The Reserve Bank of India came out with guidelines on the Default Loss Guarantee (DLG) in Digital Lending, a move aimed at ensuring the orderly development of the credit delivery system.
The Default Loss Guarantee (DLG) is a contractual arrangement, between Regulated Entities like banks, non-banking finance companies, and lending service providers (LSPs, popularly known as fintech players) in the digital lending space. DLG is also known as First Loss Default Guarantee (FLDG). The LSP provides certain credit enhancement features such as a first loss guarantee up to a pre-decided percentage of loans generated by it. Any other implicit guarantee of similar nature linked to the performance of the loan portfolio of the Regulated Entity (RE) and specified upfront, is also covered under the definition of DLG.
A working group committee of the Reserve Bank in its report released in 2021 observed that in some cases, fintechs were undertaking balance-sheet lending in partnership with a bank/ NBFC or on a standalone basis, while not satisfying the principal business criteria to remain outside regulation.
RBI had expressed reservations about the FLDG arrangement because it felt that the model could pose a systemic risk, in view of credit risk borne by the LSP without having to maintain any regulatory capital. Therefore, it has notified that;
“RE may enter into DLG arrangements only with a Lending service provider (LSP)/other RE with which it has entered into an outsourcing (LSP) arrangement. Further, the LSP providing DLG must be incorporated as a company under the Companies Act, 2013”.
As per the latest guidelines, DLG arrangements must be backed by an explicit legally enforceable contract between the RE and the DLG provider. Such a contract, among other things, must contain the details, such as the Extent of the DLG cover, the Form in which the DLG cover is to be maintained with the RE, the Timeline for DLG invocation, etc.
A RE is allowed to accept DLG only if one or more of the following forms: (a) Cash deposited with the RE (b) Fixed Deposits maintained with a Scheduled Commercial Bank with a lien marked in favour of the RE (c) Bank Guarantee in favour of the RE
Further, the Central Bank reiterated that any DLG arrangement shall not act as a substitute for credit appraisal requirements and robust credit underwriting standards need to be put in place irrespective of DLG cover.
Invocation of DLG: The RE shall invoke DLG within a maximum overdue period of 120 days unless made good by the borrower before that. The amount of DLG invoked shall not be set off against the underlying individual loans. Recovery by the RE, if any, from the loans on which DLG has been invoked and realised, can be shared with the DLG provider in terms of the contractual arrangement.
The tenor of DLG: The period for which the DLG agreement will remain in force shall not be less than the longest tenor of the loan in the underlying loan portfolio.
Cap on DLG:
It is obligatory on the part of a RE to ensure the total amount of DLG cover on any outstanding portfolio which is specified upfront shall not exceed five per cent of the amount of that loan portfolio. In case of implicit guarantee arrangements, the DLG Provider shall not bear performance risk of more than the equivalent amount of five per cent of the underlying loan portfolio.
The RE shall put in place a mechanism to ensure that LSPs with whom they have a DLG arrangement shall publish on their website the total number of portfolios and the respective amount of each portfolio on which DLG has been offered.
Guarantees covered under the following schemes/ entities shall not be covered within the definition of DLG:
- Guarantee schemes of Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), Credit Risk Guarantee Fund Trust for Low Income Housing (CRGFTLIH), and individual schemes under National Credit Guarantee Trustee Company Ltd (NCGTC).
- Credit guarantee provided by Bank for International Settlements (BIS), International Monetary Fund (IMF) as well as Multilateral Development Banks as referred to in RBI Master Circular on Basel III Capital Regulation dated May 12, 2023.
Recognition of NPA:
Recognition of individual loan assets in the portfolio as NPA and consequent provisioning shall be the responsibility of the RE as per the extant asset classification and provisioning norms irrespective of any DLG cover available at the portfolio level, the notification said.