FLDG explained: New rules, changes, and how the new framework impacts borrowers, fintechs

Seems like everyone in the fintech community is talking about ‘FLDG’.

On Thursday evening, the Reserve Bank of India (RBI) revived the popular bank-fintech partnership model for digital lending, commonly known as First Loss Default Guarantee (FLDG). The new framework comes with a new set of rules and stringent dos and don'ts for fintechs and banks and will have a significant impact on all stakeholders, including the end borrower.  

Here is all you need to know about FLDG: 

What is FLDG?

Let’s first understand why banks and non-bank financial companies (NBFCs), known as 'regulated entities' (REs), and fintechs, known as 'loan service providers' (LSPs), came together. While banks have the capital and licence to lend, fintechs have the technology and client reach. 

Banks are hesitant to extend loans to categories they consider as carrying high risks (bad loan probability) and having asymmetric financial information. These include MSMEs, agriculture companies, the blue-collar segment, and borrowers with limited credit history. 

In an FLDG arrangement, fintechs, which cannot lend directly, can get banks clients, perform certain services (such as sourcing loans, monitoring, pricing, and recovery), and—if the loan goes bad—guarantee a part of the loss up to a certain percentage.

The idea of sharing the risk with a fintech partner encourages banks to extend loans to the unserved from a larger customer pool.

Why did RBI stop FLDG earlier?

When the FLDG scheme was launched, there were issues around the guarantee arrangement limit that fintechs (mostly non-regulated) provide to banks, some even going up to as high as 100%. 

Let’s understand what this means. A fintech/LSP facilitates a bank with a loan pool of say Rs 10 crore. It offers FLDG to compensate up to 10% of the credit risk associated with the loan pool, i.e., up to Rs 1 crore, in the risk of loss.

This credit risk guarantee earlier went up to 100%, undertaken by most of the unregulated LSPs, in the absence of RBI supervision as per the outsourcing arrangement. 

Were the fintechs capable of taking such a high credit risk? Did they have the required risk management, debt-to-equity ratio requirement, capital adequacy norms, etc.? Were they prepared for bad loans? No, as per the regulator. 

The RBI imposed a complete restriction on FLDGs in August 2022, calling them 'synthetic securitisation’. However, less than a year later, the central bank has revived the FLDG model with a new framework and stricter restrictions on how banks and fintechs can partner. 

Who sources the loan? 

The fintech i.e. the LSP would source the loan/borrower. It could be done via a digital lending app, which could be a partner app or an in-house platform. 

What guarantees do fintechs cover?  

The default guarantee by fintechs has been capped at 5% of the portfolio amount. 

Taking the previous example, the risk of loss will be up to 5% i.e. Rs 50 lakh for the loan pool, collectively of Rs 10 crore, serviced for the bank. 

Second, fintechs will have to give hard guarantees to banks. The exposure will have to be secured by the fintech through a cash deposit—a fixed deposit (FD) maintained with a scheduled commercial bank with a lien (security interest over a property) or a bank guarantee marked in favour of the RE.

This ensures that the fintech company backing the guarantee is financially capable of fulfilling its obligations if a default occurs.

What are the other rules? 

The RBI has mandated fintechs to make strict disclosures. For instance, LSPs will have to publish, on their website, the total number of portfolios and the respective amount of each portfolio on which FLDG has been offered.

Some of the due diligence requirements are: 

• REs shall put in place a board-approved policy before entering into any FLDG arrangement. Such a policy shall include the eligibility criteria for the FLDG provider, the nature and extent of the cover, the monitoring and reviewing process, and the details of the fees, if any, payable to the default loss guarantee (DLG) provider.

• Robust credit underwriting standards need to be put in place irrespective of DLG cover. 

• Every time an RE enters into or renews an FLDG arrangement, it shall obtain adequate information to satisfy itself that the entity extending DLG would be able to honour it. This includes a declaration from the DLG provider, certified by the statutory auditor on the aggregate FLDG amount outstanding, the number of REs, and the number of portfolios against which the DLG has been provided. The declaration shall also contain past default rates on similar portfolios.

Who is accountable for NPAs?

Lenders are accountable for identifying individual loan assets as non-performing assets (NPAs) or loans that are not paid on time, irrespective of the DLG cover. 

Industry experts YourStory spoke to say this would bring out a better/actual view of digital lending NPAs and reduce any erstwhile leniency by REs towards underwriting.

Who does the underwriting? 

As per the guidelines, the RE has to ensure it has a robust credit underwriting framework. 

Can non-regulated entities be a part of FLDG arrangements? 

Yes. FLDG arrangement can be between:

a) RE and LSP (unregulated)

b) Two regulated entities

Regulated entities include commercial banks, small finance banks, cooperative banks, and NBFCs (including housing finance companies).

How long does the agreement last? 

The duration should be at least as long as the longest tenor of the loans in the underlying loan portfolio.

How does this impact the borrower? 

Fintech lenders will be able to serve borrowers with lower credit scores or limited credit histories (such as blue-collar workforce, MSMEs, students, and agriculture units) via this arrangement with banks.

Further, the new guidelines mandate stronger customer protection measures, along with high transparency (lenders will have to disclose their portfolios on their websites). 

How would it impact fintech companies? 

The majority of the fintechs YourStory spoke to, as well as views on social media, say a 5% cap is comfortable as it is better than 0% and allows the revival of business that has been floundering for the past nine months. 

Low FLDG is also good as fintechs have always struggled with capital that would get locked in, according to a digital lending expert.  

Industry leaders say that fintechs with low credit losses accumulated over the last 24 months will benefit the most. Serious supply partners will be happy to partner while it may be a little difficult for smaller fintechs due to the hard guarantee (cash, FD etc.) condition. 

The arrangement opens up the market for early-stage fintechs, which can partner with banks and NBFCs and source loans for them without having to wait for an NBFC licence. Many anticipate funding in digital lending fintechs to increase in the near future as investors gain clarity. 

On the flip side, the scrutiny of fintech business is set to increase as REs will be underwriting the arrangement. They can attempt to have a greater squeeze over revenue share between them and the partner fintech. 

The new guidelines have come into effect from the date of the circular issues, i.e. June 8, 2023. 

Cover image and infographics by Nihar Apte.