It is an arrangement between two entities — often two regulated entities (REs). Or, in the case of digital lending, between the regulated entity and fintech lending service providers (LSPs), whereby the LSP guarantees to compensate the RE for loss due to default up to a certain threshold of the loan portfolio. Since losses only to a certain threshold are covered under this arrangement, it’s called as first loss default guarantee or FLDG.
How do these contracts work?
Say ABC Private Ltd, a fintech lending platform, has an arrangement with XYX Ltd, an NBFC, which is a regulated entity. For practical purposes, think of ABC as a direct selling agent for the NBFC, whereby ABC assumes the responsibility of distributing and recovering the loans of XYZ. The ultimate responsibility of underwriting the loans is with XYZ and at no point can XYZ sell back the portfolio to ABC.
Now assume the contract between ABC and XYZ is for ₹100 crore. Based on June 8 guidelines, up to five per cent of the loan portfolio can be covered under FLDG; that is, up to ₹5 crore. Now if ABC had distributed these loans to one lakh borrowers at ₹10,000 each, up to 5,000 customers going bad can be accommodated through the FLDG arrangement. The FLDG clauses must be invoked within 120 days from the date of default.
Why were the fintech players asking for it?
Last year, the Reserve Bank of India revised its guidelines on securitisation and said that any ‘synthetic securitisation’ contract should not be considered valid. As a result, fintechs were challenged to enter default loss guarantee agreements. Also, without commitment towards loan loss, REs were hesitant to lend through fintechs and hence the industry was lobbying for these guidelines.
Therefore, the circular sets the base for enabling the system to handle these loans formally. That said, while on the face of it, the circular seems to be simple, there are still a few grey areas. For instance: How should loan outstanding be computed — whether daily or monthly? Until these operational aspects are addressed by the RBI, it’s still not a win-win for fintechs and the REs.
What do these mean for users of digital lending platforms?
For the users, ABC Private Ltd would be the point of contact. However, they would know the source and origin of these loans (XYZ Ltd). Usually, to cover up for the probable default guaranteed under FLDG, LSPs charge a fee akin to service fee. This was in practice even prior to the June 8 circular and many fintech players were lending based on a similar structure though named differently. Now with the RBI permitting FLGD contracts for digital lending, it’s likely that LSP may charge this officially to cover up for the likely losses. Therefore, for borrowers it could imply an increase in cost of loans.
Will this help in the growth of these platforms?
Yes, it would. However, even in the past years, fintechs have been working with REs on co-lending structures and even FLDG in a different manner. Therefore, the incremental increase in business could be difficult to quantify as yet.