Introduction
In the bustling world of finance, traditional banks have held the reins of power, carefully scrutinizing every borrower’s creditworthiness. Their approach has been effective, however, often excludes individuals with limited credit histories or those belonging to underserved segments. However, winds of change in the past few years have swept through the financial landscape with the emergence of Financial Technology (Fintech) companies. These agile innovators have disrupted the status quo, providing inclusive financial solutions and digital lending options to previously marginalized populations. However, they also face serious concerns surrounding risk management. Traditionally, fintech lenders relied on credit scoring models and collateral to determine the creditworthiness of borrowers. However, these conventional methods often failed to capture the full picture, leading to suboptimal risk assessment and occasional defaults. Lenders, especially fintech companies, have been grappling with the challenge of assessing and mitigating risk effectively. That’s where the FLDG, First Loss Default Guarantee (FLDG) comes into the picture.
What is FLDG?
First Loss Default Guarantee (FLDG) is an arrangement designed to mitigate the risks associated with lending and borrowing. In this scheme, a guarantee is provided to the lenders by a third party, typically a financial institution or government entity, if the borrower defaults on their loan. The purpose of FLDG is to enhance the confidence of lenders, particularly in situations where borrowers may have a higher risk of default. By offering a first-loss guarantee, the scheme protects lenders against potential losses in case of default. This assurance encourages lenders to provide loans to borrowers who might otherwise be considered too risky, thus promoting greater access to credit. This partnership mitigates the risk borne solely by the fintech lender, making them more inclined to extend credit to borrowers who may not meet stringent traditional credit criteria. FLDG schemes are typically used to facilitate lending to sectors or individuals with higher perceived risks, such as small businesses, startups, or borrowers with limited credit histories. By providing a safety net to lenders, FLDG schemes encourage them to extend credit and promote financial inclusion. It’s important to note that the specific details and terms of FLDG schemes may vary depending on the country, financial institution, or government entity involved.
Let’s consider an example. Suppose there is a small business owner who wants to secure a loan from a bank to expand their operations. However, the business is relatively new and lacks a substantial credit history, making the bank hesitant to approve the loan due to the perceived risk. In such a scenario, the government or a financial institution could step in and offer a first-loss default guarantee to the bank. This means that if the business owner defaults on the loan, the government or financial institution will cover a portion of the losses incurred by the bank. For instance, if the FLDG scheme guarantees 80% of the loan amount, and the borrower defaults on a loan of INR 1,00,000, the FLDG will reimburse the bank up to INR 80,000, reducing the bank’s losses. This assurance enables the bank to lend to the business owner, as the risk is significantly reduced.
Why did RBI ban FLDG earlier?
The Reserve Bank of India (RBI) initially stopped the First Loss Default Guarantee (FLDG) scheme due to concerns and issues related to the guarantee arrangements provided by fintech especially those that were non-regulated. The problem lay in the high guarantee limits offered by this fintech, which in some cases reached as high as 100% of the loan pool. To understand this, let’s consider an example mentioned in the article. A fintech or loan service provider (LSP) facilitates a bank with a loan pool worth INR 100 crore. The fintech offers FLDG to compensate for up to 10% of the credit risk associated with the loan pool, which is INR 10 crore. However, many unregulated fintechs were providing guarantees for the entire 100% of the credit risk, disregarding RBI supervision and outsourcing arrangements. The RBI had concerns about the capability of these fintechs to bear such a high credit risk. It questioned whether they had the necessary risk management practices, debt-to-equity ratio requirements, and capital adequacy norms in place. The regulator found that many fintechs were not adequately prepared to handle potential bad loans or defaults. As a response, in August 2022, the RBI imposed a complete restriction on FLDGs, labelling them as synthetic securitisation. This action was taken to address the issues of unregulated FLDG arrangements and ensure the stability and integrity of the banking system.
What are the new RBI guidelines on FLDG?
