Relief for fintechs as RBI okays default guarantee with a cap

FLDG gets legal tag; fintechs look for ‘positive loopholes’

In a significant development, the Reserve Bank of India (RBI) has finally granted approval for the implementation of first loss default guarantee (FLDG), which allows fintech lending platforms to partner banks and non-banking financial companies (NBFCs).

The central bank, however, has capped the FLDG amount at 5% of the loan portfolio.

According to RBI’s circular, regulated entities (REs) must ensure that the total amount of default loss guarantee (DLG) cover on an outstanding portfolio does not exceed 5% of the loan portfolio. “In the case of implicit guarantee arrangements, the DLG provider shall not bear performance risk of more than 5% of the underlying loan portfolio,” it added.

In a nutshell, loan service providers (LSPs), or fintechs, can allocate 5% of their loan portfolio to the RE, safeguarding against losses if a customer defaults on payments.

The development comes as a respite for many fintechs that have been struggling to sustain operations in the wake of RBI’s stringent digital lending guidelines over the past year.

While a section of industry insiders lauded RBI’s move for offering clarity and transparency on FLDG, some lingering confusion persists on its interpretation, triggering concerns over potential “loopholes”.

A top banker, working with fintechs, said there is absolute clarity on what’s possible and what’s not. “This development presents an excellent opportunity for fintech partnerships to flourish on the lending side, as it establishes well-defined risk parameters for both REs and fintech partners. That clarity is extremely important.”

The banker said the existing partnerships were not terminated after the digital lending rules came into effect, but they operated within “a specific set of risk parameters”. “Though fintech partners were willing to experiment with some risks, our risk appetite did not allow us. Now, with the introduction of FLDG, experiments will be done on a larger scale, attracting greater participation.”

The introduction of the 5% cap has, however, divided the industry, considering that fintech companies operated with a minimum FLDG level of 10% that could even go up to 100%. This discrepancy stems from the fact that fintechs operate in a relatively high-risk segment, where default rates can range from 3.5% to as high as 13%.

Uni founder and chief executive Nitin Gupta said 5% is a reasonable figure for prudent business operation. “For loans at 18-22% interest, the NPA is in the range of 1.5-6%.”

Jitendra Gupta, the founder of Jupiter, said the cap is particularly beneficial for fledgling firms, as it enables them to navigate the initial growth stages within a structured framework. “I think 5% is a lot of loss. If you lose 5% on 15% equity requirement of an NBFC, you are in a way creating a systematic risks for regulated entities. This is a very well-thought-out guideline. REs bearing burden of losses is also a good move, as it helps maintain the quality of credit assessment conducted by fintech firms.”

Kissht (Ring) founder Ranvir Singh said broader implications of this development is far more important, “The fact that FLDG is there irrespective of the percentage is much bigger news because it takes away any sort of uncertainty and sense of interpretation; and also, for the broader investor community who wanted to invest but were sitting on fences, waiting for the confirmation.”

“Good NBFCs, that are prudent with risk norms, may find 5% not as a hindrance in doing business, as 90% of the market falls in this category,” he said. “I think we are just scratching the surface,We will see heightened activity. My prediction is in next 12 months the number is going to move up to ₹2000-3000 crore.”

On the other hand, some believe that there is room for workaround. In the absence of FLDG, the industry moved to commission-led (or say pseudo-FLDG) models and also started queuing up for NBFC licenses on which Mint recently did a detailed story.

Some industry players still believe that the “performance-based payouts will continue to happen; FLDG will be the extra cover and makes the relationship clean,” a fintech founder, who didn’t wish to be quoted, says.

“REs have to do underwriting but the loss gap of what an RE is predicting and an LSP is predicting is covered by this FLDG. For instance: a loan is originated at 20% interest, an LSP makes 2% fee on loan origination and 2% as performance fee, if the loss rate is at 1%. Now, RE will ask LSP to park 5% FLDG and now if the loss goes beyond 5%, then it will deduct the origination and performance fee of the LSP. This allows you to go even beyond 5%,” the founder adds.

An NBFC head, who works with fintechs, agrees on this saying FLDG and commission-led model will continue to co-exist. “The RBI will not come into the commission aspect because if I have a service provider for loan origination and collection, then the regulator won’t decide how much commission I pay to the agent. “The RBI cannot come and say you have to give commission to LSPs.”

An industry consultant, who advises several fintechs, believes 5% is very less and nobody works in this cap. “Fintech operates at atleast 15-20% FLDG. I think the business will continue in the name of 5% FLDG, and rest 10-15% REs will take somehow because they want double cover minimum. I think the collection inefficiency angle will continue.”

Secondly, some NBFCs are worried about the execution of the 5% cap. A founder of a large fintech NBFC, on the condition of anonymity, says he stopped giving FLDG. “Now people will start asking for it. We will see how to deal with it. This is a good move, but the interpretation is a problem. 5% never worked, minimum it was 10%. How the regulators will track the 5% cap will be a challenge and the onus will be put on the RE. There is ambiguity on the cap as they have said it’s on outstanding portfolio, which is logically wrong.”

The NBFC head quoted above adds to this saying that the RBI has written 5%, but 5% of what is the question. “They have said 5% of the book but there can be a lot of workarounds for this because people will say that we want to create a ₹5000 crore book with an RE and give 5% FLDG on that…but they end up creating just ₹50 crore book because the portfolio keeps dynamically changing because of several risk factors etc. So, this may create one of those positive loopholes for the ecosystem.”

The third option could be in the form of loan pricing. “For players, who do aggressive lending and go after risky segment, there an RE can predict “a risk of double digit of say 10%. Now, the 5% FLDG cover, they can price their loan accordingly,” founder of another large NBFC shares.

While the industry sees more clarity coming in the next 6-12 months on how this is interpreted, another senior banker cautions, “Please be afraid. You just can’t mess with the RBI. If anyone will do loophole, then there will be problem because the guideline is very clear and the RBI will track the direct/indirect FLDG. It will spoil the essence of it.”

In addition, he believes the world has moved in last two years and that any good bank will not work with any and every fintech just because 5% loss is covered.

“As an RE, we are responsible for data privacy, information security, service redressal for all our partners. So, that has raised the bar a lot more. Second, I have limited bandwidth to do all this, so I will pick and choose partners when there is something very unique and that can be scaled up and that I know that my partner has stamina to go through a fairly rigorous review on governance and stamina to scale up. The banks, in last few years, read the writing on the wall from the regulator and it’s not like we will suddenly come and say that we will now do 50 partnerships,” the banker notes.