Co-lending and loan sourcing: Draft Directions seek to end Discretionary Co-lending

– Team Finserv | finserv@vinodkothari.com

Introduction

RBI vide its Statement on Developmental and Regulatory Policies dated April 09, 2025, stated that in light of evolution of co-lending arrangements and lending practices, it was decided to expand the scope of co-lending and issue a generic framework for all forms of co-lending arrangements between Regulated Entities (‘RE’). Pursuant to the same, RBI has issued draft Reserve Bank of India (Co-Lending Arrangements) Directions, 2025. (‘Draft Directions’ or simply Directions).

The Draft Directions, once implemented, will override the 5th November, 2020 Guidelines (“Co-lending Guidelines”). Importantly, the discretionary co-lending or so-called CLM 2 goes away. The Draft Directions will also be a unified framework for all loan sourcing and servicing arrangements too.

This article analyses the key changes introduced and examines the impact of the same on REs.

A quick snapshot of the key changes have been illustrated below:

Scope of the draft Directions

• All Co-Lending Arrangements (“CLA”) between REs. The draft Directions are both exhaustive and exclusive: that is, any arrangement except as permitted under the Directions will be prohibited.
• In case of digital lending transactions, to the extent digital loans have a co-lending arrangement, the Directions will be applicable. Further, the Directions will also be relevant for the arrangement of RE with the LSP (as discussed below).
• The Directions do not apply to where the value of an individual loan is more than Rs 100 crores, as such large ticket loans are covered by multiple banking or consortium arrangements.
• Para 6 of the draft Directions has provision which may, at first reading, seem strange: it seems to say that even loan sourcing, without any funding or non-fund-based commitment from other REs or non-REs, shall also be governed, mutatis mutandis, by these Directions. However, note that the Directions contain provisions on loan sourcing as well. It appears that the Directions will become a regulatory instrument for loan sourcing as well. In fact, para 31 specifically applies to sourcing arrangements.

Permitted REs

• Commercial banks – It shall be noted that Small Finance Banks, local area banks and regional rural banks are excluded. This means such banks cannot be party to a co-lending arrangement
• AIFIs
• NBFCs, including HFCs

No skin-in-the-game for the originator?

The Draft Directions, unlike the Co-lending Guidelines, do not lay a minimum 20% share of the sourcing co-lender. In fact, the definition of CLA refers to an arrangement where REs  “jointly fund a loan portfolio in a pre-agreed proportion, involving revenue and risk sharing with or without sourcing and management arrangement”. What pre-agreed proportion needs to be, is not mentioned anywhere.

Whether this was the intent, or is it an omission of a skin-in-the-game rule which is globally well accepted? This is something that will become clearer only during the comments stage. A minimum skin-in-the-game of 10% is required in case of TLE transactions; given the larger leap of faith (non discretionary nature of the arrangement) of the funding co-lender on the originating co-lender, we are still of the view that a 20% minimum risk taken by the originator should be prescribed.

Bye Bye CLM2?

We have consistently opined earlier that the so-called CLM 2, or discretionary co-lending, under Co-lending Guidelines, was an exception in case of PSL loans. Discretionary co-lending is like cherry picking, and the same is akin to transfer of loan exposures.

It seems that the draft Directions have allayed all earlier misnotions about this.

Para 20 says: “Each single loan under the arrangement shall be shared among the funding REs right from the time of first disbursement. This shall be done on the basis of a non-discretionary ex ante Inter Creditor Agreement with joint nature of rights.”

This seems to say 2 things: first, that co-lending is non-discretionary, and second, that the loan is co-funded from the very inception. It is also clear that the Co-lending Guidelines is intended to be repealed – which means the discretionary co-lending window is to be shut for all time to come.

Unrealised profits under CLA:

Para 14 of the draft Directions talks about NBFCs following applicable accounting standards for booking of profit upfront for CLAs. This seems misplaced. Co-lending is not a case of transfer of loans: CLA is an ex-ante arrangement, and therefore, from the day the loans are originated, they are put on the books of the respective parties. The question of transfer of a loan, and therefore, booking of any gain or loss on sale, does not arise as there is no sale at all.

Service fees not to serve as credit enhancement

Para 16 says that arrangement of any servicing fees or other changes by one co-lender to the other shall not involve, directly or indirectly, any credit enhancement. Credit enhancement, however, is permitted in the form of default loss guarantee (see discussion below).

Prima facie, the co-lenders are partners in business and it is not proper to envisage one of them providing services to the other. The differential sharing of interest rates between the two provides compensation for the differential share in services. A CLA is a sort of a partnership; where one partner assumes certain roles and responsibilities in a partnership, it is not possible to contend that the partner is providing services to the other partner. The mutual allocation of services is the very essence of a partnership; the same applies in case of co-lending.

Default loss guarantees

The Draft Directions extend the concept of default loss guarantee (‘DLG’) to CLAs too. The Directions permit DLG upto 5% of the pool of loans, in accordance with the 8th June 2023 circular. Note that the 8th June 2023 circular was relevant only in case of digital loans. Does that mean that DLG in case of CLA is possible only in case of digital loans? We do not think so. The Directions clearly say that a sourcing or funding party under a CLA shall be permitted to provide upto 5% guarantee. The 8th June 2023 circular is to be applied on mutatis mutandis basis – that is, to the extent appropriate. Hence, DLG may be provided for every CLA.

