Introduction
The digital lending landscape is bifurcated into two types of loan providers. On one hand, there are the Regulated Entities (REs), which are regulated by the Banking Regulation Act 1949 and have the authority to lend money under Section 5(b) of the Act. On the other hand, there are the Lending Service Providers (LSPs), who operate outside the traditional regulatory framework and partner with the REs to acquire customers through their digital platforms.
Ever wonder, when a borrower fails to repay a loan, who bears the loss? One might think that the LSPs (fintech platforms) that issue the loans are the ones who suffer the loss, but that is not always the case. Many times, the LSPs transfer the credit risk of the loan to REs, who are regulated entities such as banks or NBFCs. This means that the REs are the ones who bear the loss if the borrower fails to repay. The LSPs use an instrument to transfer the credit risk to the REs whereby default on loans extended by REs to borrowers originated through the LSP are guaranteed by the LSP. This kind of transaction is called a default loss guarantee (DLG), a mechanism that enhances the credit quality of the lender by shifting the credit risk to the guarantor. The guarantor may have better insights into the borrower’s profile and creditworthiness, while the lender may offer more attractive terms to the borrower, such as lower interest rates or higher loan amounts. This way, DLG expands the credit market and financial inclusion. The growth of the fintech sector made the instrument a very commonly used device for new players (like fintech companies) to take exposures on loan transactions by using low-cost funding from established players, such as large NBFCs and Banks.[1]
As per the guideline released by RBI on the 8th of June, 2023, Default Loss Guarantee (DLG) is defined as:
“a contractual arrangement, called by whatever name, between the Regulated Entity (RE) and an entity meeting the criteria laid down at para 3 of these guidelines, under which the latter guarantees to compensate the RE, loss due to default up to a certain percentage of the loan portfolio of the RE, specified upfront. Any other implicit guarantee of a similar nature linked to the performance of the loan portfolio of the RE and specified upfront shall also be covered under the definition of DLG.” [2]
Reserve Bank’s previous stance regarding FLDG transactions
The RBI issued Guidelines on digital lending on September 2, 2022, based on the recommendation of the Working Group on Digital Lending which seemed to ban any third-party involvement in risk sharing by an RE in lending operations.
How did the guidelines affect the business model of fintech entities and digital lenders, especially when they were not allowed to use structured guarantees? Guidelines were a major setback for the existing business model of several fintech entities and digital lenders, which heavily relied on the permissibility of structured guarantees.
Para 15 of Guidelines read as follows: “15. Loss sharing arrangement in case of default: 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 securitisation contained in Para (6)(c).”[3] Footnote 8 of the guidelines stated that “synthetic securitisation” means 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 that serve to hedge the credit risk of the portfolio which remains on the balance sheet of the lender.[4]
The guidelines prohibited the FLDG transactions by classifying them as synthetic securitisation as Para 6 (c)[5] explicitly prohibits lenders from undertaking synthetic securitisation activities.
Working Group Recommendations
The Working group reasoned that “a synthetic structure enables unregulated entities to lend without complying with prudential norms through credit risk sharing arrangements by way of a First Loss Default Guarantee (FLDG)”.[6] This created uncertainty in the industry about whether REs could join default loss guarantee arrangements[7]. “3.4.3.1 To prevent loan origination by unregulated entities, REs should not be allowed to extend any arrangement involving a synthetic structure, such as the FLDG to such entities. REs should not allow their balance sheets to be used by unregulated entities in any form to assume credit risk.”[8]
Aftermath of the September 2nd Guidelines
The RBI’s decision to restrict FLDG transactions severely affected the fintech industry and made it challenging for the players to sustain their businesses. The fintech companies adopted various models, such as loan agent or referral arrangements, performance guarantee or disguised FLDG arrangements, and co-lending arrangements, to cope with the situation. [9]
1. Loan agent or referral arrangement: The fintech company acquires customers and passes on the lead to the NBFC partner. The fintech company makes a commission when the loan is approved.
2. Performance guarantee or disguised FLDG arrangement: The fintech company acts as both a customer acquisition and a collection agent for an NBFC. The payouts are linked to collections and disbursements, which may create quasi-deposit constructs.
3. Co-lending arrangement: The fintech company with an NBFC licence provides a partial FLDG to a bigger NBFC. The co-lending arrangement is a grey area that may exploit some loopholes in the securitization model.
Reserve Bank: Oh, great intentions, I’ve got the best of interventions.
Industry: In our infliction, entrepreneurial conditions,
Oh, Lord of progress, have you forgotten about us?
