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First Loss Default Guarantee for Fintechs

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June 17, 2023

Why in news?

The Reserve Bank of India (RBI) has allowed First Loss Default Guarantee (FLDG) for fintech Lending Service Providers (LSP).

What is an FLDG arrangement?

  • Default loss guarantee (DLG) is also known as First Loss Default Guarantee (FLDG).
  • First loss default guarantee (FLDG) is a lending model between banks or non-banking finance companies (Regulated Entities) and lending service providers (fintech firms).
  • In FLDG arrangement, the initial hit on a default is taken by a third party such as fintech firm that originated the loan.
  • The fintech player (LSP) compensates lenders if the borrower defaults up to a certain threshold of the loan portfolio.

How do FLDG work?

  • The LSP provides first loss guarantee up to a pre-decided percentage of loans generated by it.
  • The loan portfolio backed by FLDG is similar to the off-balance sheet portfolio of the LSP.
  • The lender do not partake in any lending process but the nominal loans sit in the balance sheet of the lender.
  • But the credit risk is borne by the LSP without having to maintain any regulatory capital.

From the perspective of the fintechs, offering FLDG acts as a demonstration of its underwriting skills.

Why do we need FDLG?

  • To avoid ‘synthetic securitisation’ as it is prohibited by the RBI.
  • REs were hesitant to lend through fintechs without commitment towards loan loss.
  • Fintech industry’s business is affected by RE’s hesitancy.

From the perspective of the lender, FLDG ensures the platform’s skin in the business.

What did the RBI say on FDLG?

  • The RBI has released a circular clearly specifying details on scope, eligibility, structure, form, cap, disclosure requirements, and exceptions.
  • Conditions - A Regulated Entity (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 total amount of DLG cover on any outstanding portfolio does not exceed 5% of the amount of that loan portfolio.
  • The guarantee is accepted by the bank only in the form of a cash deposit, or fixed deposits in a bank.

What are the benefits of FDLG?

  • Facilitates orderly development of the digital lending ecosystem and boosts fintech activity in the financial sector.
  • Enhances credit penetration through digital space.
  • Facilitate entry of small and medium fintechs into the digital lending space in partnerships with banks or NBFCs.
  • The guidelines facilitates all players to participate in an effective and transparent manner.

Quick Facts

  • Regulated Entity (RE) - All Commercial Banks (including Small Finance Banks), Co-operative Banks and Non-Banking Financial Companies (NBFC) as per RBI.
  • Lending Service Providers (LSP) - Fintech 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.
  • The functions include customer acquisition, underwriting support, pricing support, disbursement, monitoring and recovery of specific loan on behalf of REs.
  • Underwriting - It is the process through which an individual or institution takes on financial risk for a fee.
  • Synthetic Securitisation - A structure where credit risk of an underlying pool of exposures is transferred (in whole or in part) through the use of credit derivatives or credit guarantees.
  • In this, the credit risk of the portfolio remains on the balance sheet of the lender.

References

  1. IE - RBI permits loan default guarantee in digital lending
  2. Business Line - First Loss Default Guarantee for fintech lenders
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