RBI lends clarity through first loss default guarantee

Reserve Bank of India has allowed digital lenders to go for first loss default guarantee of loans and applied a cap of 5% on the extent of guarantee to the total loan portfolio.
First loss default guarantee is a model of lending between a fintech entity and a regulated body where a third party stands guarantee to compensate default in loan of the regulated body up to a certain degree. These agreements enjoin the fintech to compensate the other party to a certain pre-agreed extent if the customer fails to repay.

Regulated bodies usually refer to banks and non-banking finance companies.
According to the guidelines of the central bank issued on June 8, all bodies regulated by RBI have to ensure that the default guarantee is invoked within 120 days of a loan becoming due.

The guideline read, “Regulated entities shall ensure that total amount of DLG (default loss guarantee) cover on any outstanding portfolio which is specified upfront shall not exceed 5% of the amount of that loan portfolio… In case of implicit guarantee arrangements, the DLG provider shall not bear performance risk of more than the equivalent amount of 5% of the underlying loan portfolio.”

The recommendations that the working group on the subject of digital lending were first made public in August last year.
The very logic of default loss guarantee is to marry responsible innovation and prudent risk management, RBI governor Shaktikanta Das remarked on June 8 while announcing the decision of the monetary policy committee meeting.
The regulated entities – banks and NBFCs – will bear the responsibility of marking loans as NPAs and making resultant provisioning.

It is felt that the guilelines might provide a shot in the arm for fintech entities. Late last year it was reported that consequent to the RBI guidelines on digital lending banks and NBFCs have stayed away from providing first loss default guarantee due to lack of clarity.

Since that elusive clarity has now been put in place, it is hoped that fintechs might look forward to better business.

Anand Kumar Bajaj, MD of PayNearby told The Economic Times, “The guidelines are crucial for us because we strongly believe that digital lending platforms and business correspondents are an extension of regulated entities, enabling us to cost-effectively deliver the essential trust of a partner bank or NBFC in the form of credit to credit-starved masses.”