearing on the balance sheet of the platform. On the other hand, the actual exposure of the lender is on the platform, whereas what is appearing on the balance sheet of the lender is the loan book.

The issue is one of financial reporting. IFRSs clearly address the issue, as a financial guarantee is an on-balance sheet item, at its fair value. If the platform is not covered by IFRSs/IndASes, then the platform will be reflecting the guarantee as a contingent liability on its balance sheet.

Conflicts of interest or misalignment of incentives:

During the prelude to the Global Financial Crisis, a commonly-noted regulatory concern was misalignment of incentives – for instance, a subprime mortgage lender might find it rewarding to lend to a weak credit and capture more excess spread, while keeping its exposure limited.

While that risk may, to some extent, remain in the present guarantee structure as well, but there are at least 2 important mitigants. First, the ultimate credit decision is that of the NBFC. Secondly, if the platform is taking full credit recourse, then there cannot be a misalignment of incentives.

Good borrowers pay for bad borrowers

It may be argued that eventually, the platform is compensating itself for the risk of expected losses by adding to the cost of the lending. Therefore, the good borrowers pay for the bad borrowers.

This is invariably the case in any form of unsecured lending. The mark-up earned by the lender is a compensation for risk of expected losses. The losses arise for the loans that don’t pay, and are compensated by those that do.

KYC or outsourcing related issues

Regulators may also be concerned with KYC or outsourcing related issues. As per RBI norms “NBFCs which choose to outsource financial services shall, however, not outsource core management functions including Internal Audit, Strategic and Compliance functions and decision-making functions such as determining compliance with KYC norms for opening deposit accounts, according sanction for loans (including retail loans) and management of investment portfolio.”

Usually the power to take credit decisions vests with the lender. However, in case the arrangement between the lender and the platform is such that the platform performs the decision-making function, the same shall amount to outsourcing of core management function of the NBFC, which is expressly disallowed by the RBI. The relevant extract from the KYC Master Directions is as follows:

“REs shall ensure that decision-making functions of determining compliance with KYC norms are not outsourced.”

Is it actually a guarantee?

Before closing, it may be relevant to raise a legal issue – is the so-called guarantee by the platform actually a guarantee?

In the absence of tripartite agreement between the parties, the arrangement cannot be said to be a contract of guarantee. Here the involvement is of only two parties in the arrangement i.e. the guarantor and the lender.

It was held in the case of K.V. Periyamianna Marakkayar and others vs Banians And Co.[1] that “Section 126 of the Indian Contract Act which defines a contract of guarantee though it does not say expressly that the debtor should be a party to the contract clearly implies, that there should be three parties to it namely the surety, the principal-debtor and the creditor ; otherwise it will only be a contract of indemnity. Section 145 which enacts that in every contract of guarantee there is an implied promise by the principal debtor to indemnify the surety clearly shows that the debtor and the surety are both parties to such a contract ; for it will be strange to imply in a contract a promise between persons who are not parties to it.”

Accordingly, the said arrangement maybe termed as a contract of indemnity wherein the platform agrees to indemnify the lender for the losses incurred on account of default by the borrower.

Conclusion

Fintech-based lending is here to stay, and grow. Therefore, risk participation by Fintech does not defeat the system – rather, it promotes lending and adds to the credibility of the Fintech’s risk assessment. Over period of time, the RBI may evolve appropriate guidelines for treating the credit exposure taken by the platforms as a part of their credit-equivalent assets.

 

 

[1] https://indiankanoon.org/doc/1353940/

From manufacturing to providing services: How does it transform?

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-Kanakprabha Jethani | Executive

(kanak@vinodkothari.com)

Background

Servitization is that foreign business term that does not find place in any dictionary but is in steps to becoming essence of many businesses. It is a transformation, from manufacturing to providing solutions, from being product-centred to being complete-solution centred. Essentially, it is a business model in which, manufacturer of a product also engages in provision of services relating to that product.

The concept of servitization arises from the traditional ideology of business of maintaining life-long relationship with customers. Cranfield University defines servitization as “the innovation of organisation’s capabilities and processes to better create mutual value through a shift from selling product to selling Product-Service Systems.”

For instance, a laptop manufacturing company, say A Co. manufactures and sells “laptops”, it is a manufacturing concern. However, when A Co. sells a “package” which includes a laptop along with provision for after-sale services, software to support operations on the laptop, anti-virus software, cloud-space for data storage etc. it is said to be servitization.

How does this model operate? How do the parties earn? Are there any existing models operating? What is their structure of operation?  Why does a manufacturer need to adopt this model? How will this be implemented? The following write-up answers all these questions and seeks to provide an all-round insight to the concept of servitization.

Structure of a servitization model

The concept of servitization has evolved answering the calls of the market that arose from phased transitions in customers approach to the products.

  • Initially, a product-oriented market was prevalent in which the manufacturer and seller had just a buy and sell relationship. They became strangers right after the sale.
  • This approach then shifted to product-oriented services, under which the manufacturer started providing additional services with respect to the product sold by it such as delivery, product installation, spare parts, updates and upgrades, warranty, maintenance etc.
  • With Rolls Royce making leaps into innovation, the concept of use-oriented services came into place. Under this companies offer product leasing, sharing, renting, and pooling services where the customer pays fee for using the product.

This concept is however different from leasing as leasing provides exclusive rights to use to the lessee. In this model, the product can be shared between two or more customers or the owner and the customer.

  • Later, the approach shifted to result-oriented services where the consideration for service provider is directly linked to the output generated by the customer.

Servitization model is a customer-oriented services model which combines features of all of the aforementioned approaches. This model serves the customers’ demand for real-time responses, effective self-service options, predictive maintenance etc.

An ideal servitization model involves an entire process from manufacturing of a product, its delivery, installation and training for its use to ongoing maintenance and consultancy relating to the product. It provides for an all-round cover of the product along with support services to the customer.

Money matters: How does the service-provider/manufacturer earn?

A typical servitization model of a manufacturer includes the following:

  • Sustainable production process
  • Supplier and customer interdependencies
  • Lifetime product maintenance
  • Repairs
  • Recycling of end product
  • Help desk
  • Customer specific support agreements

An ideal servitization relationship includes incentives for the supplier to reduce costs. It shares risks, financial risk especially, and it is based on achieving the highest performance possible. The optimal contract consists of a fixed payment or fixed price, cost-sharing and performance-based compensation.

