The Reserve Bank of India (RBI) has granted permission for a credit-risk sharing arrangement called “first loss default guarantee” (FLDG) between regulated entities and digital lending service providers. FLDG involves a third party guaranteeing compensation for a certain percentage of default in a loan portfolio held by banks and non-banking financial companies (NBFCs).
The RBI stated that it has examined the arrangements between regulated entities and lending service providers, commonly known as FLDG or default loss guarantee (DLG), and has decided to permit such arrangements. It clarified that these arrangements will not be considered “synthetic securitisation” and will not be subject to the provisions of “loan participation”.
Under the guidelines, regulated entities can only enter into default loss guarantee arrangements with lending service providers or other regulated entities with whom they have entered into outsourcing arrangements.
The guidelines require the arrangements to be supported by legally enforceable contracts that specify the extent of cover, the form in which the cover is to be maintained with the regulated entity, and the timeline for invoking the guarantee. Various forms of default loss guarantees allowed for regulated entities include cash deposits, fixed deposits with a lien marked in favor of the entity, and bank guarantees in favor of the entity.
The RBI has set a limit stating that the total amount of default loss guarantee cover on any outstanding loan portfolio should not exceed five percent of that portfolio.
The responsibility for recognizing individual loan assets as non-performing assets and making provisions will lie with the regulated entity. The RBI has instructed these entities to establish a board-approved policy before entering into any default loss guarantee arrangement.
However, the RBI emphasized that the default loss guarantee arrangement should not be seen as a substitute for credit appraisal requirements. Robust credit underwriting standards need to be established regardless of the guarantee. The Digital Lenders Association of India (DLAI) CEO Jatinder Handoo welcomed the RBI’s circular, stating that it provides clarity on the permissible structure for default loss guarantee arrangements, leaving limited room for ambiguity.