Guidelines for default loss guarantee in digital lending

The Reserve Bank of India (‘RBI’) has recently issued a circular on the Arrangements between Regulated Entities (‘REs’) and Lending Service Providers (‘LSPs’) or between two REs involving first default loss guarantee (‘DLG’).

History till date:

The RBI had constituted a Working Group on ‘digital lending including lending through online platforms and mobile apps’ (WGDL) on January 13, 2021. After taking into consideration the recommendations of the WGDL as well as public comments on the same, the RBI had notified a regulatory framework for digital lending on August 10, 2022. There were certain recommendations made by the WGDL in relation to DLG. However, the same was not adopted upfront but was adopted in principle requiring further examination. Until then it was advised that REs shall ensure the DLG arrangements / contracts shall adhere to the extant guidelines laid down in Master Direction for Securitisation of Standard Assets. Boards of REs shall ensure that the extant regulatory instructions are complied with in both letter and spirit. Further, the follow-on directions issued by RBI on September 2, 2022, the RBI advised that, for DLG, REs shall adhere to the provisions of the Master Direction for Securitisation of Standard Assets, especially, synthetic securitisation. The DLG structures are financial products generally based on contractual arrangements between the REs and the third party LSPs, wherein the latter guarantees to compensate up to a certain percentage of default in a loan portfolio of the REs. Thus, in such as risk of the default i.e., the credit risks get passed on to the LSPs. LSPs are not regulated by the RBI and therefore, are not subjected to any prudential and governance requirements applicable to REs under law such as maintaining net owned fund, debt equity ratio, etc. The arrangements for DLG are either a bilateral contract between the REs and LSPs or a tripartite agreement with the borrowers.

New guidelines for DLG:

The RBI has now notified the guidelines for DLG to be followed by REs. This alert provides a brief snapshot of the guidelines for DLG notified by the RBI:

Eligibility of the DLG providera. RE may enter into DLG arrangements only with a LSP / other RE with which it has entered into an outsourcing arrangement.
b. The LSP providing DLG must be incorporated as a company under the Companies Act, 2013.
Structure of the DLG arrangementDLG arrangement must be backed by an explicit legally enforceable arrangement between the RE and the DLG provider. Such contract must, among other things, provide for the following:
a. Extent of DLG cover;
b. Form in which DLG cover is to be maintained with the RE;
c. Timeline for DLG invocation; and
d. Disclosure requirements as prescribed
Forms of DLG coverThe DLG arrangement can be entered into by the RE with a LSP in one or more of the following
a. Cash deposited with RE;
b. Fixed deposits maintained with scheduled commercial bank with a lien marked in favour of the RE; and
c. Bank guarantee in favour of RE.
Cap on DLGa. RE shall ensure that total amount of DLG cover on any outstanding portfolio which is specified upfront shall not exceed five (5) per cent of the amount of that loan portfolio.
b. 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.
Recognition of the non-performing assetsa. Recognition of individual loan assets in the portfolio as NPA and consequent provisioning shall be the responsibility of the RE as per the extant asset classification and provisioning norms irrespective of any DLG cover available at the portfolio level.
b. The amount of DLG invoked shall not be set off against the underlying individual loans.
c. Recovery by the RE, if any, from the loans on which DLG has been invoked and realised, can be shared with the DLG provider in terms of the contractual arrangement.
Treatment of DLG for regulatory capitala. 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.
Invocation of DLGa. The RE shall invoke DLG within a maximum overdue period of 120 days, unless made good by the borrower before that.
Tenor of the DLGa. The period for which the DLG agreement will remain in force shall not be less than the longest tenor of the loan in the underlying loan portfolio.
Disclosure requirementsa. The RE shall put in place a mechanism to ensure that LSPs with whom they have a DLG arrangement shall publish on their website the total number of portfolios and the respective amount of each portfolio on which DLG has been offered.
Due diligence and other requirementsa. REs shall put in place a Board approved policy before entering into any DLG arrangement. Such policy shall include, at the minimum, the eligibility criteria for DLG provider, nature and extent of DLG cover, process of monitoring and reviewing the DLG arrangement, and the details of the fees, if any, payable to the DLG provider.
b. It is reiterated that any DLG arrangement shall not act as a substitute for credit appraisal requirements and robust credit underwriting standards need to be put in place irrespective of DLG cover.
c. Every time an RE enters into or renews a DLG arrangement, it shall obtain adequate information to satisfy itself that the entity extending DLG would be able to honour it. Such information shall, at a minimum, include a declaration from the DLG provider, certified by the statutory auditor, on the aggregate DLG amount outstanding, the number of REs and the respective number of portfolios against which DLG has been provided. The declaration shall also contain past default rates on similar portfolios.

Our comments: The above brings in much needed clarity on the DLG agreements by REs and provides standardisation to the industry in relation to these contracts. As per the earlier advisory, such contracts fell within the ambit of synthetic securitization of standard assets or loan participation. However, going forward any contracts confirming the above norms shall not be required to follow these guidelines. The existing contracts continued to be governed by the securitization contracts. Upto the issue of these guidelines, there was much flexibility in entering into DLG contracts. However, such contracts would have to comply with the new guidelines in terms of the cap of 5% – which surely, appears to be lower that the expectations of the industry, the requirement of cash collateralisation and eligibility criteria for the DLG contract – which can have the impact of restricting or constraining DLG contracts in the industry.

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