5 min readNew DelhiJun 9, 2023 04:27 PM IST
First published on: Jun 9, 2023 at 04:27 PM IST
The Reserve Bank of India (RBI) has allowed default loss guarantee (DLG), a safety-net arrangement among banks, non-banking finance companies, and lending service providers (LSPs, popularly known as fintech players) in the digital lending space.
DLG is also known as First Loss Default Guarantee (FLDG). The RBI nod for compensating banks in case of default is expected to boost fintech activity in the financial sector.
What is an FLDG arrangement?
FLDG is an arrangement whereby a third party such as a financial technology (fintech) player (LSP) compensates lenders if the borrower defaults. The LSP provides certain credit enhancement features such as first loss guarantee up to a pre-decided percentage of loans generated by it.
From the perspective of the fintechs, offering FLDG acts as a demonstration of its underwriting skills. From the perspective of the lender, it ensures the platform’s skin in the business.
For all practical purposes, credit risk is borne by the LSP without having to maintain any regulatory capital. The loan portfolio backed by FLDG is akin to the off-balance sheet portfolio of the LSP wherein the nominal loans sit in the books of the lender without having to partake in any lending process.
What reservations did RBI have initially?
RBI had expressed reservations on the FLDG arrangement because it felt that the model could pose a systemic risk.
A working group committee of the bank in its report released in 2021 observed that in some cases, fintechs were undertaking balance-sheet lending in partnership with a bank/ NBFC or on a standalone basis, while not satisfying the principal business criteria to remain outside regulation.
This was happening outside the RBI regulations. There were higher operational risks arising due to the increasing reliance of lenders on third-party service providers, it had said.
The RBI issued guidelines on digital lending in September 2022, but it did not provide clarity on the FLDG structure. In the absence of clear directions, regulated entities like banks had stopped entering into such arrangements with fintech players, posing a threat to their business. The fintech industry was demanding that the RBI should allow FLDG arrangements.
What does an LSP do?
Lending service providers are new-age players who use technology platforms in the lending space. They are agents of a bank or NBFC who carry out one or more of a lender’s functions (in part or full) in customer acquisition, underwriting support, pricing support, disbursement, servicing, monitoring, recovery of specific loan or loan portfolio on behalf of REs as per the outsourcing guidelines of the RBI.
What has the RBI said on FDLG?
The RBI, after examining FLDG, permitted the arrangements between banks and fintechs or between two regulated entities (REs). The central bank said an RE can enter into DLG arrangements only with an LSP or other REs with which it has entered into an outsourcing (LSP) arrangement.
The LSP-providing DLG must be incorporated as a company under the Companies Act, 2013.
The RBI has allowed banks to accept DLG in digital lending only if the guarantee is in the form of a cash deposit, or fixed deposits in a bank with a lien in favour of the RE, or a bank guarantee in favour of the RE. Banks and NBFCs should ensure that the total amount of DLG cover on any outstanding portfolio does not exceed 5% of the amount of that loan portfolio.
How has the fintech industry reacted?
The industry has welcomed the RBI move to permit FLDG arrangements. They said the new circular clearly specifies details on scope, eligibility, structure, form, cap, disclosure requirements, and exceptions, which leaves limited room for ambiguity.
“We consider this as a step forward for the digital lending industry. A well-defined structure will facilitate all players to participate in an effective and transparent manner and make the best use of the DLG facility,” said Jatinder Handoo, CEO of the Digital Lenders Association of India (DLAI).
This will facilitate entry of small and medium fintechs into the digital lending space in partnerships with banks or NBFCs, he said.
The RBI, after examining FLDG, permitted the arrangements between banks and fintechs or between two regulated entities (REs). The central bank said an RE can enter into DLG arrangements only with an LSP or other REs with which it has entered into an outsourcing (LSP) arrangement. (File) 
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