A regulatory framework for FLDG (First Loss Default Guarantee) model is expected to be issued as a part of the second round of digital lending norms, and is likely to be more enabling than prohibitive, according to industry sources.

The new norms will look to bring in more accountability, defined risk sharing, role of unregulated entities, appropriate underwriting and loan pricing processes, and guardrails around the amount and type of lending.

Giventhat the fintech industry is nascent and the first set of norms are just six months old, the regulator wants to give companies time to adapt and comply. But as the system is evolving, more sets of regulations will come in, with FLDG as one of the top priorities, people in the know said.

“RBI has said that it’s a complex issue and that a lot of factors need deeper examination,” a person aware of the matter said, adding that the challenge is to introduce it in a way that still serves the purpose without being manipulated.

Risk sharing

The digital lending norms were a knee-jerk reaction to the unscrupulous growth and lending practices that were taking place. Now that such practices have been ploughed back, the regulator is working to figure out the right framework and approach, they added.

Apprehension on part of the regulator pertains to the “renting a licence” model wherein the risk is transferred to unregulated entities in the name of risk-sharing, especially for high value loans, thus posing systemic and data security risks.

“These loans were making a lot of people defaulters and impacting credit scores of people who maybe should not have even got a loan in the first place,” an industry official said, adding that the sense is no one should have a model built on very high risk, especially in the securitised space as it increases the cost for customers, and because no one wants a repeat of the 2007-08 financial crisis.

Digital lending

Digital lenders have presented to the regulator on the urgency of the situation and why allowing the FLDG model is crucial due to the industry being pivoted around it and several companies having built their business models on it. A defined framework will also help reduce compliance costs, aid business expansion and expand the customer base for traditional lenders.

While most players want FLDG to be allowed between regulated entities, some are also hoping for unregulated entities to be included in the framework, albeit with appropriate restrictions and controls.

In the absence of regulatory clarification after the digital lending guidelines became effective from November 2022, fintechs have either stalled operations or started exploring options such as co-lending for small ticket loans, co-branded partnerships and alternative mechanisms.

Even those operating in the grey area experienced a decline in business as regulated entities and partners became risk-averse due to uncertainty regarding the permissibility of FLDG. The norms treated FLDG similarly to synthetic securitisation, which is not allowed for banks and NBFCs, resulting in significant shrinkage in operations.

The FLDG model allowed third-party service providers such as fintechs to compensate lenders for a certain percentage of default in the loan portfolio, thus reducing lenders’ risk. Alternative mechanisms being explored include lending based on the repayment proficiency or collection efficiency where fintechs are paid based on their collection track record, and revenue-sharing model where lenders share the interest income with fintechs, depending on the borrower delinquencies.