RBI to release guidelines to permit default guarantees

The evolution of a concept, from its inception to being prohibited, and ultimately establishing a regulatory framework to allow its practice

– Anita Baid (finserv@vinodkothari.com)

The concept of First Loss Default Guarantees (FLDGs) in the financial industry has experienced a remarkable journey, marked by its inception, subsequent prohibition, and eventually being on the verge of a resurgence with the introduction of a regulatory framework. It had gained significant attention in the realm of fintech industry, whose remarkable expansion in India is largely responsible for propelling FLDGs. Nevertheless, it is essential to note that guarantees are not a novel concept; they have been widely employed in the financial sector for a considerable period of time. (Our article on ‘Lending without risk and risk without lending’ can be read here)

In its Statement on Developmental and Regulatory Policies dated June 8, 2023, the RBI has announced its intention to issue a regulatory framework for permitting Default Loss Guarantee arrangements in Digital Lending. This article delves into the intriguing evolution of Structured Default Guarantees, examining their rise, fall, and subsequent rebirth, shedding light on the regulatory landscape that has shaped their existence.

Rise and Fall of Default Loss Guarantee Arrangements

Structured default guarantees were born out of the need to mitigate credit risk in lending practices. Lenders sought a mechanism to protect themselves from the financial consequences of borrower defaults, prompting the emergence of guarantee arrangements. The FLDG structure, by transferring the risk of default to a guarantee provider, usually sourcing agents, provided lenders with an added layer of security. (Read more on the concept of Structured Default Guarantees here)

These guarantee arrangements have been praised by the financial sector for their ability to enhance financial stability and foster innovation in lending. By offering a safety net against borrower defaults, FLDGs have encouraged traditional lenders to venture into new lending markets, including digital lending.

However, the risk of having unregulated guarantee providers have been identified as a significant concern in the implementation of FLDGs. The rise of such guarantee arrangements eventually met with their regulatory prohibition. Regulators and policymakers became increasingly wary of the potential risks associated with FLDGs, prompting them to impose a complete bar on the same. On August 10, 2022, a Press Release was issued by the RBI on the implementation of the recommendations of the Working group on Digital Lending followed by the Guidelines on Digital Lending on September 2, 2022. The said notifications were a major setback for the existing business model of several fintech entities and digital lenders, specifically due to the non-permissibility of structured guarantees (Our write up and FAQs on the DL Guidelines can be read here and here). The prohibition sought to safeguard the integrity of the financial system and also protect consumers from undue risks. The regulator had compared structured guarantees to synthetic securitisation. Strangely, the synthetic securitisation bar has been extended in the case of digitally originated loans. There is no reason why the same restriction should not be applied to any loans, be it digital or physical.

The introduction of FLDG arrangements inadvertently was encouraging regulatory arbitrage since lenders could leverage the guarantees to circumvent existing regulations, thereby increasing systemic risks. Further, the financial soundness and reliability of the guarantee provider are paramount for the effectiveness of any guarantee arrangement. Given that the guarantee provider were usually unregulated entities, they did not possess the necessary expertise and financial capacity to absorb potential losses. Inadequate due diligence or weak governance of guarantee providers had lead to systemic risks as well.

The resurrection of default guarantees is on the cards?

Notwithstanding the prohibition last year, the financial landscape has continued to evolve, and the demand for guarantee arrangements still persists. Recognizing the need to strike a balance between risk mitigation and innovation, the financial sector regulator has embarked on a path toward creating a robust regulatory framework for DLGs.

Acknowledging the importance of maintaining a balance between innovation and prudent risk management, the RBI has after extensive consultations with stakeholders, decided to lay down a regulatory framework for DLGs in digital lending.

The establishment of a regulatory framework for DLGs signifies a significant milestone. It offers an opportunity to learn from past experiences and address the concerns raised by critics. The regulatory framework must strike the delicate balance between fostering innovation and managing potential risks associated with DLGs. Robust oversight, stringent due diligence, and comprehensive governance mechanisms are essential to ensuring the integrity and effectiveness of DLGs. Further, the regulatory provisions should not just be restricted to digital lending transactions but should cover all types of lending transactions.

Moving forward, regulators must closely monitor the implementation of DLGs, track their impact on lending practices and financial stability, and make necessary adjustments to the regulatory framework as needed. A proactive approach to regulation, continuous evaluation, and periodic reviews are critical to adapt to emerging challenges and ensure the long-term viability of DLGs in the evolving financial landscape.

Conclusion

The journey of Default Loss Guarantees, from birth to prohibition and a potential resurrection, encapsulates the dynamic nature of the financial industry. The regulatory landscape has evolved in response to the potential benefits and challenges associated with DLGs. The emergence of a regulatory framework for DLGs in digital lending signifies a balanced approach that seeks to encourage innovation while safeguarding the stability of the financial system.

As DLGs enter a new phase, it is crucial to recognize the importance of effective regulation and supervision. By addressing concerns raised by critics and embracing the lessons learned from past experiences, regulators can foster a sustainable environment for DLGs to thrive, contributing to the growth and resilience of the lending ecosystem.

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