RBI Revamps Digital Lending Guidelines – DLG Permitted
The Reserve Bank of India (RBI) has released Guidelines for DLG (Default Loan Guarantee) as part of its Digital Lending Guidelines. According to the guidelines, banks regulated by the RBI can now enter DLG agreements with other lenders and lending service providers.
Released on June 8, 2023, the DLG guidelines abrogate RBI’s previous decision to classify DLG agreements under synthetic securitization or subject them to the provisions of full loan participation. Under either of these tenets, the entire loan amount was guaranteed to the bank by any entity offering lending services under the bank’s purview.
Now, lending partners will be required to compensate banks only up to a certain percentage of loan defaults. This development could potentially boost digital lending by bolstering credit penetration into underserved parts of the country.
What is DLG?
DLG or Default Loan Guarantee is a contractual arrangement between a Regulated Entity (RE), i.e., a bank, and a lending service provider (LSP) or another RE, wherein the latter agrees to compensate the former for a loss due to default.
The compensation can be up to a certain percentage of the loan portfolio of the bank offering the loan.
DLG is used interchangeably with FDLG or First Default Loan Guarantee.
A legally enforceable contract must back DLG arrangements and can be cash deposits, fixed deposits, or bank guarantees. This contract is required to contain the following elements –
- The extent of the DLG cover
- The form in which DLG cover is to be maintained with the RE
- The explicit timeline for DLG invocation
- Disclosure requirements
Banks may only accept DLG as either cash deposits, fixed deposits maintained with a Scheduled Commercial Bank (SCB), or bank guarantees in favor of the bank itself.
Additionally, banks can only enter into DLG agreements with LSPs or other banks incorporated as companies under the Companies Act 2013 and with whom they’ve also entered into outsourcing agreements.
What should Banks & Fintech Firms Know About RBI’s FDLG
Here are the key takeaways for regulated entities and financial institutions from RBI’s guidelines on DLG.
- The total DLG cover on any outstanding portfolio should not exceed 5% of the loan portfolio, and the DLG must be invoked within a maximum overdue period of 120 days.
- Banks must account for Non-Performing Assets (NPAs) in their loan portfolio and provision these accordingly. Any DLG invoked can’t be set off against these individual loans.
- All DLG agreements made with LSPs must remain in place for at least as long as the longest tenor of the loan in the underlying portfolio.
- Banks entering into DLG agreements must disclose their portfolios and the amounts on each portfolio against which DLG is provided.
- Banks must institute and conduct certain forms of due diligence before entering into DLG agreements. These include:
- A board-approved policy that includes the eligibility criteria for a DLG provider, the nature & extent of the DLG cover, a process to monitor & review the DLG arrangement, and the fees to be paid to the DLG provider.
- Before entering or renewing a DLG arrangement, banks must obtain information, including a certified declaration from the DLG provider on the aggregate outstanding DLG amount and the number of banks & respective portfolios against which the DLG is provided.
It’s also important to note that DLG arrangements are not substitutes for credit appraisal and underwriting requirements. Additionally, guarantees covered under the following schemes will not be covered under DLG:
- Guarantee schemes of Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), Credit Risk Guarantee Fund Trust for Low Income Housing (CRGFTLIH), and individual schemes under National Credit Guarantee Trustee Company Ltd (NCGTC).
- Credit guarantees provided by Bank for International Settlements (BIS), International Monetary Fund (IMF), and other Multilateral Development Banks
FDLG & the Future of Finance
Industry experts and stakeholders have generally welcomed the new framework, considering it an enabling move that provides clarity and encourages innovation in the lending sector. Previously, banks could partner up with LSPs for loans without much afterthought as they were guaranteed full returns in case of loan defaults.
The current 5% cap on default cover is reasonable and expected to encourage banks to offer competitive lending rates and create innovations such as stronger underwriting platforms.
The guidelines are expected to foster healthy competition, drive improvements in the lending sector, and build a healthier lending environment.
Recommendation of RBI’s Working Group on Digital Lending
RBI’s notification on DLG is a part of the recommendations of a working group on digital lending. The group has recently formulated a regulatory framework for digital lending to address industry concerns and ensure orderly growth.
Key recommendations from RBI for digital lending include:
- Loan disbursals and repayments must only occur between the borrower and the RE (i.e., bank) account without passing through any third-party account. Any fees or charges payable to an LSP must be paid directly by the RE & not the borrower.
- A standardized Key Facts Statement (KFS) with the Annual Percentage Rate (APR) must be provided to the borrower executing the loan contract.
- Automatic credit limit increases without borrower consent are prohibited, and LSPs must provide a grievance redressal mechanism. Additionally, banks must institute a cooling period during which borrowers can exit their digital loans without penalty by paying the principal and proportionate APR.
- All data collected by digital lenders must have consent collection, user controls, and robust audit trails.
- All lending sourced through digital lenders must be reported to Credit Information Companies (CICs) by REs. New digital lending products on merchant platforms involving short-term credit or deferred payments should also be reported.
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