FAQs on Default Loss Guarantee in Digital Lending

An understanding of the Guidelines issued by RBI

Team Finserv | finserv@vinodkothari.com

On September 02, 2022, the RBI issued the “Guidelines on Digital Lending” (“DL Guidelines”), which had essentially put a bar on “Loss sharing/ structured default guarantee arrangements” such as First Loss Default Guarantees, likening their nature to that of “synthetic securitisation” as defined under the Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 (“SSA Directions”). This caused a disruption in the digital lending industry as most of the arrangements ran on some form of loss-sharing arrangement. (Refer to our FAQs on the Digital Lending Guidelines here)

In its Statement on Developmental and Regulatory Policies dated June 8, 2023, the RBI announced its intention to issue a regulatory framework for permitting Default Loss Guarantee arrangements in Digital Lending[1]. The same day, the Guidelines on Default Loss Guarantee (DLG) in Digital Lending have been issued by the regulator (‘DLG Guidelines’).

We have developed a set of FAQs on the DLG Guidelines, where we intend to answer some of the critical questions relating to the default guarantee arrangements.

Contents

Scope of applicability	Rights/obligations of DLG provider
Implicit guarantee	NPA recognition and Capital treatment
Eligibility of guarantor	Guarantee fee
Cap on the extent of guarantee	Capital treatment for the guarantor
Form/Tenor of DLG	Compliance requirements for the RE

Scope of applicability

1. From what date do these DLG Guidelines become applicable? What happens to existing arrangements?

Response: The DLG Guidelines shall come into effect from the date of the circular, that is June 8, 2023. Prior to the issuance of these guidelines, the RBI had put a complete bar on FLDG arrangements vide the RBI Press Release “Recommendations of the Working Group on Digital Lending – Implementation” dated August 10, 2022, by treating the same as “synthetic securitisation” under the RBI Securitisation Guidelines. Hence, the question of any existing arrangements does not arise.

2. Are the DLG Guidelines applicable only in case of Digital Lending?

Response: As is apparent from the language, the DLG Guidelines are applicable only in case of digital lending. This would mean that any guarantee arrangements outside of the definition of “Digital Lending” would not be covered under the DLG Guidelines and hence, would still be treated as ‘synthetic securitisation’ and/ or shall attract the provisions of ‘loan participation’ as the case may be.

3. Does the fact that the Guidelines are applicable in case of digital lending mean, in case of non-digital lending, similar arrangements are permitted without any restriction?

Response: Our answer to this question is in the negative. In fact, the DLG Guidelines come as a carve-out from the earlier stipulation that DLG arrangements are synthetic securitisation (read our articles here and here). Therefore, in our view, there is an absolute prohibition in case of loans other than digital loans.

4. Can DLG arrangements happen in case of physical loans?

Response: Refer response to the query above, it seems as though DLG arrangements in case of physical loans would not be covered under the DLG Guidelines, since the DLG Guidelines seem to apply only in case of DLG arrangements under “Digital Lending” cases.

5. Can it be a loan-by-loan DLG or at a portfolio level? What if it is a loan by loan guarantee?

Response: As per the definition of DLG, the guarantee covered by the guidelines is only a DLG given at the portfolio level. Loan-by-loan guarantees are neither covered by the circular, nor are to be treated as a case of synthetic securitisation. There is a separate framework on guarantees and co-acceptances that may be applicable in such cases (can be viewed here).

Loan by loan guarantee will not serve the purpose of the structure default guarantee. For more details on the difference between loan-by-loan guarantees and portfolio-level guarantees, please refer to our article on structured default guarantees here.

6. Are the guidelines applicable only in case of first-loss default guarantees, or will they be applicable to a mezzanine or senior guarantee as well?

Response: The DLG Guidelines seem to cover all kinds of default loss guarantee arrangements.

7. Are the guidelines applicable if the guarantee is for the entire loan portfolio?

Response: No, the guarantee should compensate the RE in case of loss due to default up to a certain percentage of the loan portfolio of the RE, specified upfront. Refer to the definition of DLG under para 2.1 of the DLG Guidelines.

