Digital lending: Footnote prescriptions heavier than the headlines

Time to re-think on co-lending transactions and FLDG arrangements

– Anita Baid, Vice President | anita@vinodkothari.com

The August 10, 2022 Press Release of the RBI on implementation of the recommendations of the Working group on Digital Lending was a major setback for the existing business model of several fintech entities and digital lenders. Through the Press Release, RBI had sought to implement the recommendations and suggestions of the WG on digital lending. ^[1]

In furtherance to the Press Release, the RBI has issued the Guidelines on Digital Lending on September 2, 2022 (‘Guidelines’). In essence, the Press Release gets coded into the Guidelines since the text of Guideline is largely similar to the Press Release.

However, it may be important to note that there are certain modifications and insertion of footnotes that are causing confusion among the lenders and platforms. The major changes and its impact are discussed herein below.

While appreciating the intent of the RBI, we cannot overemphasize the need for a clear regulatory prescription. There cannot be a regulation by implication – if the regulators expected the regulated entities to adhere to and abide by the regulations, the intent as well as the language of the regulations has to be clear. The SC has time and again commented on unclear regulations, for instance in the case of Reliance Industries Limited Vs Securities and Exchange Board of India & Ors. ^[2] had it stated that ‘Opaqueness only propagates prejudice and partiality. ‘Opaqueness is antithetical to transparency. It is of utmost importance that in a country grounded in the rule of law, institutions ought to adopt procedures that further the democratic principles of transparency and accountability.‘

Fintech lending is such an important piece in the financial landscape of the country. There may be practices that the regulator may want to curb or discipline. However, the regulator has to use straight and comprehensible language. The use of unclear regulatory prescriptions will drive some people to extend the law beyond what its intent might have been, and some people to create gateways of escape.

Restrictions on Default Guarantee Arrangements

Para 15 of the Guidelines reads as follows:

15. Loss sharing arrangement in case of default:

As regards the industry practice of offering financial products involving contractual agreements such as First Loss Default Guarantee (FLDG) in which a third party guarantees to compensate up to a certain percentage of default in a loan portfolio of the RE, it is advised that REs shall adhere to the provisions of the Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 dated September 24, 2021, especially, synthetic securitisation8 contained in Para (6)(c).

Further, the footnote 8 states- “synthetic securitisation” means a structure where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of credit derivatives or credit guarantees that serve to hedge the credit risk of the portfolio which remains on the balance sheet of the lender.

Synthetic securitisation is a structure whereby[3] instead of transferring a pool of loans, the risk of the pool is transferred. Mostly, the device used is credit default swaps, but the more traditional instrument of guarantee is also referred to in the definition of synthetic securitisation by the RBI.

If the literal meaning of this para is taken, it would transpire that any form of risk transfer in a pool of loans by any lender, to a third party, is not permitted. To expand:

• While the word used is FLDG, however, if the entire pool is protected, it does not deviate from the said provision being applicable.
• If the guarantee is for the second loss piece, such that the first loss risk stays with the lender, and the third party (risk transferee) acquires a stake in the mezzanine tranche, is this also frowned upon? There is no doubt that mezzanine risk transfers are most common in synthetic securitisations – however, if the intent of the RBI was that the one who holds the loans dos not hold the risk, that problem does not exist in case of mezzanine risk transfers.
• What if the transferee of risk is a regulated entity? The mere fact that the guarantee is being provided by a regulated entity also does not change the applicability. The Guidelines would still be applicable for digital loans. In any case, unregulated entities cannot be the guarantee provider under the SSA Directions.
• What is the transferee of the risk is a co-lender? In a co-lending transaction, the originating co-lender provides a default guarantee, thereby protecting the losses of the funding co-lender. This is very common in most of the colending arrangements. It should also be noted that the restriction is on ‘third party guarantees’, however, the colender is a lender himself. To the extent the default guarantee is not vitiating the essence of colending as a partnership between two lenders, the same shall not be covered under the text of the Guidelines. It is a different issue that if the co-lender, with a 20% share, is bearing the risk of the 100% of the pool, and getting returns from the same, this is effectively no different from synthetic lending of the remaining 80%. However, one may choose to go by letters of the Guideline, rather than the spirit.