Fintech companies offer guarantees to cover certain aspects of their operations, and the new guidelines outline the requirements and limitations for these guarantees. One of the guarantees is the default guarantee, which has been capped at 5% of the portfolio amount. For example, if a fintech company services a loan pool worth Rs 10 crore for a bank, the maximum risk of loss would be 5%, amounting to INR 50 lakh. To ensure the validity of the guarantees, fintechs are required to provide hard guarantees to banks. This means that the exposure must be secured by the fintech through a cash deposit, such as a fixed deposit (FD) maintained with a scheduled commercial bank with a lien, or a bank guarantee marked in favour of the regulated entity (RE). By providing such guarantees, fintech companies demonstrate their financial capability to fulfil their obligations in the event of a default. The RBI also mandates fintech to make strict disclosures regarding their guarantees. For instance, Loan Service Providers (LSPs) must publish on their websites the total number of portfolios and the respective amounts for which FLDG have been offered. Additionally, fintechs are required to have a board-approved policy before entering into any FLDG arrangement. This policy should include eligibility criteria for the FLDG provider, details of the coverage, monitoring and reviewing processes, and information on applicable fees, if any. Furthermore, robust credit underwriting standards need to be in place regardless of the default loss guarantee (DLG) cover. Each time an RE enters into or renews an FLDG arrangement, they must gather adequate information to ensure that the DLG provider will be able to honour the guarantee. This includes a declaration from the DLG provider, certified by the statutory auditor, which includes details on the aggregate FLDG amount outstanding, the number of REs and portfolios covered, and past default rates on similar portfolios. It is important to note that lenders are accountable for identifying individual loan assets as non-performing assets (NPAs), irrespective of the DLG cover. This ensures that lenders are responsible for accurately assessing loan performance and recognizing NPAs on time. The guidelines aim to provide a more accurate view of digital lending NPAs and reduce leniency in underwriting practices by REs.
Regarding the underwriting process, the guidelines state that the regulated entity (RE) must have a robust credit underwriting framework in place. This emphasizes the importance of strong credit assessment and risk management practices within fintech companies. The FLDG arrangements can involve both regulated and non-regulated entities. It can be between an RE and an unregulated Loan Service Provider (LSP), or between two regulated entities. Regulated entities include commercial banks, small finance banks, cooperative banks, and NBFCs (including housing finance companies). The duration of the FLDG agreement should be at least as long as the longest tenor of the loans in the underlying loan portfolio. This ensures that the guarantees remain in effect for the appropriate duration.
Impact of the new FLDG guidelines
The Reserve Bank of India’s (RBI) new FLDG guidelines bring both opportunities and challenges for fintech companies in India. These guidelines foster fintech innovation, enhance financial inclusion, and promote transparency in the sector, however, the implementation of stricter requirements has raised concerns among fintech players. One significant impact of the FLDG guidelines is the capping of default guarantees at 5% of the portfolio amount. While this measure aims to mitigate risks associated with potential defaults, it poses challenges for fintech companies. The cap limits the extent to which fintech can protect lenders from default risks, potentially affecting their ability to attract investment and expand their operations. The FLDG guidelines emphasize the accountability of lenders for identifying non-performing assets (NPAs) irrespective of the default loss guarantee (DLG) cover. This enhances risk assessment practices within fintech companies, ensuring better identification and management of NPAs. The FLDG guidelines introduce a mandate for fintech companies to make strict disclosures. They are required to publish information on their websites regarding the portfolios and amounts covered by FLDG. This move towards transparency allows borrowers and stakeholders to have a clearer view of the guarantees offered and make informed decisions. However, compliance with these disclosure requirements may involve additional administrative burdens for fintech companies. The revamped FLDG guidelines also have implications for borrowers and lenders. Stricter risk assessment practices and greater accountability ensure that lenders maintain a more accurate view of digital lending NPAs. This reduces the leniency that was observed in the past and promotes more responsible lending practices, benefiting borrowers in the long run. The guidelines also facilitate collaboration opportunities between fintech lenders and traditional financial institutions, leading to a more inclusive and integrated financial ecosystem. LSPs, as intermediaries in the lending process, face specific challenges under the new FLDG guidelines. The guidelines require LSPs to maintain robust credit underwriting frameworks regardless of DLG cover. This emphasizes the importance of thorough credit assessment practices and risk management, demanding higher compliance standards from LSPs. Meeting these requirements might entail additional costs and resources for fintech companies.