Through servitization, the seller is bound to provide services to the buyer till the product exists. This bond is achieved by tying the supplier’s compensation to the output value of the equipment generated by the customer. This creates a lasting relationship between the seller and buyer. This is the transformation from earning profits to creating mutual value.

Economics of servitization

For a business, the essence of servitization lies in establishing long-term relationship with customers. This lengthened relationship results in maintenance of steady revenues which then results in greater profitability and customer retention. Further, streamlining the supply and services reduces the risk of quality deterioration. To sustain in the market, it is very necessary to provide value addition. The market wants innovation and new offerings every day and has offerors all around. For a business to stay, will have to provide more than just a product. Providing aftersales services and advanced services such as consultancy services and solutions enables a business to meet customers’ demand for complete solution packages and thus ensures sustainability.

Further, through servitization, manufacturers are exposed to a whole new set of issues faced during operation of their products. This provides them insights for future R&D and helps them bring innovation in their products and ensure continuous product improvement.

For a customer, the prime benefit that servitization brings out is that the customer has to pay only for the value derived from the product. The customer is saved from risk of unproductive expenditure. Further, the quality of product is maintained as the manufacturing entity only does further servicing of the product. Since, the customer has to pay for what is operational, it also ensures that the ‘operational time’ is productive as well. This urges the customer to undertake profitable operations only.

Risks in servitization

  • Financial risks: The transition from a manufacturing model to servitization model requires a complete shift in the operational basis of the entity. Also, the revenue generation model is completely changed by shifting the point of revenue generation from sale to outcome, which would result in elongation of operating cycle. Due to this, requirement of working capital is increased.
  • Operational risks: Manufacturers face operational issues like how to assess the use of asset, level of maintenance required, frequency of updations etc. Further, the transition requires a complete turnaround in the operating team and procedures which involves a very long downtime.
  • Partner risks: The concept of servitization is based on a generation of revenue when some other person is in operation. The return to manufacturer is directly linked with the operation or outcome of the customer. Thus, it poses a risk over the earning of the manufacturer.

Why does a business need to servitize?

For a business, where all competitors are trying to knock you down, survival is a lonely process. In order to stay, the business needs to keep the market interested. Following are certain factors which lead a business towards the direction of transformation:

  • Economic rationale: In a competitive market, it is not possible for firms to compete on basis of cost as they already operate on very low margins. In such a case, innovation is the key to stand out from the competitors. Further, stability of revenues is yet another driving force in this direction.
  • Strategic rationale: Through servitization, a business is able to retain its customers for a very long time. Lock-in customers and lock-out competitors is a clear implication of this. Moreover, customers are very much educated and aware in the present day market. They demand such models and a business that fulfils their demands, stays.
  • Environmental rationale: The world is moving towards sustainability. Responding to the current environmental changes, if a single entity is engaged during the entire lifecycle of the product, it would result in preservation of resources to a great extent. A business with such values and respect towards the environment always achieves a higher place in the eyes of the customer.

Global examples

The philosophy of “co-existence” has laid its nets in the business also. The concept of mutual-benefit has become the new definition of profitability and the world is responding to this change in the following manner:

  • Rolls Royce: This was the pioneering engine solution which changed the deal with customers from a transactional purchase of equipment towards a ten-year contractual relationship guaranteeing operational time of the engine. This model gave rise to the concept of ‘Performance-Based Logistics’ (PBL) which was initially introduced by Rolls Royce for jet engines. Later a similar model was proposed for the marine industry as well.
    Under this model, a fixed amount for flying per hour is charged. The customer are provided with accurate projections for maintenance cost and assurance for avoidance of breakdown costs.
  • Xerox’s print management: This model offers a bundle of services and copier to the customer. It provides a comprehensive set of capabilities which prevent malicious attacks, proliferation of malware and misuse of unauthorised access to printers etc. as well as services to help better manage documentation. The customer is charged based on the number of sheets of paper they have copied or printed.
  • MAN’s Financial Services: Offers comprehensive services around drivers’ behaviour and fuel efficiency in order to help customers operate more efficiently, with charging based on the distance trucks are driven.
    This was launched with the basic motive of reducing the cost of lease during off-seasons. It enabled the lessee to pay certain sum on each kilometre travelled by the leased truckthereby reducing the downtime costs.
  • Lumenstream: This Britain based start-up provides customers with fully maintained LED lighting with no upfront cost. In line with the proven fact that LED lights save upto 60% energy costs, the customer is charged based on share of energy savings achieved over a period of five years.
  • Small Robot Company: This company is transforming the process of farming through their Farming as a Service (FaaS) model. Under this model a series of robots (Tom, Dick and Harry) with ‘clever’ operating systems are linked to provide a full-fledged farming support. One of the robots monitors the crops, soil and weeds. The other two take care of all the feeding, seeding, and weeding. They record location of every crop and take care of each individual plant until it is entirely grown up.
    The farmer does not need to make any upfront payment for leasing the robot. Instead the farmer is charged on the basis of per-hectare subscription fee of robots working.
  • Philips: Philips provides LED lighting as a service to Amsterdam Schiphol airport through ‘Internet of Things’ (IoT) connectivity. Under the arrangement, Philips takes responsibility of the performance of the LED lamps. On the other hand, the airport is able to save 50% energy cost by using LED lights. A share of saved cost is paid as consideration to Philips.

How has the world responded to servitization?

Penetration of servitization model: Country-wise

Servitization has been a buzz in the recent times. Some countries have already made it the core model of their businesses while some are still struggling to get familiar with the concept itself. To understand how servitization has impacted and will continue to impact the world, it is first important to understand, how deep servitization has spread its roots in business models of various countries.

Following chart depicts that, out of certain number of entities, selected on random basis, what percentage of entities were practising servitization as on November 2013.