As there is an explicit provision for DLG, all previous views about subordination or other inherent forms of credit support get ruled out. Para 27 also clearly provides that DLG in any other form will not be permitted.

Bureau reporting

Para 25 provides about the reporting to CICs, Each RE shall be required to report their share of the loan in accordance with the provisions as per the CICRA Act, 2005 and the RBI Credit Reporting Directions, 2025.

What happens to existing arrangements?

A troubling question will be: what about the existing arrangements? Many of the existing arrangements will be conflicting with the proposals in the draft Directions. Will they be allowed to run down? It seems logical to assume that existing arrangements may be continued to run down, but any fresh disbursements under those arrangements should stop, and new arrangements will all have to be in compliance with the new Directions.

Further, it has been clarified that the outstanding loans in terms of the circular ibid would continue to be classified under priority sector till their repayment or maturity, whichever is earlier.

Asset classification

Provisions of Para 28 may surely require a review. It says if any of the co-lenders classifies a borrower as bad, the other co-lender also will have to follow the same. This is both counter intuitive and lacks purpose and rationale.

A borrower may become non-performing with one of the lenders either because of another facility, or because of guarantee to other exposures, or because of different NPA norms followed by the particular lender (some of the NBFCs are yet to transition to 90 DPD norm). The question of binding the other co-lenders may such treatment should not arise.

Sourcing and servicing arrangements:

Benign-looking provisions of para 31, dealing with loan sourcing and servicing arrangements, may actually require rejigging of existing practices, particularly in case of securitisation and TLE transactions.

Para 31.2 provides that loan sourcing/servicing arrangements may be with an RE or non RE, but it has to be on an arm’s length basis. In securitisation transactions, the originator acts as a servicer. In case of TLE transactions too, the erstwhile seller continues to act as servicer. However, in most transactions, servicing is carried with nominal fees. The regulation now necessitates an arm’s length servicing arrangement. It further says that the payment of the servicing fees should not be capable of deferral etc – this is also usually done so as to act as a performance support.

Disclosure Requirements:

The Co-lending guidelines presently required the RE to publish their co-lending policy on the website. Additionally, the Draft Directions introduce certain additional disclosure requirements on the website and the financial statements as follows:

• On the website (Refer para 32)
  • List of Co-lending  partners for various arrangements
  • Indicative range of blended interest rates and fees/charges charged to the borrowers under different CLAs
• Disclosures in financial Statements under Notes to Accounts – Quarterly basis(Refer para 33)
  • Quantum of CLAs
  • Weighted average rate of interest
  • Fees charged/paid
  • broad sectors in which co-lending was undertaken
  • performance of loans under CLA
  • details related to default loss guarantee

Escrow arrangements:

• The Co-lending Guidelines provide that the transactions shall be routed through an escrow account, now Para 19 of the draft directions clarifies that all transactions, including disbursements and repayments, must be routed through an escrow account maintained with a bank. This escrow account may be held with the bank participating in the CLA.
• Additionally, with respect to the outsourcing of lending services—such as loan servicing and repayment collections—it is provided that any amount collected from the borrower must be directly credited to the permitted entities’ bank account. Under no circumstances should such collections be routed through a third-party account.

Policy and Documentation Requisites for co-lending

• The Draft Directions mention that such co-lending arrangement shall be formalised by an ex ante legal agreement, accordingly, a co-lending agreement needs to be in place (similar to erstwhile requirement).
  • Detailed terms and conditions
  • Criteria for selection of borrowers;
  • Specific product lines and areas of operation;
  • Fees payable for lending services, if any; (lending service shall mean activities related to lending such as customer acquisition, underwriting, pricing, servicing, monitoring, and recovery  etc. performed by permitted REs or the agents on behalf of the permitted REs, subject to adherence of outsourcing guidelines]
  • Provisions related to segregation of responsibilities; customer interface and customer protection issues.
• Credit policies should make suitable provisions for CLAs (similar to erstwhile requirement).
  • Internal limit w.r.t. proportion of their lending portfolio
  • Target borrower segments
  • Due diligence of partner entity
  • Customer service
  • Grievance redressal mechanism
• Loan agreement with the funding RE to make an upfront disclosure w.r.t. segregation of roles and responsibilities of co-lending partners:
  • Entity having customer interface to be specified, subsequent change in customer interface to only be done after taking explicit customer consent
  • Customer protection and grievance redress mechanism
• Requisite details to be made part of KFS:
  • Format as prescribed under the KFS Directions – Annex A
  • APR should also include any fee/charges payable to the sourcing or servicing entity

Conclusion

The Draft Directions provide a unified framework for both co-lending and loan sourcing and servicing. The fact that there was no framework for co-lending earlier has been the breeding ground for a lot of aberrations. Having a well-defined framework provides a safe harbour as well as certainty to behaviour.

However, CLM 2 was the one that was the source of popularity for co-lending arrangements, virtually providing relief from the discipline of TLE Directions while at the same time, giving banks the ability to cherry pick loans. A lot of stakeholders may not like what the Directions propose, but in our view, this is how it should have been.

---

Our Resource Centre on Co-lending:

Our Resources on Co-lending