Ramifications of RBI’s guidelines on FLDG transactions between Fintech Companies and Regulated Entities

Ramifications of RBI’s guidelines on FLDG transactions between Fintech Companies and Regulated Entities

Introduction

Securitisation

According to RBI “securitisation involves transactions where credit risk in assets are redistributed by repackaging them into tradable securities with different risk profiles which may give investors of various classes access to exposures which they otherwise might be unable to access directly.”^[1] Securitisation refers to the process of transforming illiquid assets into marketable securities. It involves pooling and repackaging loans or other financial assets into securities that can be sold to investors. Securitisation can provide liquidity, risk diversification and lower funding costs for the originators of the assets. The securitization market first emerged in the US in the 1970s^[2], Lewis Ranieri popularized the concept of securitization in the financial world. Ranieri was a pioneer in securitization, a process of creating new financial products by pooling and repackaging cash flows and debt obligations.^[3] He helped to develop collateralized mortgage obligations (CMOs), which are complex securities backed by mortgages and sold to investors.

FLDG

FLDG stands for first loss default guarantee, which is a type of credit enhancement that protects lenders from losses in case of borrower default. It is a mechanism whereby a third party compensates lenders if the borrower defaults. As the third party pays for the losses, it gives lenders confidence to give out loans. It is an insurance against a loss.^[4] FLDG is typically used for securitization transactions, where a pool of loans or other assets are sold to investors as securities. This type of transaction ensures that the investors receive timely payments of principal and interest, even if some of the underlying borrowers fail to repay their loans. It can reduce the cost of borrowing for the originator and increase the attractiveness of the securities for the investors. FLDG can be provided by a third-party guarantor, such as an insurance company or a government agency, or by the originator of the loans, who retains a portion of the risk.

Utilities and risks attached to FLDG transactions

Regulated Entities can lend to customers who may not have a good credit history or collateral, while the fintech company can leverage its data analytics and underwriting capabilities to assess the creditworthiness of the borrowers. FLDG transactions have some benefits for both the RE and the fintech companies, as well as for the borrowers and the economy. By offering partial assurance on the repayment of the loan, these schemes enable lenders to relax their underwriting standards and accept more risk. This way, borrowers who would otherwise face difficulties in accessing funds can receive the money they need.

FLDG transactions need to be regulated and monitored carefully by both the RE and the fintech company, as well as by an independent nodal agency or a self-regulatory organisation, as suggested by an RBI-constituted working group on digital lending.^[5] FLDG transactions also need to be communicated clearly and transparently to customers, who should be educated about their rights and responsibilities as borrowers. FLDG transactions have the potential to transform digital lending in India, but they also require responsible lending and borrowing practices from all stakeholders involved.

However, FLDG transactions also have some challenges and risks that need to be addressed by regulators, lenders, and borrowers. FLDG transactions may expose the RE to higher credit risk if the fintech company fails to honour its guarantee or if there is a systemic default by borrowers due to external factors. It may create regulatory arbitrage and compliance issues^[6] if the fintech company is not regulated or supervised by the same authority as the RE or if there are gaps in the legal framework governing digital lending. FLDG transactions may raise consumer protection and data privacy concerns if the fintech company does not disclose the terms and conditions of the loan or if it misuses or leaks the personal and financial data of the borrowers. It may also lead to over-indebtedness and irresponsible borrowing behaviour if the customers are not aware of their repayment obligations or if they take multiple loans from different lenders without proper assessment of their repayment capacity.

Regulations of FLDG transactions

RBI released Guidelines on Digital Lending on September 02, 2022. The guidelines made it clear that underwriting is the sole responsibility of the regulated entity. Para 15. Loss sharing arrangement in case of default states:

“As regards the industry practice of offering financial products involving contractual agreements such as First Loss Default Guarantee (FLDG) in which a third party guarantees to compensate up to a certain percentage of default in a loan portfolio of the RE, it is advised that REs shall adhere to the provisions of the Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 dated September 24, 2021, especially, synthetic securitization contained in Para (6)(c).”

As mentioned in the Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021, it is only applicable to the following entities:

1. Scheduled Commercial Banks (excluding Regional Rural Banks);

2. All India Term Financial Institutions (NABARD, NHB, EXIM Bank, and SIDBI);

3. Small Finance Banks (as permitted under Operating Guidelines for Small Finance Banks dated October 6, 2016 and as amended from time to time); and,

4. All Non-Banking Financial Companies (NBFCs) including Housing Finance Companies (HFCs).

Para 6 of the Master Directions provides a list of assets that cannot be securitized:

1. Re-securitisation exposures;

2. Structures in which short term instruments such as commercial paper, which are periodically rolled over, are issued against long term assets held by a SPE (special purpose entity);

3. Synthetic securitisation; and

4. Securitisation with the following assets as underlying:

5. revolving credit facilities as underlying – These involve underlying exposures where the borrower is permitted to vary the drawn amount and repayments within an agreed limit under a line of credit (e.g., credit card receivables and cash credit facilities);

6. Restructured loans and advances which are in the specified period;

• Exposures to other lending institutions;

1. Refinance exposures of AIFIs;

2. Loans with bullet payments of both principal and interest as underlying; and

3. Loans with residual maturity of less than 365 days;

Securitisation transactions are allowed for any loans and advances-related exposures of lenders that are on their own balance sheet, except for the ones specified in the list above. Apart from the risks mentioned above the main concern of RBI with the FLDG transactions done by the unregulated fintech companies is if there is no regulation on the fintech companies to underwrite the loans, this might incentive the fintech companies to issue risker loans and securitize the same, without providing the material guarantee.