Source: University of Cambridge[1]

From the above figure it can be seen that USA has already embossed the concept of servitization in its ideology of business. A major chunk of the firms in USA covered by the research operate on servitization model. Seemingly, servitization model is in the steps of becoming the core model for majorly all businesses in USA. UK is following the footsteps of USA and has implemented servitization to some extent. Countries like Germany, India and France seem to be advancing in this field of innovation and some entities in these countries have initiated adopting servitization models. Russia seems to be resistant towards adoption of this innovation in its business models.

All that matters is growth

Benefits, growth, profits are the words that really matter in a business. Whether an innovation should be introduced or not? The answer lies in the benefits it gives. Businesses see benefits in growth and profitability. Increased sales, turnover, consumer base is what they look forward to.

Following figure shows how servitization has effected the turnover growth in various countries and what the forecasts are for the near future.

Source: European Commission report on servitization

From its inception till 2018-19, the initial stages of implementation of servitization have shown the very high levels of growth in turnover for countries like Germany, Italy and Netherlands where servitization has been implemented upto reasonable levels. A study in France by European Commission shows that with 70% of SMEs in France being servitized, rate of employment also grew by 30% and an average annual increase of around 10% in turnover in the country was also witnessed. By 2020-21, when servitisation would already have been implemented in major countries, the pace of growth would tend to slow down. However, there are still no signs of negative growth forecasts in any of the countries. Servitization is expected to increase turnovers of various countries by averagely 3-4% in the coming years.

Striking the balance

Seemingly, the structure of servitization-based models is altogether a risky exertion. The manufacturer is exposed to huge risks as the consideration is based on the output of the customer. This might, on one hand, result in blocking of funds in the initial stages. While on the other hand, the customer base of the manufacturer is strengthened. Earning of the manufacturer depends on operations of the customer which are substantially out of the control of the manufacturer. This creates a gap in the chain of flow of income for the manufacturer.

The servitization model requires integration of operations of manufacturer and the customer. It calls for a close connection between the both. The manufacturer shall not only communicate with the person procuring the product, but also with the person actually engaged in operation of the product. The necessity of rethinking internal and external processes is highly felt while transforming from a product-based to a customer-based structure. Introduction of new technology and human resources specializing the service industry has to be the primary step in the transformation process. Extensive use of data and analytics is an inseparable part of servitization industry.

In essence, manufacturer will have to implement servitization as one major programme, which would address everything, from production processes to client communication and revenue generation. A risk-return balance will have to be achieved so that continuous inflow of income for the manufacturer is ensured.

Way forward

While some countries have implemented it to a large extent, some are advancing, some struggling and some oblivious to it, servitization seems to have entered all territories. Various sectors also have reacted differently to servitization, but reasonable growth has been recognised in all of them by now. Flaws would pop-up with time and would be handled accordingly. The concept of servitization is based on the principle of value for all. It has the potential to serve productivity and profitability at all levels of a value chain. Like every other innovation, operational aspects obviously have certain glitches which one can understand only after continuous operation. An effective implementation of servitization models would require consistent updations and modifications to achieve a feasible structure suitable to specific needs of both, the manufacturer and the customer. It’s a slow pathway to growth: Innovation and consistency are the keys.

[1]https://cambridgeservicealliance.eng.cam.ac.uk/resources/Downloads/Monthly%20Papers/2013November_ServitizationinGermany.pdf

Draft guidelines for on tap licensing of SFBs: decoded

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-Kanakprabha Jethani | Executive

(kanak@vinodkothari.com)

The Reserve Bank of India (RBI) has issued draft guidelines for ‘on tap’ licensing of Small Finance Banks (SFBs). The guidelines are largely similar to the existing guidelines for licensing of SFBs. However, the major difference is that the licensing will be allowed ‘on tap’. Further, there are certain changes in the eligibility requirements as well. The following write-up intends to answer all the questions relating to licensing of SFBs under the new ‘on tap’ mechanism.

What is ‘on-tap’ licensing?

Under the existing framework, the RBI issues licences for SFBs in batches i.e. all the applications are reviewed in a decided time frame and approvals for a number of SFBs are issued at once. The RBI doesn’t give out approvals as and when applications are received. Rather, when sufficient number of applications are received, they are reviewed at once and the applications that satisfy RBI’s criteria are issued with licenses.

Under the ‘on-tap’ mechanism, RBI will initiate the review of applications as and when they are received. Individual applications will be reviewed and licenses will be issued accordingly.

Who is eligible to apply?

Eligible Promoters:
Resident individuals Atleast 10 years’ experience in banking and finance sector at senior level
Professionals who are Indian citizens Atleast 10 years’ experience in banking and finance sector at senior level
Companies/societies owned and controlled by residents Having successful track record of running their business for atleast 5 years
Conversion:
Existing NBFCs, Micro Finance Institutions (MFIs), Local Area Banks (LABs) -in private sector + controlled by residents + successful track record of running the business for atleast 5 years
Primary Urban Co-operative Banks (UCBs) As per the scheme for voluntary transition.
Fit and Proper Criteria:
Promoters/ promoter group Past record of sound credentials and integrity, financial soundness and successful track record of professional experience or of running their business for atleast 5 years

Who cannot apply?

Joint ventures by different promoter groups for purpose of setting up SFB. Public sector entities, large industrial houses or business groups, bodies set up under state legislature, state financial corporations, etc. Group with assets of Rs. 5000 crores or more+ non financial business accounting for 40% or more

What will be the structure of SFB?

An SFB maybe floated either as a standalone entity or under a holding company, which shall act as the promoting entity of the bank. Such holding company shall be a Non-Operative Financial Holding Company (NOHFC) or be registered with the RBI as NBFC-CIC.

What activities can an SFB carry out?

Primarily, an SFB is allowed to carry out basic banking activities.

Apart from the primary functions, SFBs can also undertake non-risk sharing simple financial activities, not requiring commitment of their own funds, after obtaining approval of the RBI. Also, they are allowed to become Category II Authorised Dealer in foreign exchange business.

An activity that involves commitment of funds of the SFB, such as issue of credit cards, shall not be allowed.

What will be the capital structure in SFB?