Therefore, if the entire pool of loans is guaranteed (which, in effect, is equal to a loan-by-loan guarantee), there is no offence of either the DLG Guidelines nor is such arrangement prohibited.

8. Will the guarantor necessarily be a sourcing agent or could be any other agent?

Response: The eligibility criteria for the DLG can be provided by a Lending Service Provider (LSP), as defined under Para 2.5 of the Annex to the Circular on ‘Guidelines on Digital Lending’ dated September 02, 2022. This would include not just sourcing agents but also other outsourcing agents to whom the lender has outsourced any lending function. However, it is important to note that the guarantee is an offshoot of the loan sourcing arrangement, and therefore, it is counterintuitive to expect guarantees from any other outsourcing agent.

9. Are there any exceptions from the definition of DLG?

Response: As per para 14 of the DLG Guidelines, guarantees covered under the following schemes/ entities shall not be covered within the definition of DLG –

• Guarantee schemes of Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), Credit Risk Guarantee Fund Trust for Low Income Housing (CRGFTLIH) and individual schemes under National Credit Guarantee Trustee Company Ltd (NCGTC).
• Credit guarantee provided by Bank for International Settlements (BIS), International Monetary Fund (IMF) as well as Multilateral Development Banks as referred to in Paragraph 5.5 of RBI Master Circular on Basel III Capital Regulation dated May 12, 2023.

Other exceptions have been discussed in some of our other FAQs – for example, a pool-wide guarantee, rather than upto a particular level.

10. Will the guidelines be applicable in case of co-lending arrangements?

Response: The eligibility (as specified in para 3 of the DLG Guidelines) includes an RE with which it has entered into an outsourcing (LSP) arrangement. Since, in a co-lending arrangement, there is no outsourcing agreement with the co-lender and the arrangement is not that of an outsourcing but rather that of shared lending, a co-lender cannot provide DLG to the other co-lender.

That, however, does not prevent both the co-lenders from seeking a DLG from a sourcing agent, who acts as an LSP for the co-lending arrangement itself.

Implicit guarantee

11. What exactly is the meaning of implicit guarantee? If the guarantee is implicit, and not explicit, how does one not see it or contractually stipulate it?

Response: Implicit guarantee does not mean an informal understanding, as the RBI could not have recognised any understanding which is not a contractual commitment between the parties. Hence, what implicit arrangements mean is such contractual arrangements, where the arrangement is not structured as a guarantee, but has the economic impact equivalent to a guarantee. That is, where there is a commitment to make a payment or suffer an outgo or sacrifice, by an RE or LSP, on the basis of the performance of the pool, even if the same is not structured as a guarantee, such commitment will be treated as a case of an implicit guarantee.

For instance, if there is a subordination of servicing fees, such that the servicer compensates the lender for loss or shortfall in performance upto a predefined level, the arrangement may be regarded as an implicit guarantee.

12. It is usual to have representations and warranties in sourcing arrangements, whereby the sourcing agent may be required to compensate the lender for referring a loan that does not meet prescribed underwriting standards. Would such an arrangement also be regarded as an implicit guarantee?

Response: Not really. A guarantor agrees to compensate for deterioration in the credit quality of an asset. A representation or warranty relates to the position of the loan as on the date of its origination.

13. Whether implicit guarantees would be subject to the same requirements as explicit guarantees?

Response: Yes, since implicit guarantees fall under the definition of DLG and only those DLG arrangements which conform to/ comply with the DLG Guidelines would not be treated as ‘synthetic securitisation’ and/ or shall also not attract the provisions of ‘loan participation’, implicit guarantees would be subject to the same requirements as explicit guarantees.

14. Will every subordination of cashflows be a case of implicit guarantee?

Response: It is not possible to generalise and say, every subordination or linking of cashflows to a service provider with the performance of the pool is a case of an implicit guarantee. For example, a servicer is entitled to servicing fees, and the fees may be linked with performance. There may be a matrix of fee scale based on performance, so as to reward or penalise the servicer for achieving levels of performance. Such a scalar fee arrangement cannot be said to be an implicit guarantee.