Revision in regulation by the Reserve Bank, regarding FLDG transactions
After consulting various stakeholders and balancing innovation with prudent risk management, the RBI introduced a new regulatory framework for digital lending on 8 June 2023. The framework allows default loss guarantee (DLG) arrangements.[10] The RBI guideline states that the DLG arrangements that conform with the guidelines will not be treated as “synthetic securitisations” and won’t attract the provisions of “loan participation”.[11]
Eligibility as DLG Provider
- The regulated entities can only enter into arrangements with RE and with the LSP, with which it has already entered into an outsourcing arrangement.[12]
- The (LSPs) providing FLDG must be incorporated as a company under the Companies Act, 2013.[13]
- The lender must ensure that the total amount of FLDG covered on any outstanding portfolio does not exceed 5% of the amount of that loan portfolio.[14]
- The lender must disclose the FLDG arrangements and the related risks in its financial statements and regulatory returns.[15]
Conclusion
Synthetic securitisation is used in different countries for various purposes, such as, in the European Union, synthetic securitisation is used by banks to achieve capital relief and risk management for their loan portfolios, especially commercial real estate. The EU has recently introduced a new framework for simple, transparent and standardised synthetic securitisation to promote this market and provide favourable regulatory treatment.[16] In the United States, synthetic securitisation is used by Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs), to transfer the credit risk of their mortgage portfolios to private investors through credit risk transfer transactions. These transactions help reduce the exposure of the GSEs and taxpayers to mortgage losses and support the stability of the housing finance system.[17] In the United Kingdom, synthetic securitisation is used by banks and other lenders to diversify their funding sources and optimise their capital structure. Some examples of synthetic securitisation deals in the UK include those backed by agricultural mortgages, residential mortgages, and consumer loans.[18] Synthetic securitisation can also pose legal and ethical issues, as illustrated by the case of Goldman Sachs’ involvement in a synthetic collateralized debt obligation (CDO) called Abacus 2007-AC1, which resulted in a fraud suit by the SEC.[19] This is an example of how synthetic securitisation can be used as an instrument for causing fraud. Goldman denied any wrongdoing and claimed that the investors were sophisticated and had access to extensive information about the underlying mortgage securities.
Some of the regulatory challenges faced by RBI were defining what constitutes a synthetic securitisation, ensuring adequate disclosure and transparency, assessing the credit quality and risk profile of the underlying assets, and monitoring the market developments and potential systemic risks; and with the introduction of new guidelines, the Fintech landscape seems promising.
[1] Aditya Narayan Parida, “Structured Default Guarantees” available at https://vinodkothari.com/2022/09/structured-default-guarantees/
[2] “Guidelines on Default Loss Guarantee (DLG) in Digital Lending” RBI/2023-24/41 DOR.CRE.REC.21/21.07.001/2023-24 available at https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12514&Mode=0
[3] Guidelines on Digital Lending (September 02, 2022), available at https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12382&Mode=0
[4] ibid
[5] Para 6(c) of the Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021, available at https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12165
[6] 3.3.1.2 Rent-an-NBFC model by digital lenders, Report of the Working Group on Digital Lending including Lending through Online Platforms and Mobile Apps, available at https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=1189#S54
[7] 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
[8] Supra note 5
[9] 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
[10] Dinesh Gupta, Jasmeet Kaur Munday, “RBI GUIDELINES ON FIRST LOSS DEFAULT GUARANTEE: A CREDIT LINE FOR FINTECH PLAYERS” available at https://www.legal500.com/developments/thought-leadership/rbi-guidelines-on-first-loss-default-guarantee-a-credit-line-for-fintech-players/
[11] June 8, 2023, “Guidelines on Default Loss Guarantee (DLG) in Digital Lending”, available at https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12514&Mode=0#FN2
[12] Guideline 3
[13] Ibid
[14] Guideline 6
[15] Guideline 11
[16] REPORT ON STS FRAMEWORK FOR SYNTHETIC SECURITISATION UNDER ARTICLE 45 OF REGULATION (EU) 2017/2402 available at Report on framework for STS syntetic securitisation.pdf (europa.eu)
[17] CREDIT RISK TRANSFER PROGRESS REPORT Fourth Quarter 2020, available at Credit Risk Transfer Progress Report 4Q20 (fhfa.gov)
[18] SCI Events calendar: 2022, available at SCI-CRT-Awards-2021.pdf (huntonak.com)
[19] “Goldman Sachs and Abacus 2007-AC1: A Look Beyond the Numbers” available at Goldman Sachs and Abacus 2007-AC1: A Look Beyond the Numbers – Knowledge at Wharton (upenn.edu)
Author Bio
good piece!