Minimum paid-up equity capital:
All applicants Rs. 200 crores
For UCBs converting into SFB Initially Rs. 100 crores, which shall be required to be increased to Rs. 200 crores within 5 years
Capital Adequacy Ratio:
Tier I capital 7.5% of total risk-weighted assets
Tier II capital Maximum 100% of tier I capital
Capital 15% of total risk- weighted assets
Promoters Contribution:
Promoters’ holding Minimum 40% of paid-up voting equity capital

·         Bring down to 30% in 10 years

·         Bring down to 15% in 15 years
In case of conversion of NBFC/MFI to SFB, if promoters’ shareholding is maintained below 40% but above 26% due to regulatory requirements or otherwise, the same shall be acceptable. Provided that promoters’ shareholding doesn’t fall below 20%.
Lock-in on promoters’ minimum holding 5 years
If promoters’ shareholding > 40% Bring down to 40%

·         within 5 years from commencement of business (in case of other SFB)

·         within 5 years from the date paid-up capital of Rs. 200 crores is reached (in case of conversion from UCB)
No person other than promoters shall be allowed to hold more than 10% of the paid-up equity capital.
Foreign Shareholding:
Under automatic route Upto 49%
Government route Beyond 49% upto 74%
Atleast 26% of the paid-up equity capital should be held by resident shareholders.

Will the SFB be listed?

An application for listing of the SFB can be made voluntarily after obtaining approval of the RBI. However, on reaching a paid-up equity capital of Rs. 500 crores, listing shall be made mandatory.

What will be the compliance requirements for SFBs?

  • Have in place a robust risk management system.
  • Prudential norms as applicable to commercial banks shall be applicable.
  • 75% of Adjusted Net Bank Credit (ANBC) shall be extended to priority sectors.
  • The maximum loan size to a single person or group shall not be more than 10% of SFB’s capital funds.
  • The maximum investment exposure to a single person or group shall not be more than 15% of SFB’s capital funds.
  • Atleast 50% of loan portfolio should consist of small size loans (upto Rs. 25 lakhs per borrower).
  • There should be no exposure of the SFB to its promoters, shareholder holding 10% or more of the paid-up capital, and relatives of promoters.
  • Payments bank may make application to set up an SFB, provided that both the banks shall be under NOHFC structure.
  • SFB cannot be a Business Correspondent of other banks.

Are there any specific compliance requirements for NBFCs/MFIs/LABs converting into SFB?

Following are the specific requirements to be complied with in case of conversion from NBFC/MFI/LAB:

  • Have minimum paid-up capital of Rs. 200 crores. In case of deficiency, infuse the differential capital within 18 months.
  • Convert the branches of NBFC/MFI to branches of the SFB within 3 years from commencement of operations.
  • In case any floating charges stand in the balance sheet of the NBFC/MFI, the same shall be allowed to be carried until the related borrowings are matured.

How to make an application to set up an SFB?

An application shall be made to the RBI in Form III along with a business plan and detailed information of the existing as well as proposed structure, a project report regarding viability of the business of SFB and any other relevant information. The application shall be submitted to the RBI in physical form in an envelope superscripted “Application for Small Finance Bank” addressed to the Chief General Manager of the RBI.

In case, the application satisfies the RBI criteria, the fact of approval shall be placed on the RBI website. In case, the application is rejected, the applicant will be barred from making fresh application for a period of three years from such rejection.

 

Sharing of Credit Information to Fintech Companies: Implications of RBI Bar

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-Financial Services Division | Vinod Kothari Consultants Pvt. Ltd.

(finserv@vinodkothari.com)

The RBI recently wrote a letter, dated 16th September, 2019, to banks and NBFCs, censuring them over what seems to have been a prevailing practice – sharing of credit information sourced by NBFCs from Credit Information Companies (CICs), to fintech companies. The RBI reiterated that such sharing of information was not permissible, citing several provisions of the law, and expected the banks/NBFCs to affirm steps taken to ensure compliance within 15 days of the RBI’s letter.

This write-up intends to discuss the provisions of the Credit Information Companies (Regulation) Act, 2005 [CICRA], and related provisions, and the confidentiality of credit information of persons, and the implications of the RBI’s letter referred to above.

Fintech companies’ model

Much of the new-age lending is enabled by automated lending platforms of fintech companies. The typical model works with a partnership between a fintech company and an NBFC. The fintech company is the sourcing partner, and the NBFC is the funding partner. A borrower goes to the platform of the fintech company which provides a user-friendly application process, consisting of some basic steps such as providing the aadhaar card or PAN card details, and a photograph. Now, having got the individual’s basic details, the fintech company may either source the credit score of the individual from one of the CICs, or may use its own algorithm. If the fintech company wants to access the data stored with the CICs, it will have to rely on one of its partner NBFCs, since CIC access is currently allowed to financial sector entities only, who have to mandatorily register themselves as members of all four CICs.

It is here that the RBI sees an issue. If the NBFC allows the credit information sourced from the CIC to be transferred to a fintech company, there is an apparent question as to whether such sharing of information is permissible under the law or not.

We discuss below the provisions of the law relating to use of credit information.

Confidentiality of credit information

By virtue of the very relation between the customer and a banker, a banker gets access to the financial information of its customers. Very often, an individual may not even want to share his financial data even with close family members, but the banker any way has access to the same, all the time. If the banker was to share the financial details of a customer, it would be a clear intrusion into the individual’s privacy, and that too, arising out of a fiduciary relationship.

Therefore, the principle, which has since been reiterated by courts in numerous cases, was developed by UK courts in an old ruling in Tournier v National Provincial and Union Bank of England [1924] 1 KB 461. Halsbury’s Laws of England, Vol 1, 2nd edition, says: “It is an implied term of the contract between a banker and his customer that the banker will not divulge to third persons, without the consent of the customer, express or implied, either the state of the customer’s account, or any of his transactions with the bank or any information relating to the customer acquired through the keeping of his account, unless the banker is compelled to do so by order of a Court, or the circumstances give rise to a public duty of disclosure or the protection of the banker’s own interests requires it.”

The above law is followed in India as well.

In Shankarlal Agarwalla v. State Bank of India and Anr. AIR 1987 Cal 29[1], it was held that compulsion to disclose must be confined to the regular exercise by the proper officer to actual legal power to compel disclosure.

In case any information is disclosed without a legal compulsion to disclose, the same is wrongful on the part of the lender.