The whole concept of a “implicit guarantee” is an arrangement which, in substance, is a guarantee, but is not a guarantee in form. In all substance-over-form arrangements, the judgment becomes subjective and circumstantial.

15. Para 2.1 says about implicit guarantee, however, clause 4 says there must be a legally enforceable explicit contract – how to read these provisions sounding contradictory to each other?

Response: Refer to our response to query 11 above, implicit guarantees have the economic effect of a guarantee. Its economic impact is legally not structured as a guarantee but serves the purpose of a guarantee. That means the implicit guarantee is also an explicit contractual commitment, though not in the form of a guarantee.

Eligibility of guarantor

16. What are the entities permitted to provide DLG?

Response: A Regulated Entity (bank or NBFC) may enter into DLG arrangements only with a Lending Service Provider (LSP) or another RE with which it has entered into an outsourcing (LSP) arrangement. Further, the LSP providing DLG must be incorporated as a company under the Companies Act, 2013.

Further, the DLG provider is also required to provide a declaration certified by its statutory auditor on the aggregate DLG amount outstanding, the number of REs and the respective number of portfolios against which DLG has been provided and past default rates on similar portfolios and such other information to satisfy the RE that it would be able to honour the DLG.

[Our comment: This requirement does not seem reasonable, given the fact that the entire guarantee commitment is either already pre-funded, or is counter-guaranteed by a bank. Hence, any further inquiry into the financials of the LSP seems meaningless, much more so for the auditor’s certificate]

Thus:

• The DLG provider must be an outsourcing service provider, and as discussed earlier, essentially a sourcing partner for the lender.
• Thus, such LSP may be either an RE itself or may be an unregulated entity, engaged by the RE as an LSP.
• The LSP must demonstrate its ability to meet the guarantee commitment with an auditor certificate.

17. Whether an individual sourcing agent can become a guarantor?

Response: Only a company incorporated under the Companies Act, 2013 can become a guarantor, as the eligibility under para 3 of the DLG Guidelines specifies that REs may enter into DLG arrangements with LSPs who must necessarily be incorporated as a company under the Companies Act, 2013.

18. Whether a co-lender may be a guarantor?

Please refer to the response to Q. 10 above.

19. Whether a non-regulated entity may be a guarantor?

Response: Yes, however, the non-regulated entity must be a LSP as defined under para 2.3 of the ‘Guidelines on Digital Lending’ dated September 02, 2022.

Cap on the extent of guarantee

20. Is there a cap on the extent of guarantee that can be provided under the guidelines?

Response:  Para 6 of the guideline, explicitly provides that the guarantee extended shall not exceed 5% of the amount of that “loan portfolio”. Accordingly, guarantee arrangements shall require to adhere to the said limit set.

It shall further be noted that any implicit support provided shall also be factored in whilst arriving at the cap on the guarantee.

21. Can a guarantee be provided upfront for an expected pool size?

Response: Credit guarantees typically operate on a pre-agreed and fixed basis, determined by the target pool size. Once this agreement is made, the pool can be ramped up over a period of time. However, the utilization of the guarantee must be proportional to, that is, not more than 5% of the loan portfolio created/originated on a specific date.

For instance, let’s consider a scenario where two parties enter into an arrangement to create a pool of Rs. 100 crores. One party agrees to provide a 5% funded guarantee to the other party. The guarantee provider may deposit the entire amount with the recipient of the guarantee upfront. However, when it comes to utilizing the guarantee, the recipient will only be able to use it proportionately based on the extent of the loans already disbursed.

