Guidelines On First Loss Default Guarantee: Brief Summary And Takeaways

With increased penetration of internet and technological innovation, there has been a surge of FinTech players. Especially in digital lending space, there has been an increased reliance placed by the regulated entities (i.e., the banks and non-bank financial companies who are permitted to carry out lending business) (“RE”) upon third party lending service providers (“LSPs”). The LSPs (mostly unregulated) are essentially technology-centric entities which have the client reach and are thus capable to offer a marketplace for both lenders and borrowers. The LSPs generally under an outsourcing arrangement offer their services to REs for a fee/commission. The services offered include customer acquisition, underwriting support, pricing support, disbursement, servicing, monitoring, collection, recovery of specific loan etc.

With an objective to monitor the digital lending ecosystem including the above arrangements between REs and LSPs, the Reserve Bank of India in January 2021 constituted a Working Group (“WG”) on Digital Lending. The WG submitted its report in November 2021. Following the public consultation(s) on the report, the RBI issued detailed guidelines on digital lending in September 2022 (“Digital Lending Guidelines”). However, the guidelines on First Loss Default Guarantee (“FLDG”) were not included in the Digital Lending Guidelines as the FLDG arrangements were under examination by the RBI.

FLDG and concerns

In simple terms, the FLDG is a credit risk sharing arrangement, between RE (who is the lender) and LSP, under which the LSP guarantee to compensate to RE if the borrower defaults. The WG in its report highlighted the following certain concerns surrounding FLDG arrangements, and recommended that REs should not be allowed to extend FLDG arrangements to unregulated entities:

• “FLDG act as a synthetic structure enabling unregulated entities to lend without complying with prudential norms…
• For all practical purposes, credit risk is borne by the LSP without having to maintain any regulatory capital…
• The loan portfolio backed by FLDG is akin to off-balance sheet portfolio of the LSP wherein the nominal loans sit in the books of the lender without having to partake in any lending process….”

While the RBI kept WG’s recommendations on FLDG for further examination, in the Digital Lending Guidelines it was mandated that in relation to FLDG, the RE(s) shall comply with the RBI’s directions on Securitisation of Standard Assets^[1]. The said directions prohibit the lenders from assuming securitisation exposure arising through ‘synthetic securitisation’^[2] arrangements. Thus, by extending the applicability of these directions, the RBI seemingly directed that FLDG arrangements should not be continued. After examining the FLDG arrangements, the RBI has decided to permit such arrangements (subject to strict riders) and in this regard has issued the ‘Guidelines on Default Loss Guarantee (DLG) in Digital Lending’ on June 8, 2023 (“FLDG Guidelines”).

FLDG Guidelines – Riders:

1. The LSP providing FLDG must be incorporated as a company under the Companies Act, 2013.
2. FLDG arrangement to be backed with an explicit legally enforceable contract between RE and LSP.
3. FLDG should be backed with: (a) cash deposited with RE; (b) fixed deposits with scheduled commercial bank with lien marked in favor of RE; (c) bank guarantee in favor of RE.
4. FLDG cover on any outstanding portfolio to be capped to 5% of the amount of that loan portfolio.
5. Irrespective of the FLDG cover, the RE shall be responsible to recognize and make provision for individual loan asset as NPA. Also, the RE shall continue to have in place the robust credit underwriting standards, and the FLDG shall not act as substitute for the same.
6. The loans cannot be set-off against the guarantee invoked. However, if any loan amount (against which guarantee has been invoked and realized) is subsequently recovered by RE, then, RE may share the recovery amount with the FLDG provider.
7. RE shall invoke guarantee within 120 days of default.
8. The FLDG arrangement shall remain in force till longest tenor of the underlying loan portfolio.
9. The REs prior to entering or renewing any FLDG arrangement shall obtain adequate information to ensure that the FLDG provider would be able to honor it. To this effect, the RE shall at least obtain a declaration from DLG provider (certified by its auditor) regarding existing obligations of DLG and details of past defaults.

Key Takeaways:

FLDG arrangements enables the lenders to widen the customer reach and enhance their portfolio by extending loans to high-risk customer category (such as students, MSME etc.). From the LSPs perspective, it allows them to essentially perform most of the lender’s functions (such as sourcing customer, do credit-worthiness check of the customer with help of technology), and earn commission/ fee therefrom, without being subject to the strict lender’s norms.

However, owing to surfacing concerns (such as FLDG cost being passed to borrower in the form of higher interest rates, lenders increased reliance on LSPs, no tight regulations to nab LSPs if they fail to execute guarantee etc.) the RBI restricted FLDGs considering them as akin to a synthetic securitization structure. Now, when the FLDGs have been permitted, it would have to be seen, if they continue to remain operationally attractive with the strict riders built in the FLDG Guidelines.

The RBI intent seems to be clear that REs cannot pass on their liability or onus on LSPs, and thus REs shall inter alia continue to have robust underwriting standards, recognize NPAs etc. Further, the requirement of FLDG cover to be backed with the locked-in hard cash, would ensure that only those LSPs who are genuine and who have the financial ability to perform the guarantee participate in FLDG arrangements. However, this would perhaps discourage the start-ups/small players who often face cash crunch challenges from venturing into FLDG space. Lastly, the requirement of registering as a company, would enable continuous monitoring of the financials of LSPs backed by a rigid audit and disclosure process which Indian companies (as opposed to other form of organizational structures) are subject to.

Authors: Itee Singhal and Nupur Gupta, Luthra and Luthra Law Offices. Views are personal.

1. Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 issued on September 24, 2021. ↑

2. Para 5 (y) of aforesaid Master Directions defines ‘synthetic securitisation’ as “a structure where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of credit derivatives or credit guarantees that serve to hedge the credit risk of the portfolio which remains on the balance sheet of the lender” ↑