Credit Information Companies and sharing of information

When an RBI Working Group set up in 1999 under the chairmanship of N. H. Siddiqui recommended the formation of CICs in India, the question of confidentiality of credit information was discussed. It was noted by the Working Group that all over the world, there are regulatory controls on sharing of information by credit bureaus:

The Credit Information Bureaus, all over the world, function under a well defined regulatory framework. Where the Bureaus have been set up as part of the Central Bank, the regulatory framework for collection of information, access to that information, privacy of the data, etc., is provided by the Central Bank. Where Bureaus have been set up in the private sector, existence of separate laws ensure protection to the privacy and access to the data collected by the Bureau. In the U.S.A. where Credit Information Bureaus have been set up in the private sector, collection and sharing of information is governed by the provisions of the Fair Credit Reporting Act, 1971 (as amended by the Consumer Credit Reporting Reform Act of 1996). The Fair Credit Reporting Act is enforced by the Federal Trade Commission, a Federal Agency of the U.S. Govt. In the U.K., Credit Bureaus are licensed by the Office of the Fair Trading under the Consumer Credit Act of 1974. The Bureaus are also registered with the Office of the Data Protection Registrar, appointed under the Data Protection Act, 1984 (replaced by the Data Protection Commissioner under the new Act of 1998). In Australia, neither the Reserve Bank of Australia nor the Australian Prudential Regulation Authority (APRA) plays a role in promoting, developing, licensing or supporting Credit Bureaus. APRA holds annual meetings with the major Bureaus in Australia. The sharing of information relating to customers is regulated in Australia by the Privacy Act. This Act is administered by the Privacy Commissioner, who is vested with the responsibility of framing guidelines for protection of privacy principles and to ensure that Bureaus in Australia conform to these guidelines. In New Zealand, a situation similar to that of Australia exists. In Sri Lanka, the Bureau was formed by an Act of Parliament at the initiative of the Central Bank. A Deputy Governor of the Central Bank is the Chairman of the Bureau in Sri Lanka and the Bank is also represented on the Board of the Bureau by a senior officer. In Hong Kong, the Hong Kong Monetary Authority (HKMA), though not being directly involved in the setting up of a credit referencing agency has issued directions to all the authorised institutions recommending their full participation in the sharing and using of credit information through credit referencing agencies within the limits laid down by the Code of Practice on Consumer Credit Data formulated by the Privacy Commissioner. HKMA also monitors the effectiveness of the credit referencing services in Hong Kong, in terms of the amount of credit information disclosed to such agencies, and the level of participating in sharing credit information by authorised institutions.[2]

The inherent safeguards in the CIC Law

CICRA provides the privacy principles which shall guide the CICs, credit institutions and Specified Users in their operations in relation to collection, processing, collating, recording, preservation, secrecy, sharing and usage of credit information. In this regard, the purpose of obtaining information, guidelines for access to credit information of customers, restriction on use of information, procedures and principles for networking of CICs, credit institutions and specified users, etc. must be clearly defined.

Further, no person other than authorised person is allowed to have access to credit information under CICRA. Persons authorised to access credit information are CICs, credit institutions registered with the CICs and other persons as maybe specified by the RBI through regulations.

The Credit Information Companies Regulations provide that other persons who maybe allowed to access credit information are insurance companies, IRDAI, cellular service providers, rating agencies and brokers registered with SEBI, SEBI itself and trading members registered with Commodity Exchange.

Clearly, fintech companies or technology service providers are not authorised to access credit information. Access of information by such companies is a clear violation of CICRA.

Secrecy of customer information: duty of the lender

Paget on the Law of Banking observed that out of the duties of the banker towards the customer among those duties may be reckoned the duty of secrecy. Such duty is a legal one arising out of the contract, not merely a moral one. Breach of it therefore gives a claim for nominal damages or for substantial damages if injury is resulted from the breach.

Further, in case of Kattabomman Transport Corporation Ltd. V. State Bank of India, the Calcutta High Court held that the banker was under a duty to maintain confidentiality. An appeal[3] was filed against this ruling, the outcome of which was the information maybe disclosed by the banks, only when there is a higher duty than the private duty.

NBFCs providing access to the fintech companies is undoubtedly a private duty and thus, is a breach of duty on the part of the lender.

The case of Fintech Companies and NBFC partnership:

The letter of the RBI under discussion, dated 17th September, 2019, has been seen as a challenge to the working of the fintech companies. However, to understand in what way does this affect the working of fintech companies, we need to understand several situations.

Before coming to the same, it must be noted that the RBI’s 17th September circular is not writing a new law. The law on sharing of credit information has always been there, and the inherent protection is very much a part of the CICRA itself. The RBI circular is, at best, a regulatory cognition of an existing issue, and is a note of caution to NBFCs, who, in their enthusiasm to generate business, may not disregard the provisions of the law.

The situations may be as follows:

  • Fintech company using its own algorithm: In this case, the fintech company is relying upon its own proprietary algorithm. It is not relying on any credit bureau information. Therefore, there is no question of any credit information being shared. In fact, even if the fintech uses the score developed by it, without relying on CIC data, with other entities, it is a proprietary information, which may be shared.
  • NBFC sharing credit information with Fintech company, which is sourcing partner for the NBFC: If the NBFC is sharing information with a fintech company, with the intent of using the information for its own lending, can it be argued that there is a breach of the provisions of the CICRA? It may be noted that regulation 9 of the CIC Regulations requires CICs to protect credit information from unauthorised access. As already discussed, access by such fintech companies is unauthorised.
  • NBFC sharing credit information with Fintech company, which is not partnering with the NBFC: In case, the NBFC is not partnering with the NBFC and is still sharing credit information, there seems to be no reason for such sharing other than information trading. Several NBFCs have at many instances, been reported to have engaged in information trading for additional income.
  • NBFC sharing credit information with another NBFC/bank, which is a co-lender: The NBFC may authorise its co-lender to obtain credit information from CICs and the same shall not be an unauthorised access of information, since the co-lender is also a credit institution and is registered with CICs.
  • Bank sharing credit information with another NBFC which is a sourcing partner and not a c0-lender: If the sourcing partner is a member of CICs, it may access the credit information directly from the CICs. If the sourcing partner is not a member of CICs, sharing of credit information is violation of customer privacy, and thus, shall not be allowed.