Let’s consider a scenario where two parties enter into an arrangement to create a loan pool of Rs. 100 crores. One party agrees to provide a 5% funded guarantee to the other party. The guarantee provider may deposit the entire amount with the recipient of the guarantee upfront. It may be worthwhile to note that usually, it would take some time before the target size of Rs. 100 crores is achieved, however, the guarantee is placed at the very inception. Let’s say it takes 5 months to reach the target size of Rs. 100 crores, originating Rs. 20 crores each. The question that arises is will the lender be able to utilise the entire guarantee even before the target size is reached? The answer is negative, the guarantee can be invoked proportionately based on the extent of disbursement. So in the present case, after the first month’s originations, if there are any defaults in the second month, the lender will have at its disposal, guarantee worth Rs. 1 crore (5% of Rs. 20 crores) for invocation, irrespective of the fact that the guarantor has already placed Rs. 5 crores.

22. The cap would apply to the sanctioned amount of the loans or the principal outstanding?

Response: The Guidelines provide that “RE shall ensure that total amount of DLG cover on any outstanding portfolio which is specified upfront shall not exceed five per cent of the amount of that loan portfolio. In case of implicit guarantee arrangements, the DLG Provider shall not bear performance risk of more than the equivalent amount of five per cent of the underlying loan portfolio.”

The capping of 5% should be computed on the value of loans disbursed within a particular cohort (disbursed in a month, or disbursed over several months upto a certain pool size), to be utilised for defaults (as defined between the parties – may be either the EMIs or the full value of defaulted loans).

The guaranteed amount (backed by FD or bank guarantee) may remain with the beneficiary till the full discharge of the loans forming part of the cohort or loan and will continue to come down on the basis of utilisation of the said guarantee for meeting defaults. Hence, the guaranteed amount comes down in 2 ways (a) basis utilisation for meeting defaults; (b) when the POS on the guaranteed pool has dropped below the value of the unutilised guarantee.

23. Can there be implicit support in addition to the cap, discussed above?

Response: Refer our response to Q. 21.

24. Can this guarantee be replenished or reinstated?

Response: In the context of loan pools, which are typically revolving in nature with a target pool size, it is important to consider the possibility of replenishing or reinstating the guarantee. Loan pools operate by adding new loans as earlier ones are amortized, maintaining a constant pool size. However, this revolving principle does not extend to the guarantee itself.

If we were to replenish the guarantee every time it is utilized, it would result in an infinite guarantee. Therefore, even though the 5% limit on the guarantee is based on the revolving pool concept, the guarantee itself is not replenishable.

Form/Tenor of DLG

25. What forms of DLG are allowed?

Response: The form of DLG has been specified under the DLG Guidelines (para 5). The RE can accept DLG only in one or more of the following forms –

• Cash deposited with the RE;
• Fixed Deposits maintained with a Scheduled Commercial Bank with a lien marked in favour of the RE;
• Bank Guarantee in favour of the RE.

This would mean that DLG maintained in any other form would not conform to the DLG Guidelines.

26. If it is a cash deposit, is it in the nature of a security deposit?

Response: Yes, the amount may be considered as a security deposit, as the purpose of such deposit is to secure the obligations of the guarantor.

27. In what form must any implicit guarantee be maintained?

Response: An implicit guarantee would mean that it is not explicitly provided in the form of a guarantee hence, the question of maintaining it in the form of a cash deposit or fixed deposit shall not arise. The specific terms of such a guarantee shall determine the form. Further, considering the applicability of the DLG Guidelines on such implicit guarantee, the other provisions such as the capping, eligibility of guarantor, etc. shall be applicable.

28. Can it be in the form of a corporate guarantee?

Response: The framework talks about the acceptance of guarantees in only three forms, as discussed in Q. 28, and corporate guarantee is not one of the acceptable modes.

29. Does the circular specify any minimum/maximum period for which DLG shall remain in force? Please illustrate.

Response: The duration of the DLG agreement will be determined based on the longest tenor of the loans in the underlying loan portfolio. This means that the agreement will remain in force for a period not less than the longest loan tenor.

For instance, let’s consider a scenario where a pool consists of loans with varying tenures. Although the average maturity of the pool is calculated to be 36 months, there is a loan with a legal tenor of 54 months, which is the longest among all the loans. In this case, the tenor of the guarantee provided will be 54 months, even though the majority of the loans will be retired or paid off within 36 months.