Securitization of loans by Fintech Companies: synthetic securitisation

According to RBI “synthetic securitisation” means a structure where the credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of credit derivatives or credit guarantees that serve to hedge the credit risk of the portfolio which remains on the balance sheet of the lender”^[7]. An FLDG loan is a type of synthetic securitisation product^[8]. The fintech companies act as loan originators and share the credit risk with a regulated entity (RE), such as a bank or a non-banking finance company (NBFC) by agreeing to cover a certain percentage of the losses if the customers default. The bank/NBFC partners provide the funding for the loans from their own balance sheets but rely on the fintech firms for their technology and underwriting capabilities. This way, traditional lenders can expand their customer base and access new market segments, while the fintech firms can leverage their digital solutions and data analytics. FLDG is a tool to bridge the credit gap and has also been employed by the government in the form of credit guarantee schemes to incentivise RE-lenders for extending collateral-free credit flow to small businesses.^[9]

FLDG transactions by fintech companies before and after the September guidelines

Before the introduction of the new guidelines the fintech companies didn’t have a licence to underwrite loans, therefore they used to collaborate with the regulated entities i.e., banks and NBFCs to facilitate the loan by relying on FLDG arrangement, wherein in the fintech company will compensate the regulated entity in case the borrower defaulted. This model, in turn, gave confidence to banks and NBFCs to work with new-age fintech companies.^[10] In this type of arrangement, the fintech companies used to underwrite the loan and not the RE but with the introduction of the September guidelines, RBI made it clear that underwriting can only be done by the regulated entities and imposed restrictions on existing loan disbursement and repayment fund-flows, prohibiting the grant of credit on e-wallets, regulating the collection of fees by lending apps, mandating compulsory reporting of all digital loans to the credit bureaus, regulating collection and usage of customer data by fintech companies, and curbing FLDG arrangements.^[11]

Alternatives adopted by the Fintech Companies after the September guidelines

The FLDG arrangements between fintech companies and regulated entities still exist but in subtler ways. One-way fintech companies are still active is through the loan agent or referral arrangement^[12] in this model, NBFC underwrites the loan and the fintech companies act as an agent by acquiring customers and referring them to the NBFC, and charges commission when the loan gets approved. A fintech company can apply to RBI for an NBFC licence but it can take time, instead of applying for a license well-capitalised fintech company can acquire an NBFC and access its license.^[13]  This is one grey area where FLDG is still active between a Fintech company with an NBFC license and an NBFC, both being regulated entities.

Conclusion

The RBI’s guidelines for digital lending in India have disrupted the fintech industry and its partnership with regulated entities. The guidelines aim to protect customers and prevent systemic risks by banning the FLDG model, which allowed fintech companies to provide default guarantees to lenders. The guidelines also mandate that lenders are responsible for underwriting, fee collection, credit reporting, and data usage. As a result, many fintech companies have seen their business decline, and have sought alternative models or acquisitions to survive.

[1] Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021

[2] Sean Ross, “How Debt Securitization Got Started”, available at https://www.investopedia.com/ask/answers/052015/what-are-some-historical-examples-debt-securitization.asp.

[3] Julia Kagan, “Who is Lewis Ranieri”, available at https://www.investopedia.com/terms/l/lewis_ranieri.asp#:~:text=Ranieri%20helped%20to%20create%20collateralized,can%20be%20sold%20to%20investors. (last accessed on 30th April 2023)

[4] Tinesh Bhasin, “First loss guarantee system helps borrowers indirectly”, available at https://www.livemint.com/money/personal-finance/first-loss-guarantee-system-helps-borrowers-indirectly-11597940697579.html. (last accessed on 30th April 2023)

[5] —, “Recommendations of the Working group on Digital Lending – Implementation”, available at https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=54187. (last accessed on 30th April 2023

[6] Greg Buchak &Gregor Matvos &Tomasz Piskorski & Amit Seru, “Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks”, Journal of Financial Economics,  available at https://www.fdic.gov/analysis/cfr/bank-research-conference/annual-17th/papers/15-piskorski.pdf.

[7] Supra 1

[8] Vishwanath Nair,  “RBI’s Digital Lending Guidelines Could Slow Down India’s Fintech Express”, available at https://www.bqprime.com/economy-finance/rbis-digital-lending-guidelines-could-slow-down-the-fintech-express.

[9] Aryan Babele, “FLDG Conundrum: Interplay between Digital Lending Guidelines and Securitisation Directions”, Indian Journal of Law and Technology, available at https://www.ijlt.in/post/fldg-conundrum-interplay-between-digital-lending-guidelines-and-securitisation-directions.

[10] Arti Singh, “Fintech haggle for licence to survive” available at https://livemint.com/news/india/fintechs-in-india-turn-to-buying-nbfcs-to-survive-post-rbi-regulations-11682446941373.html.

[11] Prashanth Ramdas and Pritish Mishra, “ Impact of digital lending rules on borrowing”, available at https://www.livemint.com/money/personal-finance/impact-of-digital-lending-rules-on-borrowing-11672850425731.html.

[12] Ibid

[13] —, “BharatPe acquires 51% in NBFC Trillion Loans to bolster lending play”, available at https://m.economictimes.com/tech/startups/bharatpe-acquires-51-in-nbfc-trillion-loans-to-bolster-lending-play/amp_articleshow/99935144.cms.