Fintechs haggle for a licence to survive

In January this year, Uni Cards, a buy-now-pay-later startup, acquired OHMY Technologies, a non-banking financial company (NBFC) that is into peer-to-peer lending. In February, Lendingkart, a digital lending NBFC for small enterprises, acquired Mumbai-based fintech Upwards, in a cash-and-stocks deal pegged at ₹100-120 crore. In March, payments company BharatPe secured approval to acquire 51% stake in Trillionloans Fintech, a Mumbai-based NBFC, for about ₹300 crore in a stock deal.

Well, fintechs are buying NBFCs and many NBFCs are trying to mop up fintechs. What’s going on?

India’s fintech lending space is not what it was even a year back. The country’s digital lending market grew at a compounded rate of nearly 40% over the last 10 years and was worth $270 billion in 2022, a report by Experian, a consumer credit reporting company, stated. It grew too large, too soon, giving headaches to the government and the Reserve Bank of India (RBI), India’s central bank. Chinese lending apps mushroomed; fintechs resorted to aggressive lending and collection practices; exorbitant interest rates were charged; customer data protection norms were disregarded.

Then came a series of regulations from the RBI.

In September 2022, the central bank issued guidelines to regulate digital lending operations in India. These included guidelines around collection of fees by lending apps, reporting of all digital loans to the credit bureaus, and usage of customer data. Importantly, the first loss default guarantee (FLDG) model—the lifeline of fintech lending in India—was disallowed, particularly when it involved unregulated entities.

While banks and NBFCs are regulated, most fintechs are not since they don’t have a licence that allows them to underwrite loans. The fintech industry, therefore, partnered with regulated entities to pass on customer leads and banked heavily on the FLDG arrangement to make a loan happen. In such an arrangement, the fintech compensated the regulated entity in case a borrower defaulted. This model, in turn, gave comfort to banks and NBFCs to work with new-age fintechs.

But the RBI wasn’t comfortable. In many FLDG arrangements, the underwriting was executed not by the lender but the fintech. The September guidelines made it clear that underwriting is the sole responsibility of the regulated entity.

“The RBI is not misplaced in its concerns that the practice of furnishing FLDG comfort could pose systemic risks to the ecosystem as a whole. This is because lenders were solely relying on the strength of the FLDG comfort provided by unregulated fintech companies," wrote Prashanth Ramdas and Pritish Mishra of Khaitan & Co., a law firm, in Mint earlier this year.

But since this arrangement was the industry’s lifeline, disallowing it nearly took the life out of many small fintechs. “The digital lending business is today down by about 50-60% in the last one year," said Mikhil Innani, chief executive of Mumbai-based NBFC Apollo Finvest, which works with several fintechs.

Everyone scrambled to find alternative models to survive. Some pivoted. And buying out NBFCs came into fashion.

But first, let’s understand some of the alternative models at play.

Fintech’s jugaad

Mint spoke to about a dozen executives, including bankers, NBFC officials, and fintech lending consultants and discovered interesting operating structures. In some cases, the FLDG arrangement still exits, but in a disguised manner.

One model currently in vogue is the loan agent or referral arrangement. Here, unlike in FLDG, the NBFC underwrites. The fintech’s role is only limited to acquiring customers and passing on the lead to the NBFC partner. The fintech company makes a commission when the loan is approved.

“The role itself gets limited because fintechs cannot influence credit risk underwriting, which was happening earlier due to FLDG. On top of this, the loan approval rates are dependent upon how your NBFC partner underwrites," Parijat Garg, a former official of CRIF, a credit bureau, said. He advises fintech startups.

Worse, commissions have shrunk. Earlier, loan agents used to make 2-3% commission but the market is now over crowded with fintechs that have fewer options after the RBI guidelines. Commissions are now in the range of 0.5%-1%, Innani said.

The other models offer some sort of a performance guarantee—or these are FLDGs in a new avatar. In one of them, the fintech morphs into both a customer acquisition and a collection agent for an NBFC. While the fintech can theoretically make 5-6% on 100% collection, the NBFC pays this component in bits and pieces, over the tenure of the loan and not at once.

But since the payouts are linked to collections and disbursements get aggregated at the NBFC’s end, this translates into quasi deposit constructs, said industry watchers.

This might irk the RBI again. “In the absence of FLDG, the industry is going to discover their own construct—some of which may be acceptable to the RBI and some of it may not be," Garg said.

Yet another disguised FLDG arrangement is to ask for a ‘security deposit’ from the fintech which is now a collection partner. NBFCs have to pay interest on such deposits but what they dole out to the fintech is essentially part of the loan interest paid by the customer.

