This article provides a summary of the key regulations under the framework for digital lending in India and explores their impact on all stakeholders. The article discusses the challenges faced by stakeholders in handling funds and entering default loss guarantee arrangements and gives recommendations for addressing these issues.

Digital Lending Ecosystem in India

The market size of the Indian FinTech sector is around USD 111.14 billion in 2024 and is expected to grow to USD 421.28 billion in 2029, indicating a CAGR of 30.55 percent. Digital lending is a crucial segment of the FinTech sector in India. It aids small and medium-sized enterprises, and individuals to easily avail of loans from Regulated Entities.

The Reserve Bank of India (RBI) has, under the Guidelines on Digital Lending (Guidelines), defined digital lending as a remote and automated lending process. It can be undertaken by a Regulated Entity, or through an arrangement between a Regulated Entity and a Lending Service Provider, on a Digital Lending App.

The RBI issued the Guidelines to organise an unorganised digital lending market with the objective of protecting customers from widespread unethical practices and facilitating innovation in financial services. The RBI aims to ensure an orderly growth of the sector and promote greater financial inclusion by developing a digital lending ecosystem that is secure and accessible for the end consumer. The RBI has also sought to address the unintended consequences of third-party lending service providers mis-selling to unsuspecting customers, concerns over breach of data privacy, unethical business conduct, and illegitimate operations.

While the Guidelines appear to be a positive step towards achieving the above objectives, they have also caused a stir in the market because of restrictions on prevalent business structures between the Regulated Entities and Lending Service Providers, particularly in relation to the handling of funds and default loss guarantee (DLG) arrangements. This led to the stakeholders in the sector raising their concerns and submitting requests for clarifications from RBI. To address these concerns, the RBI issued the frequently asked questions (FAQs) and the Guidelines on Default Loss Guarantee in Digital Lending (DLG Guidelines). The FAQs and the DLG Guidelines issued by the RBI provide much-needed clarity on multiple aspects. However, many stakeholders continue to face practical challenges that are discussed in the article. 

Key Provisions under the Regulatory Framework 

Handling of Funds

Under the Guidelines, all funds related to a loan must flow directly between the Regulated Entity and the borrower’s bank account, and not through a third-party account, such as a pass-through account or a pool account. Any amount payable to a Lending Service Provider for its services must be paid directly by the Regulated Entity and cannot be charged to the borrower.

Default Loss Guarantee

Under the DLG Guidelines, Regulated Entities must ensure that the total amount of DLG cover provided by a Lending Service Provider or a Regulated Entity shall not exceed 5 percent of the loan portfolio. Even in implicit guarantee arrangements, the provider of the DLG must not bear a performance risk of more than 5 percent of the underlying loan portfolio. Additionally, the RBI has mandated the Regulated Entities to invoke DLG within a maximum overdue period of 120 days.

Practical Challenges

Restrictions on services offered by Payment Aggregators

The RBI aims to ensure that unregulated Lending Service Providers do not have any access to or control over the financial aspects of any digital loans, to protect the end-customers. However, the RBI’s mandate that the transfer of funds should be executed only between the Regulated Entity and the borrower has posed a challenge for the digital lending ecosystem.

Various Regulated Entities were availing themselves of the services of Payment Aggregators, who also provided the services of a Lending Service Provider, for handling funds. Payment Aggregators authorised by the RBI under the RBI’s Guidelines on Regulation of Payment Aggregators and Payment Gateways (PAPG Guidelines) can provide payment aggregation services, i.e., receiving payments from customers, pooling, and transferring them to the merchants.

The Payments Council of India had also requested the RBI to exempt Payment Aggregators from the restrictions on the handling of funds in digital loans since they are primarily regulated by the RBI. The RBI clarified that Payment Aggregators offering only payment aggregation services in isolation would not be brought under the ambit of the Guidelines. However, the Payment Aggregators providing the services of a Lending Service Provider will have to comply with the Guidelines and not be involved in any transfer of funds, despite holding an authorisation under the PAPG Guidelines.

The restriction under this provision extends to all digital lending offerings including ‘Buy Now Pay Later’ products because of which several FinTech entities undertook operational restructuring and, in some cases, had to shut down.

Restrictions on DLG and their impact on the growth of businesses

The RBI released the DLG Guidelines to hedge systemic risks arising out of DLGs provided by unregulated Lending Service Providers. DLG arrangements allowed unregulated entities to lend without complying with prudential norms and for all practical purposes, credit risk was borne by the Lending Service Provider without having to maintain any regulatory capital. The loan portfolio backed by first loss default guarantee is akin to off-balance sheet portfolio of the Lending Service Provider wherein the nominal loans sit in the books of the lender without having to partake in any lending process. The RBI also observed that the entire costs associated with DLG are passed on to the borrowers resulting in higher interest rates.

Lending Service Providers earlier offered 25 to 30 percent of the loan portfolio on an average as DLG, and at times up to even 100 percent of the loan amount. However, due to the above concerns, the RBI has mandated that any DLG arrangement cannot exceed a threshold of 5 percent of the loan portfolio.

The DLG providers have been significantly impacted due to this restriction and the segments where DLGs have traditionally existed, particularly in unsecured personal and business loans, have witnessed a decline in business since the cap on the DLG threshold. The limit on providing DLG has discouraged the Regulated Entities from entering DLG arrangements and the co-lending market has seen a drop in the volume of loans as the industry adjusts to these regulations.

Way Forward

Although the regulatory framework has had a positive impact on customers who are availing financial products and services in a market that is flooded with unscrupulous players, a balance must be ensured between the interests of the customers and legitimate FinTech entities to create a robust digital lending ecosystem.

The RBI may consider exempting authorised Payment Aggregators that offer services of a Lending Service Provider from the restriction on handling of funds, as they already hold valid authorisations from the RBI to offer money aggregation services. This will allow Payment Aggregators authorised by the RBI to offer a wider range of services to customers and Regulated Entities, while protecting the end customers’ interests. Allowing authorised Payment Aggregators to handle funds in connection with digital loans will also create a conducive space for innovation in this sector while ensuring that unscrupulous Lending Service Providers are not able to defraud end customers.

Further, while the restrictions on DLG thresholds are important for avoiding the systemic risks discussed above, the RBI may consider increasing the DLG threshold to 10 – 15 percent. This will encourage the Regulated Entities to offer credit at higher volumes and will also allow a wider range of underserved borrowers, including small and medium-sized enterprises, to access credit in a regulated and protected environment. A 10 – 15 percent DLG threshold will ensure that unregulated players do not pose systemic risks and that the Regulated Entities actively participate in the credit assessment without relying on the underwriting of digital lenders.

Bharucha & Partners – Vivek Mishra and Vatsal Srivastava