Strangely, the synthetic securitisation bar has been extended in case of digitally originated loans. There is no reason why the same restriction should not be applied to any loans. If we take the bar to that extent, any form credit risk transfers in case of any loan pools will be barred. This, however, will completely kill the market for risk mitigation and risk sharing.

Regulations for Co-lending transactions

As per the Press Release and as also confirmed by the Guidelines, REs are to ensure that loan servicing, disbursement, repayment, etc. is to be done directly in their bank account without any pass-through account/ pool account of any third party. An exception is made in case of flow of money between REs for co-lending transactions[4].

The RBI has guidelines in place for regulating the co-lending arrangement between a bank and NBFC for PSL loans. However, the other colending arrangements, like those between NBFC and NBFC as well as those for non-PSL loans were not regulated as such. Most of the co-lending transactions are accordingly undertaken based on the contractual and commercial arrangement between the colenders.

However, there has been a footnote inserted in the Guidelines stating that Co-lending arrangements shall be governed by the extant instructions as laid down in the Circular on Co-lending by Banks and NBFCs to Priority Sector dated November 05, 2020, and other related instructions.

The possible interpretation of the aforesaid footnote could be as follows:

1. First, only those co-lender transaction that are between bank and NBFC for PSL loans would be exempted from the restriction on flow of funds to a third-party account.
2. Second, all co-lending transaction are to be in line with the RBI Circular on Co-lending

The first interpretation may not be feasible since, majority of colending in the market is happening for non-PSL loans and colending transaction would necessarily require the flow of funds from either of the colenders.

Going by the second interpretation would mean that all colending transaction would have to pari materia follow the existing RBI regulations, including but not limited to a minimum loan share of 20%.  There were several colending transaction prevalent in the market wherein the loan sharing ratio was 99:1 or 95:5 or 90:10. This would mean that all such colending would have to fall in line with the 80:20 loan sharing requirement.

It is also peculiar to have this kind of a direction flow from a mere ‘footnote’ which usually is to clarify the terminology or concept.

Applicability and Grandfathering

All instructions contained in the Guidelines would apply to existing customers availing fresh loans as well as to new customers getting onboarded. The applicability would still remain as the date of Press Release only. However, there is a deferment for existing digital loans as on the date of the Press Release, which provides time till November 30, 2022, to put in place adequate systems and processes to ensure that existing digital loans sanctioned as on the date of the guidelines are also in compliance with the Guidelines in both letter and spirit.

Carve Out for Specific End Use

The exemptions from the flow of funds directly into the bank account of the borrower has been provided to disbursals for specific end use, provided the loan is disbursed directly into the bank account of the end-beneficiary. Hence, the BNPL facilities as well as loans for purchase of goods and services, requiring disbursal to the merchant directly would fall under the exemption.

Cooling Off Period Specified

The WG Report or the Press Release had not stipulated the no. of days for the cooling off period. However, as per para 8 of the Guidelines, the period so determined shall not be less than three days for loans having tenor of seven days or more and one day for loans having tenor of less than seven days

Responsible Lending

The usual practice of fintech to provide loans to anyone and everyone, just to increase their outreach, may have to stop now. The Guidelines mandate the REs to capture the economic profile of the borrowers covering (age, occupation, income, etc.), before extending any loan over their own DLAs and/or through LSPs engaged by them, with a view to assessing the borrower’s creditworthiness in an auditable way.

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^[1] Refer to our article on the DL Press Release- https://vinodkothari.com/2022/08/rbi-regulations-on-digital-lending/  Refer to our FAQs on Digital Lending- https://vinodkothari.com/2022/08/faqs-on-digital-lending-regulations/

Lending Service Providers for digital lenders: Distinguishing agency contracts and principal-to-principal contracts – https://vinodkothari.com/2022/10/lending-service-providers-for-digital-lenders-distinguishing-agency-contracts-and-principal-to-principal-contracts/

[2] https://indiankanoon.org/doc/101304571/

[3] Refer to Vinod Kothari’s book on Credit Derivatives and Structured Credit Trading – https://vinodkothari.com/crebook/
Refer to our article on the revival of synthetic securitisation here- https://vinodkothari.com/2022/03/resurgence-of-synthetic-securitisations/

[4] Refer to our detailed write up on Law of Co-lending- https://vinodkothari.com/2022/07/the-law-of-co-lending/

Our write-ups on Digital Lending: https://vinodkothari.com/?s=digital+lending