Conclusion

The credit bureau reports are actually being exchanged in the system without much respect to the privacy of the individual’s data. With the explosion of information over the net, it may even be difficult to establish as to where the information is coming from. Privacy and confidentiality of information is at stake. At the same time, the very claim-to-existence of fintech entities is their ability to process a credit application within no time. Whether there is an effective way to protect the sharing of information stored with CICs is a significant question, and the RBI’s attention to this is timely and significant.

 

[1] https://indiankanoon.org/doc/1300997/

[2] https://www.rbi.org.in/scripts/PublicationReportDetails.aspx?ID=76

[3] https://indiankanoon.org/doc/908914/

 

Partial Credit Guarantee Scheme

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A Business Conclave on  “Partial Credit Guarantee Scheme” was organised by Indian Securitisation Foundation jointly with Edelweiss on September 16,2019 in Mumbai.

On this occasion, the presentation used by Mr. Vinod Kothari is being given here:

http://vinodkothari.com/wp-content/uploads/2019/09/partial-credit-enhancement-scheme-.pdf

 

We have authored few articles on the topic that one might want to give a read. The links to such related articles are provided below:

The cult of easy borrowing: New age NBFCs ride high on tempting loan offers

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-Rahul Maharshi and Kanakprabha Jethani

(finserv@vinodkothari.com)

 

“यावज्जीवेत्सुखं जीवेत् ऋणं कृत्वा घृतं पिबेत् |

भस्मीभूतस्य देहस्य पुनरागमनं कुतः ||”

The ancient couplet from the Charvak Darshan, in Indian mythology is popularly known as the philosophy of life. There are various interpretations of the above, in general, the meaning of the above couplet gives us a saying that “One should live luxuriously, as long as he is alive, and to attain the same, one may even live on credit and in debt. Because once you are dead and cremated, it is foolish to think about afterlife and rebirth.”

It is seen today that the financial services industry is taking the above couplet too seriously and making the borrowers flooded with opportunities and facilities to burden them with debt in one click. Even the person who is unwilling to enter into a debt trap is somewhat lured by the “instant loan” facilities given by numerous NBFCs these days.

Whilst the Indian economy facing a slowdown and banks in India showing significant falls in their lending volumes, the NBFCs engaged in e-lending are displaying an inverse relation to the trend. The NBFCs have been showing extravagant growth in their lending volumes. On one hand banks are tightening the lending norms considering the current state of the economy, NBFCs seem to be doing reckless lending and reporting exceptionally high lending volumes. The financial market seems to be showing a transition from secured lending to unsecured lending, from corporate finance to personal finance, from paperwork to digitisation. This transition is the reason behind such a drastic shift of lending volumes.

CURRENT STATE OF LENDING TRANSACTIONS

NBFCs are crossing milestones, making new records everyday. A leading NBFC reported disbursal of Rs. 550 crores in 3,50,000 loan transactions and has been consistently disbursing loans over Rs. 80 crores every month[1]. Another NBFC reported an existing customer base of 1.1 million. An app-based lender NBFC has 100 million downloads of its app and has disbursed around Rs. 700 crores in FY 19 with an expectation of increasing the amount of disbursals to Rs. 2,000 crores in FY 20[2].

On the contrary, banks are showing a completely opposite picture. Under the 59-minute loan scheme introduced by the Prime Minister for small entities (having turnover upto Rs. 25 crores) to avail loans of amount upto Rs. 5 crores from banks within an hour, only 50,706 loans were given approval in the FY 19. The growth rates in the banking sector are lowering. The growth in retail loans fell down to 15.7% in April 2019 as compared to 19.1% in April 2018. The growth rate in credit card loans has also shown a decline of 8.8%[3].

UNDERSTANDING THEIR BUSINESS MODEL

NBFCs do unsecured lending of small-ticket size loans, usually personal in nature. The market tends to be more inclined towards obtaining finance from such NBFCs. The basic features of loans provided by NBFCs can be understood through following points:

  • Unsecured: The loans provided by NBFCs doing e-lending are generally unsecure loans. The borrower or the customer is not required to provide any security for obtaining such loans. Thus, even if borrowers have no assets at all, they can still obtain loans.
  • Instant: These NBFCs process the loans within a very short period (‘superfast processing’ as they call it) and the disbursement is made within a period ranging from 5 minutes to 3 days depending on the size of the loan. There is no requirement of long procedures as required to be followed in case of bank loans.
  • Digital: Usually, these NBFCs have an app-based or website based platform through which they provide such loans. The KYC process is also carried out through the app or website itself.
  • High-interest rates: The interest rates on such loans are very high as compared to the interest rates on loans provided by banks. The rates usually range from 15% p.a. to 130% p.a.
  • Small-ticket size: The loan size is generally small ranging from Rs. 500 to Rs, 50,000
  • Short-term loans: The term of loan is also short. Repayment is required on weekly, fortnightly or monthly basis.
  • Credit Score based decisions: The lending decisions made by NBFCS are largely dependent on the credit score of the borrower. A strong network of Credit Information Companies (CICs) stores the credit information of the borrowers and the borrower making default of even a single day would be barred from accessing any other e-lending platform as well. However, for first time borrowers, the only way to check credit standing is their bank statement.
  • Source of funds: NBFCs get their funds from banks as well as bigger size NFCs and Private Equity investors.
  • Purpose: These loans are provided mostly for personal purposes like marriage ceremonies, buying a car, medical issues, travel etc.
  • Innovation: Each of the e-lending platform has a different model. While some involve students in their marketing activities, some have tied-up with sellers and buyers to finance transactions between them and some tying up with different brands to finance their operations.

