The Reserve Bank of India (RBI) has proposed that banks meet their priority sector lending targets through co-origination of loans with non-banking finance companies (NBFCs). Rather than hold on to the convenience of lending to micro lenders and other NBFCs who in turn would give loans to small borrowers, the central bank believes banks should directly underwrite loans along with other lenders to meet their priority sector requirements.

In short, attend to the customer together rather than just pay your way to get the label of a small-borrower-friendly bank.

To the extent that this arrangement would bring the much-needed heft of deposit-taking banks in bringing down costs to the end borrower, it is indeed a win-win proposal.

The regulator has had the end borrower in mind while rooting for co-origination.

It also makes perfect sense for RBI to push banks to underwrite loans using their strengths and outsourcing what they cannot do.

Banks get to underwrite risk without spending much on setting up shop in a remote village to chase small customers.

A micro lender or NBFC saves the cost of borrowing money from a bank and then charging a spread on it while giving out loans. Thus, for the end borrower, the cost could be lower.

While broad guidelines are expected in September, what such a co-origination of loans would look like can be guessed.

An illustrative example is as follows:

A bank in need to meet its 40% priority sector lending target currently has to rely on buying such loans from others through certificates or even securitization. Here, the bank doesn’t have much control on the risk it is taking on its books. The priority sector lending certificates market is an opaque one but nevertheless growing in leaps and bounds.

According to ratings agency Icra Ltd, these certificates grew by 47% in the June quarter.

In co-origination, the bank gets to decide its NBFC partner and can enters into a standard agreement in terms of pricing and the extent of loan that needs to be disbursed from each of them. The bank and the NBFC, too, have the power to choose what suits them in terms of the borrower profile.

In all probability, the edge in interest rates or borrowing cost will emerge from the bank given that banks have access to low-cost deposits.

NBFCs and microfinance companies have proven their last-mile reach to underwrite risk at the small borrower level.

But there is a flip side to this model. For banks, it takes away the convenience of just lending to an NBFC or a micro lender. It now has to work on the granular level. Banks would also have to rely on the risk assessment of borrowers by NBFCs. Finance companies tend to be more lenient than banks in pricing risk and can afford to take higher risk. While pricing the loan, banks would need to be cautious of this.

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