This ensures that the guarantee remains effective and in place for the entire duration of the longest loan in the portfolio, providing the necessary coverage and protection until the loan is fully repaid. By aligning the guarantee tenor with the longest loan tenor, it ensures that the guarantee remains in force for the duration required to safeguard against any potential risks or defaults in the loan portfolio.

30. Can the guarantee provider earn interest on the cash deposit/ fixed deposit?

Response: The fixed deposit has to be maintained with a Scheduled Commercial Bank with a lien marked in favour of the lender. Hence, the interest on FD could either be retained by the guarantee provider or could be made a part of the guarantee and utilised by the lender. In case of a cash deposit, there is no restriction on the payment of interest and hence, the same may be mutually decided between the parties.

Rights/obligations of DLG provider

31. How can the RE compensate DLG provider for the DLG provided? Does the circular make any provision with respect to the same?

Response: The circular does not talk much about compensation for DLG, except at one place, where it has mentioned that the details of fees payable to the DLG provider, if any, should be made a part of the Board approved policy for availing DLG. Having said that, it is obvious that  if one party assumes risk and provides a guarantee, it will expect some compensation in return, which could be in the form of commission or fee.

32. Can the RE share the returns with the DLG provider?

Response: The arrangements that existed until now allowed the DLG provider to sweep the excess spread arising from the pool of loans against which the guarantee has been provided, that way, the transactions placed the DLG providers in the shoes of an equity holder, where it had the obligation to absorb the first losses, at the same time had the right to sweep the residual income.

While it might sound equitable to offer a share of or the entire residual income to the DLG provider if they are absorbing the first losses, however, it also opens up another question. If the DLG provider is compensated with the residual income alone, are they not being exposed to the risk of variability of residual income as well, and consequently, increasing the extent of risk absorption in the transaction?

Ideally, this should be considered as an implicit guarantee and the aggregate of the implicit and explicit guarantee, if any, should not exceed the cap of 5% of the outstanding loan portfolio.

32A. Can the RE share the returns with the DLG provider?

Response: The invocation of DLG could either be for the EMIs or the full value of defaulted loans – the same shall be based on the arrangement agreed with the guarantor.

Looking at the stance of the Guidelines, since the lender does not have the option to transfer the loans to the Guarantor upon invocation, EMI level would be preferred. However, in case the lender intends to invoke the entire loan with the guarantee amount and even write off the same, it can be done. 

NPA recognition and Capital treatment

33. What would be the NPA treatment in case the guarantee is invoked?

Response: Through the DLG Guidelines RBI has stated that the NPA classification would be the responsibility of the RE and would be as per the extant asset classification and provisioning norms irrespective of any DLG cover available at the portfolio level [para 7 of the DLG Guidelines]. The amount invoked by the DLG cannot be set off against the underlying individual loans and thus, asset classification and provisioning would not be affected by any DLG cover.

However, any future recovery by the RE from the loans on which the DLG cover was invoked and realised can be shared with the DLG provider in terms of their contractual arrangements.

34. Since the guarantee invoked cannot be set off against the loan, how would the guarantee amount be shown in the books of the RE?

Response: Accounting-wise, if the amount has been recovered, it is set off from the outstanding pool However, there is a departure here between accounting treatment and the NPA/capital requirements, as the RBI expects the NPA recognition to be continued in the books of the lender.

Similarly, capital requirements will also remain unaffected. However,  it will be wrong to show the amount recovered from the guarantor as a liability as it is not a liability – though there may be an understanding that any recovery from the loans will be paid back to the guarantor. It is also wrong to treat the amount received from the guarantor as income, as the payment consists of both interest and principal.

35. What would be the capital treatment for loan portfolios covered by DLG?

Response: The capital treatment as specified in the circular states: capital computation, i.e., computation of exposure and application of Credit Risk Mitigation benefits on individual loan assets in the portfolio shall continue to be governed by the extant norms.

Therefore, for the purpose of the capital treatment for the recipient of the DLG, the assets should be treated as guaranteed to the extent of the DLG, and accordingly, the capital will have to be maintained on the net amount.