NBFCs BRUSHING OFF THE REGULATIONS: THEIR OWN SWEET WAYS

The operational structures of such loans are in defiance of many requirements of the RBI Directions. One can see disparity from the RBI Directions in many ways. Following are the areas where most of the NBFCs take their own sweet ways:

  • KYC process: As per the KYC Master Directions an authorised representative of the lender NBFC to physically visit and originally see and verify the KYC details of the borrower. There are further requirements of maintaining the KYC records and carrying out Customer Due Diligence (CDD) which the NBFCs fail (refuse) to comply with in the hurry of their “superfast processing”.
  • Fair Practice Code (FPC): The FPC requires lender NBFCs to display annualised interest rates in all their communications with the borrowers. However, most of the NBFCs show monthly interest rates in the name of their “marketing strategy”.
  • Risk Management: The Directions require the NBFCs to assess the risk before granting loans to borrowers, which is overlooked while providing speedy disbursals.
  • Recovery Process: NBFCs do not even have properly defined recovery process. They are just making rapid disbursals ignorant of whether these loans will be repaid.
  • Risk to personal information: Many NBFCs obtain access to the personal information such as text messages and social media profile of the borrower by way of incorporating clauses in this regard in the detailed terms and conditions of the loan agreement.

RISKS TO THE BORROWERS

The borrowers face several risks under such loan transactions, ranging from personal to financial such as:

  • Many borrowers usually don’t read the entire set of terms and conditions and end up granting the NBFCs access to their personal information. Privacy of the borrower is at stake as information trading is yet another business that the NBFCs may secretly engage into posing a threat to borrowers’ personal information.
  • The lucrative advertising strategies of these NBFCs might make a borrower take loans for purposes which otherwise would not have been a necessity or priority for the borrower. Hence, the borrower tends to borrow without any actual requirement because a demand has been created by the lender NBFCs.
  • The interest rates are very high on such loans. In case the amount of loan is high, the borrower is unable to pay the huge amount of interest and thus has to take another loan to repay the first.
  • The credit score of the borrower may get affected at the slightest delay in repayment, even if the amount of loan is as small as Rs. 500. Thus the credibility of borrower is at a risk of degradation.

THE BUBBLE OF ATTRACTION: PLAYING WITH THE PSYCHOLOGY

Even in existence of such high interest rates, why is a borrower more attracted to loans from NBFCs? The only answer one finds to this is the ease and the fact that they are instant. In an era where everyone wants everything in a jiffy, be it food or health solutions, being attracted to instant loans is a very natural thing.

For example you meet an accident and don’t have money for treatment to be done, take a loan. You are shopping and suddenly realise you forgot your purse, take a loan.

The most crucial thing is that these NBFCs do not monitor the end use of the loan amounts disbursed. So a borrower may specify any purpose for the loan, which he might not actually use the loan for. Moreover, the high interest rates are not noticed by the borrowers as most of the NBFCs show monthly interest rates rather than the yearly rates in their communications on the app or the website.

Many borrowers usually don’t read the entire set of terms and conditions and end up granting these NBFCs access to their personal information. Information trading is yet another business that the NBFCs may secretly engage into posing a threat to borrowers’ information.

The NBFCs are rightly playing the psychology game by becoming a friend in need for the borrowers. No matter how high the interest rates maybe or how risky the transaction maybe, it is a handy help whenever needed.

Furthermore, the advertisements made by these NBFCs are so catchy that they may lure a person who might not really be in need of finance. The catchy phrases like “make your dream wedding come true”, “let the wanderlust in you come alive” create a “need” for the customer to become a borrower. Marriage functions, travel and luxuries things are the Indian way of showing richness and the abovementioned philosophy wraps people in a comfortable blanket of justification to remain under debt-burden.

ALL OUR MONEY INTO THE BLACK HOLE

While lending to businesses results in more capital formation and growth of the economy. Personal lending mostly results in wasteful expenditure. Further, the interest rates being so high, many a times the borrowers obtain another loan to pay the previous loan and gets trapped into the vicious circle of obtaining and repaying loans. The increasing lending volumes are not an indication of overall growth of the economy. Most of the purposes for which such loans are availed are consumption-based and have no value-addition. All the money taken on loan is being used in consumption-based expenditure and not in value-addition activities and thus even after such high lending volumes, the growth of the economy is just disappearing into the black hole.

CONCLUSION

While on one hand, such loans are helping us in need, on the other hand they are luring us to take unnecessary debt burden. The lender NBFCs are under the risk of regulatory action by the regulators since many of them are in non-compliance with regulatory requirements. The borrowers are under the risk of pressing themselves under unnecessary debt burden and huge interest costs. The recovery procedures of these NBFCs are very lenient but due to the high interest costs, the cost of funds is readily recovered by the lender NBFC. Even when banks have tried to provide quick loans under 59-minutes loan scheme, they have failed to do away with the procedural requirements such as document submission and are still regarded as “slow-loans” considering the super-fast loans being provided by NBFCs within 5 minutes.

Though immensely helpful, these loans have a potential to impact the economy in such a manner that it seems to be beneficial while it’s actually not. The borrowers are happily floating in the bubble of “instant loans” which is definitely going to burst in no time.

 

[1] Source: Economic Times

[2] Source: CNBC

[3] Source: Business Standard

Introduction of Digital KYC

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Anita Baid (anita@vinodkothari.com)

The guidelines relating to KYC has been in headlines for quite some time now. Pursuant to the several amendments in the regulations, the KYC process of using Aadhaar through offline modes was resumed for fintech companies. The amendments in the KYC Master Directions[1] allowed verification of customers by offline modes and permitted NBFCs to take Aadhaar for verifying the identity of customers if provided voluntarily by them, after complying with the conditions of privacy to ensure that the interests of the customers are safeguarded.

Several amendments were made in the Prevention of Money laundering (Maintenance of Records) Rules, 2005, vide the notification of Prevention of Money laundering (Maintenance of Records) Amendment Rules, 20191 issued on February 13, 2019[2] (‘February Notification’) so as to allow use of Aadhaar as a proof of identity, however, in a manner that protected the private and confidential information of the borrowers.

The February Notification recognised proof of possession of Aadhaar number as an ‘officially valid document’. Further, it stated that whoever submits “proof of possession of Aadhaar number” as an officially valid document, has to do it in such a form as are issued by the Authority. However, the concern for most of the fintech companies lending through online mode was that the regulations did not specify acceptance of KYC documents electronically. This has been addressed by the recent notification on Prevention of Money-laundering (Maintenance of Records) Third Amendment Rules, 2019 issued on August 19, 2019[3] (“August Notification”).

