Improving Loan Performance Portfolio: First Loan Default Guarantee as RMS
In the digital lending model, fintechs partner with banks and traditional lenders – fintechs help in sourcing borrowers and banks help fund the loans. This helps banks reach out to new segments of borrowers – and provide loans to slightly riskier segments as compared to traditional lenders. Therefore, the cost of funding these loans given the risk of default is higher as compared to traditional lenders. To mitigate the risk of lending by fintechs, fintechs provide a default loss guarantee – basis this guarantee fintechs share losses with traditional lenders if the loan becomes an NPA.
This could have earlier led to systemic risk as fintechs may not have sufficient funds to cover for NPAs & default guarantees. The RBI, therefore, introduced new digital lending guidelines, emphasising a greater necessity to reduce risks, with the new guidelines for 'First Loss Default Guarantee' (FLDG). These firmer guidelines help bring clarity and regulatory sanctity to the use of FLDG by banks and non-banking financial companies (NBFCs) in co-lending arrangements. The impact of these changes will vary depending on the nature of the lending institution. For banks that acquire lenders, the increase in reported asset quality metrics and gross credit costs will require them to reassess their risk management strategies and allocate sufficient provisions to cover potential losses. The received FLDG amount cannot be used to offset provisions. It will be recorded as income, consequently, the reported earnings will not be impacted.
The implementation of the 5% cap diverges from the prevailing practices among fintech companies in India. These companies traditionally operated with a minimum FLDG cover of 10%, which could go as high as 100%. The disparity emanates from the inherent nature of the fintech sector, which operates in a high-risk segment, witnessing default rates that fluctuate between 4% to as much as 14%. Through austere rules, the RBI intends to instil greater trust and confidence between fintechs, lenders, and borrowers. The imposition of a cap on FLDG cover and NPA recognition will discourage lenders from entering partnerships in high-yielding segments, leading to a preference for less risky customer and asset segments – thus helping reduce systemic risk. On the flip side, restrictions may impact the growth of assets under management through partnership arrangements for sourcing-NBFCs, in lucrative segments. Additionally, the new guidelines disallow non-cash forms of FLDG, except for bank guarantees. This may necessitate additional fundraising by the involved sourcing-NBFCs, considering that a significant portion of FLDG is typically in the form of corporate guarantees.
The focus on partnership arrangements will encourage lenders to seek out reliable and compatible co-lending partners. The 5% threshold may act as a prudent benchmark for promoting sound business practices. With interest rates ranging between 16% and 22% for loans, the non-performing asset (NPA) ratio falls within the range of 1.5% to 6%. This limit proves particularly advantageous for emerging enterprises, offering them a structured framework to navigate the initial stages of growth.
Impact of FLDG
The newly introduced guidelines mandate the recognition of loan assets as non-performing assets under the applicable norms, regardless of the First Loss Default Guarantee cover available. This change will have a significant impact on the co-lending portfolios of banks that acquire lenders, increasing reported asset quality metrics and gross credit costs. However, it's important to note that for acquiring lenders that are non-banking financial companies (NBFCs) and already adhere to such NPA recognition under the Indian Accounting Standards (Ind-AS), the impact on NPA recognition would be relatively lower, as they have already incorporated these practices into their existing frameworks.
Conclusion
Under the revised guidelines, the received FLDG amount can no longer be utilised to reduce provisions. While this may pose challenges for banks and lenders, it aims to provide greater transparency and accuracy in assessing the true state of loan assets.
The guidelines will likely pave the way for a more disciplined approach to risk assessment, provisioning, and partnership arrangements, aligning the digital lending industry with globally recognized best practices.
By Shashank Sharma, Director, ScoreMe Solutions