Guarantee fee

36. There is absolutely no mention in the Guidelines about guarantee fee. In what all forms can be the guarantee fee be structured?

Response: There are no provisions or guidance provided for the computation or payment of the guarantee fee, except at one place, where it has mentioned that the details of fees payable to the DLG provider, if any, should be made a part of the Board approved policy for availing DLG.. Hence, in our view, the same shall be determined as per the contractual terms agreed between the parties.

Capital treatment for the guarantor

37. What is the capital treatment for the guarantor, if the guarantor is an RE covered by capital requirements?

Response: The response to this question would depend on the nature of the guarantee provided by the guarantor.

First Loss

If the guarantee is first loss in nature, then, as the principle goes, the RE will have to maintain capital on the entire pool, since, it is exposed to the all the risks associated with all loan accounts individually, subject to a ceiling on the amount of guarantee it has provided.

For instance, if the guarantor provides a 5% FLDG for a pool of loans aggregating to Rs. 100 crores, and the regulatory capital requirement of the guarantor is 15%, then the capital required to be maintained against such pool is:

Lower of

• 15% of Rs. 100 crores * 100% (Assuming 100% is the applicable risk weight of such loans)
• 5% of Rs. 100 crores

= Rs. 5 crores.

Second Loss

If the guarantee is second loss in nature, then, the losses will start piling up on the guarantor only once the first loss support is exhausted. Unlike the other case, here, the guarantor is not exposed to all the risks associated with all loan accounts individually. Therefore, the capital will have to be maintained on the amount of guarantee provided instead of the entire pool.

Using the same example, as used in the earlier case, the capital requirement for the RE will be:

Rs. 100 crores * 5% * 15% = Rs. 0.75 crores.

Compliance requirements for the RE

38. Will the borrower be aware of the guarantee extended by the LSP?

Response: Though there is a mandatory requirement of explicitly disclosing the DLG arrangement between the RE and LSP to the borrower, the LSP providing a DLG is required to publish on their website the total no. of portfolios and the respective amount of each portfolio on which DLG has been offered. This would essentially mean that all the DLG arrangements of the LSP would be publicly available.

This, however, neither means the scope of the guarantee (i.e. which all borrowers are covered) is to be publicly specified, or the borrower has to be notified of the guarantee.

39. What are the operational checks to be ensured by the lender before and after entering into the DLG arrangement?

Response:

Before the DLG Arrangement	After/During the DLG Arrangement
Put in place a Board approved Policy which shall include: Eligibility criteria for DLG provider, Nature and extent of DLG cover, Process of monitoring and reviewing the DLG arrangement,Details of the fees, if any, payable to the DLG provider.	Ensure that the total amount of DLG cover on any outstanding portfolio shall not exceed 5% of the amount of that loan portfolio.
Declaration from DLG Provider Obtain adequate information to satisfy itself that the DLG provider would be able to honour it. In this regard, a declaration should be obtained from the DLG provider, certified by its statutory auditor on: Aggregate DLG amount outstanding;No. of REs and the respective no. of portfolios against which DLG has been provided;Past default rates on similar portfolios.	In case of default, recognition of the asset as NPA and provisioning shall be as per existing norms irrespective of the DLG cover.
Enter into a legally enforceable contract with the DLG provider. The contract must contain the following details w.r.t the DLG: Extent of DLG cover;Form in which DLG cover is to be maintained with the RE;Timeline for DLG invocation;Disclosure of the total no. of portfolios and the respective amount of each portfolio on which DLG has been offered by the LSP on its website.	Invoke DLG within a maximum overdue period of 120 days
	Share the recovery, if any, from the loans on which DLG has been invoked and realised, with the DLG provider as per the terms of the contract.

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[1] Refer to our write up on the press release here – https://vinodkothari.com/2023/06/rbi-to-release-guidelines-to-permit-default-guarantees/

Our resources on Digital Lending – https://vinodkothari.com/category/financial-services/digital-lending/