Digital KYC Process

The August Notification has defined the term digital KYC as follows:

“digitial KYC” means the capturing live photo of the client and officially valid document or the proof of possession of Aadhaar, where offline verification cannot be carried out, along with the latitude and longitude of the location where such live photo is being taken by an authorised officer of the reporting entity as per the provisions contained in the Act;

Accordingly, fintech companies will be able to carry out the KYC of its customers via digital mode.

The detailed procedure for undertaking the digital KYC has also been laid down. The Digital KYC Process is a facility that will allow the reporting entities to undertake the KYC of customers via an authenticated application, specifically developed for this purpose (‘Application’). The access of the Application shall be controlled by the reporting entities and it should be ensured that the same is used only by authorized persons. To carry out the KYC, either the customer, along with its original OVD, will have to visit the location of the authorized official or vice-versa. Further, live photograph of the client will be taken by the authorized officer and the same photograph will be embedded in the Customer Application Form (CAF).

Further, the system Application shall have to enable the following features:

  1. It shall be able to put a water-mark in readable form having CAF number, GPS coordinates, authorized official’s name, unique employee Code (assigned by Reporting Entities) and Date (DD:MM:YYYY) and time stamp (HH:MM:SS) on the captured live photograph of the client;
  2. It shall have the feature that only live photograph of the client is captured and no printed or video-graphed photograph of the client is captured.

The live photograph of the original OVD or proof of possession of Aadhaar where offline verification cannot be carried out (placed horizontally), shall also be captured vertically from above and water-marking in readable form as mentioned above shall be done.

Further, in those documents where Quick Response (QR) code is available, such details can be auto-populated by scanning the QR code instead of manual filing the details. For example, in case of physical Aadhaar/e-Aadhaar downloaded from UIDAI where QR code is available, the details like name, gender, date of birth and address can be auto-populated by scanning the QR available on Aadhaar/e-Aadhaar.

Upon completion of the process, a One Time Password (OTP) message containing the text that ‘Please verify the details filled in form before sharing OTP’ shall be sent to client’s own mobile number. Upon successful validation of the OTP, it will be treated as client signature on CAF.

For the Digital KYC Process, it will be the responsibility of the authorized officer to check and verify that:-

  1. information available in the picture of document is matching with the information entered by authorized officer in CAF;
  2. live photograph of the client matches with the photo available in the document; and
  3. all of the necessary details in CAF including mandatory field are filled properly.

Electronic Documents

The most interesting amendment in the August Notification is the concept of “equivalent e-document”. This means an electronic equivalent of a document, issued by the issuing authority of such document with its valid digital signature including documents issued to the digital locker account of the client as per rule 9 of the Information Technology (Preservation and Retention of Information by Intermediaries Providing Digital Locker Facilities) Rules, 2016 shall be recognized as a KYC document. Provided that the digital signature will have to be verified by the reporting entity as per the provisions of the Information Technology Act, 2000.

The aforesaid amendment will facilitate a hassle free and convenient option for the customers to submit their KYC documents. The customer will be able to submit its KYC documents in electronic form stored in his/her digital locker account.

Further, pursuant to this amendment, at several places where Permanent Account Number (PAN) was required to be submitted mandatorily has now been replaced with the option to either submit PAN or equivalent e-document.

Submission of Aadhaar

With the substitution in rule 9, an individual will now have the following three option for submission of Aadhaar details:

  • the Aadhaar number where,
    1. he is desirous of receiving any benefit or subsidy under any scheme notified under section 7 of the Aadhaar (Targeted Delivery of Financial and Other subsidies, Benefits and Services) Act, 2016 or
    2. he decides to submit his Aadhaar number voluntarily
  • the proof of possession of Aadhaar number where offline verification can be carried out; or
  • the proof of possession of Aadhaar number where offline verification cannot be carried out or any officially valid document or the equivalent e-document thereof containing the details of his identity and address;

Further, along with any of the aforesaid options the following shall also be submitted:

  1. the Permanent Account Number or the equivalent e-document thereof or Form No. 60 as defined in Income-tax Rules, 1962; and
  2. such other documents including in respect of the nature of business and financial status of the client, or the equivalent e-documents thereof as may be required by the reporting entity

The KYC Master Directions were amended on the basis in the February Notification. As per the amendments proposed at that time, banking companies were allowed to verify the identity of the customers by authentication under the Aadhaar Act or by offline verification or by use of passport or any other officially valid documents. Further distinguishing the access, it permitted only banks to authenticate identities using Aadhaar. Other reporting entities, like NBFCs, were permitted to use the offline tools for verifying the identity of customers provided they comply with the prescribed standards of privacy and security.

The August Notification has now specified the following options:

  1. For a banking company, where the client submits his Aadhaar number, authentication of the client’s Aadhaar number shall be carried out using e-KYC authentication facility provided by the Unique Identification Authority of India;
  2. For all reporting entities,
    1. where proof of possession of Aadhaar is submitted and where offline verification can be carried out, the reporting entity shall carry out offline verification;
    2. where an equivalent e-document of any officially valid document is submitted, the reporting entity shall verify the digital signature as per the provisions of the IT Act and take a live photo
    3. any officially valid document or proof of possession of Aadhaar number is submitted and where offline verification cannot be carried out, the reporting entity shall carry out verification through digital KYC, as per the prescribed Digital KYC Process

It is also expected that the RBI shall notify for a class of reporting entity a period, beyond which instead of carrying out digital KYC, the reporting entity pertaining to such class may obtain a certified copy of the proof of possession of Aadhaar number or the officially valid document and a recent photograph where an equivalent e-document is not submitted.

The August Notification has also laid emphasis on the fact that certified copy of the KYC documents have to be obtained. This means the reporting entity shall have to compare the copy of the proof of possession of Aadhaar number where offline verification cannot be carried out or officially valid document so produced by the client with the original and record the same on the copy by the authorised officer of the reporting entity. Henceforth, this verification can also be carried out by way of Digital KYC Process.

[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11566#F4

[2] http://egazette.nic.in/WriteReadData/2019/197650.pdf

[3] http://egazette.nic.in/WriteReadData/2019/210818.pdf