Introduction:
The Reserve Bank of India (RBI) has recently issued new guidelines, effective immediately, regarding default loss guarantee in digital lending. These guidelines allow various financial institutions, including commercial banks, cooperative banks, non-banking financial companies, and housing finance companies, to enter into default loss guarantee arrangements with lending service providers. Let’s take a closer look at the key highlights of these guidelines.
- Default Loss Guarantee (DLG) Arrangements: Under the DLG Guidelines, the RBI defines DLG as a contractual agreement between lending service providers and financial institutions. The agreement enables the service providers to compensate the financial institutions for any losses incurred due to defaults on loans, up to a certain percentage of the loan portfolio. It is important to note that DLG does not involve transferring the underlying loan exposure between the parties, and any other implicit guarantee related to loan performance also falls under the definition of DLG.
- Permissible DLG Structures: The RBI permits DLG arrangements in the following forms: a) Cash deposited with the financial institution. b) Fixed Deposits held in a Scheduled Commercial Bank with a lien marked in favor of the financial institution. c) Bank Guarantee issued in favor of the financial institution.
However, the DLG Guidelines prohibit DLG arrangements in the form of contractual or third-party guarantees, excluding bank guarantees. Financial institutions must carefully evaluate existing and future DLG arrangements to ensure compliance with the guidelines.
- Cap on DLG: DLG cover on any outstanding loan portfolio should not exceed 5% of the portfolio’s total amount. This cap also applies to implicit guarantee arrangements. Financial institutions must clearly specify the percentage cover in the contractual arrangements and ensure that it aligns with the commercial agreement between the parties. Any existing arrangements may need to be restructured to comply with the DLG Guidelines on this aspect.
- Eligibility as DLG Provider: Financial institutions are permitted to enter into DLG arrangements only with lending service providers or other financial institutions with whom they have outsourcing arrangements. Furthermore, the DLG provider must be incorporated as a company under the Companies Act, 2013. This requirement addresses concerns related to illegal third-party apps that were functioning as lending service providers. All lending service providers now need to be incorporated as companies under the Companies Act, 2013.
- Conditions and Due Diligence: DLG arrangements must be supported by explicit and legally enforceable contracts. These contracts should clearly state the extent of DLG cover, the form in which DLG cover is maintained, and the timeline for DLG invocation. Financial institutions must establish a board-approved policy before entering into any DLG arrangement, which includes eligibility criteria for DLG providers, monitoring processes, and reviewing arrangements.
Additionally, financial institutions should conduct due diligence on DLG providers to ensure they have the capacity to honor the guarantees. This includes obtaining adequate information, such as declarations from the DLG provider certified by their statutory auditors, which contain details of aggregate DLG amounts outstanding, default rates on similar portfolios, and more.
- Account Classification and Provisioning: Financial institutions must adhere to existing account classification and provisioning norms for individual loans, regardless of the DLG cover available at the portfolio level. The amount of DLG invoked cannot be set off against the underlying individual loans. Any recovery from loans on which DLG has been invoked and realized can be shared with the DLG provider according to the contractual arrangement. The capital computation of exposure and application of credit risk mitigation benefits will continue to follow existing norms.
Conclusion:
The RBI’s issuance of the DLG Guidelines strikes a balance between permitting DLG arrangements in a regulated manner and ensuring compliance with existing regulations. Financial institutions will need to review and restructure their existing DLG arrangements to align with these guidelines. Non-compliant structures may be considered “synthetic securitizations,” which are prohibited by the RBI. It is crucial for financial institutions to carefully evaluate their DLG arrangements and adjust them accordingly to comply with the DLG Guidelines.