This article explains the concept of Default Loss Guarantee (DLG) and its evolution under the digital lending framework prescribed by the Reserve Bank of India (RBI). It explores the benefits and explains how DLG enhances risk management for lenders and sets out its implications and practical challenges faced in its implementation. The article highlights the importance of a balance between allowing innovation in digital lending and ensuring the stability of the ecosystem.

Default Loss Guarantee – The Concept

A DLG (alternatively referred to as First Loss Default Guarantee) is a contractual arrangement between a Regulated Entity and a regulated or unregulated DLG provider (DLG Provider), wherein the latter guarantees to compensate for any loss due to default up to a certain percentage of the loan portfolio.

In a typical DLG arrangement, while the Regulated Entities hold the license to lend and provide capital, the unregulated DLG Provider, i.e., a FinTech company, provides DLG, technological infrastructure, a large customer base, and market expertise. The DLG Provider does not engage in the actual lending process, but the arrangement is similar to an off-balance sheet portfolio for the DLG Provider. DLG arrangements encourage Regulated Entities to disburse loans with minimal risk in their books as the loan portfolio is backed by DLG. Such arrangements provide easy credit access to underserved sectors like agriculture, micro, small and medium-sized enterprises, and blue-collar workers.

The controversial subject of DLG has experienced a roller-coaster ride in the FinTech sector, from initially being unregulated to being prohibited for a brief period, and to eventually being regulated by the RBI. DLG has constantly been one of the drivers of the digital lending market throughout its evolution in the past few years.

Regulatory Evolution of DLG

Pre-regulation practices adopted by market players

Prior to 2022, FinTech companies offered a DLG of around 25 to 30 percent and at times 100 percent of the loan portfolio to Regulated Entities. This practice caught the attention of the RBI since most FinTech companies did not have adequate risk management capacities and struggled with credit risks due to scarce capital resources.

Additionally, unlike Regulated Entities, DLG Providers were under no obligation to adhere to any minimum capital or net worth requirements or maintain any debt-to-equity ratio. The losses incurred while writing off bad loans were eventually passed on to genuine borrowers packaged as extremely high interest rates, default rates, hidden charges, and other fees.

Unregulated DLG arrangements were prone to systemic risks and increased operational risks due to the lack of assured credibility of the FinTech companies, thereby posing a bigger risk to the whole economy. This vulnerability in the extant system fueled the RBI to frame regulations on the subject, as discussed in this article.

Recommendations of the Working Group

Addressing the need of the hour, the RBI constituted a Working Group on Digital Lending (Working Group) that issued a report. The Working Group suggested disallowing any Regulated Entity from being party to an arrangement involving a synthetic structure (like DLG) with unregulated entities, thereby saving their balance sheets to be used (or hypothetically rented) by unregulated entities to assume credit risk.

In August 2022, the RBI issued a regulatory framework, laying out the implementation plan for the recommendations in the Working Group’s report, wherein it stated that the recommendation related to DLG was under examination. The RBI directed the Regulated Entities to adhere to the Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 (Master Direction on Securitisation) in the meantime. According to the Master Direction on Securitisation, the Regulated Entities are prohibited from undertaking synthetic securitization. In addition, only regulated entities are allowed to be originators of securitization transactions.

These restrictions effectively placed a ban on DLGs and forced multiple market players to shut down. While some established FinTech companies restructured their offerings, many other companies continued to provide DLGs in violation of the Master Direction on Securitisation.

DLG Guidelines – The Balancing Act and Key Provisions

The RBI issued the Guidelines on Default Loss Guarantee in Digital Lending (DLG Guidelines) and subsequently issued responses to the frequently asked questions (FAQs). The DLG Guidelines have relaxed the blanket ban on DLGs and set out provisions for entering valid DLG arrangements. As per the DLG Guidelines, any DLG cover cannot exceed 5 percent of the amount of the loan portfolio. Even in implicit guarantee arrangements, the DLG Provider must not bear a performance risk of more than 5 percent of the underlying loan portfolio.

The DLG Guidelines also prescribe that DLG arrangements should be backed by legally enforceable contracts that should include the extent and form of DLG cover, timeline for DLG invocation, and disclosure requirements. The DLG furnished must be in the form of a hard guarantee, which could either be a cash deposit with the Regulated Entity, a fixed deposit with a lien in favour of the Regulated Entity, or a bank guarantee in favour of the Regulated Entity. The Regulated Entities are also required to procure a declaration from the DLG Provider containing details of their DLG engagements.  

These provisions offer much-needed clarity to Regulated Entities and DLG Providers for entering legally compliant DLG arrangements. This has led to the growth in the number of DLG arrangements compared to the abysmally low activity during the period that such arrangements were prohibited under the Master Direction on Securitisation.

Identifying gaps and suggestions for bridging the gaps

While the FinTech sector has viewed the DLG Guidelines as a welcome step, many stakeholders have expressed their discontent with the current DLG thresholds. Prominent industry consultants and Lending Service Providers indicated that the 5 percent cap is too low for the high-risk segments of borrowers that are targeted by the DLG Providers. DLG Providers are instead catering to safer segments like housing and personal loans, effectively limiting credit access to underserved sectors.

Additionally, the 5 percent limit means that even if the unregulated DLG Providers have adequate capacity to underwrite loans for the Regulated Entities, they cannot guarantee the losses incurred by a Regulated Entity. Not only does this limit the volume of potential customers that can be served by hampering otherwise genuine and robust DLG arrangements, but it also goes against the RBI’s principles of financial inclusion in a digital economy.

As a solution, the RBI may opt to increase the DLG limit to around 10 to 15 percent, which will ensure increased participation from the stakeholders. There are other checks and balances under the DLG Guidelines like the requirement of a declaration from the DLG Provider and hard guarantees. Such requirements will ensure that the suggested increase in the cap on DLG will not dilute RBI’s objectives of creating robust digital lending ecosystem. It would allow the FinTech entities the ability to attract more Regulated Entities to enter DLG arrangements, thereby increasing the access to credit for prospective underserved borrowers such as MSMEs, and agriculture and blue-collar sectors.

Furthermore, the requirement of hard guarantees from the DLG Provider can pose a challenge for smaller FinTech players that operate on tight margins and limited working capital. The obligation of providing DLGs in forms like cash deposits, fixed deposits and bank guarantees will reduce the liquidity in the books of small FinTech players. To make the DLG Guidelines more inclusive, the RBI may consider exempting small players based on net-worth or duration of existence from the requirement of hard guarantees and allow them to guarantee losses due to default by way of collateralization of assets.

The suggested reforms will ensure greater participation from market players and a wider access of credit to the underserved sectors, without compromising with the RBI’s goals of creating a stronger digital financial infrastructure.

Bharucha & Partners – Vivek Mishra and Vatsal Srivastava