Co-lending is a mechanism devised by the RBI to ensure that low-cost funds of banks is made available to NBFCs that operate in deeper geographies and work in the MSME (micro, small and medium enterprises), EWS (economically weaker sections), LIG (low-income group) and MIG (middle-income group) categories, where banks are slightly shy of lending due to higher operating cost and credit risks.

The primary focus of co-lending is to improve the credit flow to the unserved and underserved segments of the economy. The co-lending model allows NBFCs to seek funds at low cost from banks vide a tie-up arrangement, and requires them to put in the balance 20 per cent from their own sources of fund.

This 80:20 ratio ensures that the NBFC does not originate poor quality loans as their 20 per cent stake would also get impacted with losses that would arise from such origination.

This mechanism ensures a win-win situation for all three parties – borrower, bank and NBFC. Borrowers get the funds at a lower cost than what would have got on a standalone basis from the NBFC. The bank would get better deployment of their funds in the unserved and underserved sector, and the NBFC would have a steady flow of economical and reliable source of funding.

If the model is so good, then what is plaguing its growth?

Complexity of the model: The model requires banks to publish their credit policy for accepting such loans. Further banks and NBFC have to enter into a master agreement pertaining to loan servicing and customer service . There is also a complex accounting methodology that needs to be set up for the three components of co-lending – 80 per cent, 20 per cent and 100 per cent. Separate accounts need to be maintained for the bank, NBFC and borrower.

Demand-supply mismatch in the PSL (priority sector lending) segment: Banks are normally short on the PSL mandate of RBI, and they depend on NBFCs to sell them their loans (since NBFCs do not have such mandate). The supply of PSL loans by NBFCs is far lower than their demand, making the commercial negotiation between the banks and NBFC very lopsided in favour of NBFCs.

NBFCs also keep most of the other earnings by way of processing fees, insurance commissions, additional interest rate, cheque bouncing charges, penal interest.

Curious case of blended cost of fund and borrower’s rate of interest: NBFCs say that they are not sure whether banks would approve a particular loan originated by them for co-lending during the pool selection by banks and, therefore, cannot pass on the benefit of the blended cost to the borrower at the time of origination.

This is a big concern as this uncertainty ends up defeating the purpose of co-lending at lower interest rate as was envisaged by the regulator.

NBFC customer segment does not overlap with bank: The credit profiles of NBFC customers are relatively riskier and, hence, the likelihood of higher credit loss cannot be ruled out. Banks also complain that their ability to absorb higher credit loss is very limited. Banks have very little understanding of the credit risk of the NBFC borrowers.

Regulatory compliances are different for Banks and NBFCs: The regulatory standards for banks and NBFCs are different, hence there are issues around know your customer (KYC) norms, collateral norms. Do these issues make co-lending model unviable? Well, the benefit of the model far outweighs the concerns on both sides. There are solutions that will emerge from these challenges which will hopefully make this model a great success.

Some IT and fintech companies have already come up with the accounting and escrow solution for NBFCs and banks. The demand supply mismatch will solve for itself over time. Unless co-lending takes off, the supply (of PSL loans) will not improve as NBFCs find it very difficult to raise funds for lending. Unless NBFCs grow in scale and prove their ability to manage credit, liquidity risk well, the issue of NBFC scale will not get solved.

Co-lending provides a perfect opportunity to take care of the initial concerns of low-cost funds for lending. As the co-lending model grows, the competition amongst NBFCs will ensure that the blended cost is passed on to the end customer.

On the issue of banks not understanding the credit nuance of this segment, it will get sorted out over time as banks gain experience of managing these acquired portfolios and are able to see the performance of these segments over time. There are guarantee companies in the MSME and home loan space in India that can be leveraged by the banks while defining their risk appetite for the co-lending business with NBFCs, and also taking credit default guarantee up until they are ready to take on this risk on their own.

The terms between banks and NBFCs, as both start to see the benefits, will eventually get settled despite the demand supply mismatch in the PSL sector.

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