Fintech advances should be accommodated by RBI rather than banned

Fintech advances should be accommodated by RBI rather than banned

This development comes on the heels of a proposal from an RBI Working Group constituted to address customer protection and other concerns in the digital lending space. The Working Group proposed an overhaul of regulations applicable to digital lenders. It recommended self-regulation of LSPs and disallowed them from providing credit enhancements such as FLDG (first-loss-default-guarantee) to the lenders. The Working Group reasoned that FLDG contributes to risk build-up at the LSPs’ end that remains invisible to regulated lenders. There are also concerns that FLDG could increase the price of the loan and incentivise coercive collection practices.

According to news sources, the Reserve Bank of India (RBI) is investigating the contractual agreements between its regulated institutions, such as banks and non-bank financial companies (NBFCs), and loan service providers (LSPs). The latter provide regulated balance sheet lenders like banks and NBFCs with lending-related services such as loan origination, underwriting, and collections. The RBI appears to be specifically seeking information on the size and scope of loss-sharing arrangements between banks/NBFCs and LSPs. The First Loss Default Guarantee is one such arrangement (FLDG). FLDG is a credit enhancement feature that requires LSPs to compensate lenders for a pre-determined degree of default, such as the portfolio’s first 10% loss.

The Working Group’s attention to the issue is welcome. However, a risk-proportionate regulation of the FLDG could address its risks, while allowing the ecosystem to benefit from innovative LSPs. The use of FLDG for credit enhancement is not unique to digital lending. Business Correspondents (BC) and NBFCs routinely offer FLDGs to regulated lenders. When done well, it checks moral hazard on the part of new BCs or LSPs, incentivises lenders to partner with new entrants, and enables price discovery. The quantum of FLDG could signal the operating maturity and risk profile of the LSP.

Market participants report that FLDGs in Indian digital lending tend to be high, sometimes as high as 80 percent. Also, some LSPs have provided FLDGs a few times their equity cushions and therefore it is unclear whether they have adequate means to service these claims if they materialise.

The RBI panel observed that high levels of FLDG amount to off-balance sheet lending by the LSP, without the comfort of regulatory capital. This could expose lenders to unforeseen systemic risks. Presently, the RBI has little visibility, through its regulated lenders, either of the lending ecosystem’s reliance on FLDGs from LSPs or of the adequacy of the LSPs’ equity cushions to make good on them.

These concerns are not trivial. However, banning FLDG would discourage lenders from partnering with LSPs or expanding the pool of LSPs they partner with. It risks shutting out newer and smaller LSPs with innovative solutions from the emergent fintech lending ecosystem. It could also have a chilling spill-over effect on the universe of private credit enhancement instruments in use for many years now. This does not bode well for competition and financial inclusion.

In our assessment, a risk-proportionate approach to regulate all types of credit enhancements including FLDGs (but also other forms such as cash collateral, over-collateralisation), could reconcile policy objectives and create fewer market distortions than the proposed blanket prohibitions.

What would risk-proportionate regulation of FLDGs look like?

First, where LSPs use the lender’s underwriting criteria, any credit enhancement sought/offered (including any form of FLDG) should only cover for operational risk/servicer risk of the LSP, as all credit risk is ascertained by the lender’s own models and held on its own books. Second, where LSPs use their own underwriting criteria and commit credit enhancements to partner lenders, the enhancement (whether FLDG or not), should only cover historically expected losses. Where this information is unavailable, the RBI could place explicit onus on the lender to verify or audit the LSP’s valuation models, and its existing, aggregate credit enhancement commitments in the market, before determining the level of FLDG. The lender must establish that the risks undertaken are aligned with its board-approved policies on risk appetite and business strategy. After all, credit risk management is the lender’s core business.

Third, where the LSP is a bank or an NBFC, they can offer financial guarantees or cash collateral subject to the principles above. But unlike other LSPs, they can also sell the originated portfolio through either – direct assignment, in which case a minimum holding period (MHP) would apply and no credit enhancement would be permitted; or, through securitization, in which case, over-collateralization would also be possible. Fourth, the industry body proposed by the Working Group could publish a public register of LSPs’ credit enhancements, including their quantum and modality (through lien marked FDs/ corporate guarantees/ cash collaterals holdback on service fees, or a combination of these). It would allow entities to compete on the strength of their balance sheets vis-à-vis the degree and historical performance of their FLDGs, making it an efficient marker of operating risks. It would also allow regulators to identify emergent concentration risks and excessive off-balance sheet liability-creating activity among LSPs.

Finally, capital guarantees may do little to test the robustness of, or prevent risks that arise from, automated decision-making systems often used in digital lending. Technological safeguards such as explainable and auditable algorithms would complement capital buffers well and help guard against operational risks arising from tech-intensive LSPs. By taking a risk-based adaptive stance, the RBI can avert shocks to non-bank and fintech-led credit expansion. Further, given the technology-intensive character of LSP partnerships, RBI’s enforcement toolkit could look beyond capital buffers and include technological safeguards to reduce operational/servicer risks.

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