Meanwhile, the FLDG arrangement continues between two regulated entities, say a small fintech with a NBFC licence and a bigger NBFC. It is a co-lending arrangement. While the RBI has not explicitly disallowed this, it remains a grey area.

“The industry assumes that FLDG between regulated entities are allowed," an NBFC executive, who didn’t want to be identified, said. “It is a grey area because nothing has been said. Some are doing FLDG of 10%, going upto 30%," he added. This implies that the larger NBFCs are demanding guarantees against default of up to 30% of the loan amount.

According to media reports, the sudden spurt in the co-lending model has indeed caught the RBI’s attention. The regulator is scrutinizing whether some of the loopholes in the securitization model are being exploited by lenders in such arrangements.

Securitization involves transactions where the credit risk in assets is redistributed by repackaging them into tradeable securities.

The NBFC hunt

This brings us to the yearning for licence; it’s the licence to survive.

Most of the models mentioned above, like the loan agent arrangement, are small hacks to keep the business running. None of them are sustainable or scalable. There is little margin to be made by the fintech and, more importantly, they are always at the mercy of bigger NBFCs or banks for underwriting and owning the decisions.

“Nobody wants to grow at a slow pace. Fintechs want to disburse loans at crazy level—that will only happen when you limit the risk of NBFCs with FLDG, which you cannot do officially now," Innani said.

So, acquiring an NBFC licence becomes the key.

Well capitalized fintechs can well apply to the RBI for an NBFC licence but that’s a time consuming affair—it can take between 9 and 12 months for the central bank to accept. Moreover, the RBI’s bandwidth is limited. Buying an NBFC, and accessing its licence, is an easier route and can potentially be completed within six months.

There are 9,400 NBFCs in India today and a majority of them are either small, mid-sized, or dormant—roughly around 5,000. A dormant NBFC is one that isn’t active but has the licence. This cohort has become the hunting ground for many smaller fintechs. Such NBFCs are selling for as low as ₹75 lakh. The asking price can go up to ₹2 crore.

In reality, fintechs have to shell out a lot more. That’s because of a regulatory requirement for minimum ‘net-owned funds’. Net-owned funds are the aggregate of the paid-up equity capital and free reserves as disclosed in the latest balance sheet of the company. It is a financial metric used to assess the financial stability and solvency of NBFCs in India.

While a new licence application now requires ₹10 crore in minimum net owned funds, previously, the regulatory requirement stood at ₹2 crore. A fintech buying an older NBFC, therefore, has to pay the net-owned fund amount plus the asking price, called ‘premium’ in the banking world. The outgo, thereby, can vary between ₹2.75 crore and ₹4 crore.

The ₹10 crore requirement for a new licence is also why many fintechs are keener on buying versus applying for a new licence. Considering the funding winter, many smaller fintech startups aren’t that well capitalized.

“Every fintech out there is looking to buy out an NBFC. That is the current state of the ecosystem in a nutshell," Innani added.

Another fintech consultant, who spoke to Mint but did not want to be identified, concurred. His hands are full working on merger deals, he said. “If you see the number of players applying for a licence or buying one, that number is huge. Every week, I get at least three queries for an NBFC buyout."

Unfit NBFCs

But not every fintech in the market makes the cut, he added.

“I received at least 30 applications and I have rejected 25 of them. These startups lack net-worth or banking background; neither can they get any banker on their board," the consultant added.

The RBI has a ‘fit and proper’ criteria to approve an NBFC licence. This means a company needs to have the experience of running a regulated entity or have a senior banker as director. For more than 24% stake in an NBFC, the RBI’s approval is necessary.

Even when a fintech buys an NBFC, running it isn’t a cake walk. NBFCs are slowly but surely becoming a big boys club. “NBFCs are not for small timers any longer. It’s a serious game and you have to have deep pockets and credibility to run an NBFC," said Pratekk Agarwaal, a former executive of BharatPe and founder of Operator VC, a company advising fintechs.

NBFCs can raise equity money, and regulation, today, allows them to raise debt four times the equity money. Debt is required for scale. “Until and unless you have ₹100-200 crore in the bank and have the money to invest in people and compliance, there is no point. And while raising equity is easier now, raising debt is tough. The debt market still has not changed," Agarwaal added.

Meanwhile, not every NBFC can be useful. Some have a shady past and fintechs buying such companies can find themselves in a quagmire—bigger NBFCs wouldn’t want to work with co-lending partners with a poor track record.

“Small, old, dormant NBFCs come with a lot of baggage and most of them have had issues in the past. Some NBFCs have been used as an instrument to route black money. The moment you buy them out, you become legally liable," an NBFC official said.

For fintech lenders already struggling to survive, this isn’t comforting news.