According to industry sources, the second round of digital lending norms is expected to include a regulatory framework for the First Loss Default Guarantee (FLDG) model. This framework is anticipated to be more facilitative than restrictive. The new norms aim to enhance accountability, define risk sharing, address the role of unregulated entities, establish appropriate underwriting and loan pricing processes, and set boundaries for the amount and type of lending.

 

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Given that the fintech industry is still in its early stages and the initial set of regulations is only six months old, the regulator intends to provide companies with sufficient time to adapt and comply. However, as the system evolves, additional regulations will be introduced, with FLDG being a top priority, according to informed individuals. They stated that the Reserve Bank of India (RBI) acknowledges the complexity of the issue and the need for a thorough examination of various factors. The challenge lies in implementing the framework in a way that serves its purpose without being manipulated.

The digital lending norms were initially a reactive response to the unethical growth and lending practices prevalent at the time. With those practices largely curtailed, the regulator is now focused on devising the right framework and approach. Concerns of the regulator revolve around the "renting a license" model, where risk is shifted to unregulated entities under the guise of risk-sharing, especially for high-value loans. This poses systemic and data security risks. Such loans led to a rise in defaults and adversely impacted the credit scores of individuals who may not have qualified for a loan in the first place. Industry officials emphasize the need to avoid models based on excessively high risk, particularly in the securitized space, as it increases costs for customers and prevents a recurrence of the 2007-08 financial crisis.

Digital lenders have emphasized to the regulator the urgency of the situation and the crucial role of the FLDG model, which the industry heavily relies on. Numerous companies have built their business models around it. A well-defined framework would also reduce compliance costs, facilitate business expansion, and broaden the customer base for traditional lenders.

While most stakeholders advocate for FLDG to be allowed between regulated entities, some also hope for unregulated entities to be included in the framework, albeit with appropriate restrictions and controls. In the absence of regulatory clarity since the implementation of the digital lending guidelines in November 2022, fintech companies have either halted their operations or explored alternatives such as co-lending for small loans, co-branded partnerships, and other mechanisms. Even those operating in a grey area experienced a decline in business as regulated entities and partners became risk-averse due to uncertainty surrounding the permissibility of FLDG. The norms treated FLDG similarly to synthetic securitization, which is not permitted for banks and non-banking financial companies (NBFCs), resulting in a significant contraction of operations.

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

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