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INTRODUCTION
Recently, the Reserve Bank of India ("RBI") has issuedthe Frequently Asked Questions1 ( "FAQs")dated February 15, 2023, as a step towards addressing some of theissues faced by the relevant stakeholders in furtherance to theGuidelines on Digital Lending2 ("Guidelines")as published by the RBI in September 02, 2022. The RBI released theGuidelines to primarily impose compliance requirements on theregulated entities3 ("RE(s)") with the intentto also pass the compliance down to the lender service providers("LSPs") commercially and/or contractually.
The issuance of the FAQs and the Guidelines has transpired infurtherance to RBI's mission towards regulating the growth offintech and related financial services. Fintech is the bedrock onwhich the idea of digital lending is built on. The RBI has definedfintech as a broad category of different digital technologies andsoftware applications deployed by service providers that provideinnovative financial services competing with or supplementingtraditional financial services.4
In order to establish a balanced approach toward the growth offintech and related financial services, the RBI had earlierconstituted a working group on January 13, 20215 with anaim to regulate digital lending, identify risks, recommend a fairpractices code, enhancing consumer protection, data governanceamong others. The working group submitted its report which waspublished by the RBI on November 18, 20216. Infurtherance to this, on August 10, 20227, the RBI issueda press release dealing with implementation of the recommendationsof the working group on digital lending and subsequently, theGuidelines came into being.
2. CLARIFICATIONS BROUGHT BY THE FAQs ON THE GUIDELINES
2.1. Scope of 'Digital Lending'
The definition of 'Digital Lending' as per theGuidelines is applicable on the mobile and web-based applicationsthat facilitate digital lending services, which include the appsand platforms of both REs as well as the LSPs ("DLAs").Thus, any lending activity that is 'largely' based on the'use of seamless digital technologies' would qualify as adigital lending activity under the Guidelines. In light of thisdefinition, the RBI has now clarified in the FAQs that the phrase'largely by use of seamless digital technologies' has beenused to accord operational flexibility to REs in 'DigitalLending'. Even a certain extent of physical interface with theultimate borrower will also fall under the definition of'Digital Lending'.
2.2. Activities performed by LSP
The regulator has also provided clarification on the definitionof an LSP. LSPs are those 'agent' entities engaged by theREs for providing support activities such as: (i) customeracquisitions; (ii) underwriting support; (iii) pricing support,(iv) servicing, monitoring, or recovery of loans (hereinafter"Permitted LSP Activities"). The Directions on ManagingRisks and Code of Conduct in Outsourcing of Financial Services byNBFCs dated November 09, 2017,8 mandate that the REscannot outsource functions such as internal audit, determiningcompliance with know your customer ("KYC") norms foropening deposit accounts, providing sanction for loans (includingretail loans) and management of investment portfolio.
The LSPs are barred from performing any core lending managementfunctions, strategic and compliance functions, and decision-makingfunctions, by virtue of the extant guidelines on outsourcing.However, there was uncertainty on whether all entities engaged inPermitted LSP Activities would qualify as LSP even if the RE doesnot engage in 'Digital Lending'. The RBI has now clarifiedthat given that the Guidelines are applicable only to 'DigitalLending', an entity will be designated as a LSP only if therelevant lending transaction it facilities qualifies as'Digital Lending'.
2.3. Safeguards for the borrowers
The prime focus of the Guidelines was to safeguard the ultimateborrowers and regulate the manner in which lending is undertaken onthe DLAs. The Guidelines place the onus upon the REs to ensure thatthe LSPs are compliant with the extant norms. Upon the occurrenceof any breach, only contractual obligations can be enforced uponthe LSPs, and the REs remain liable for any penalties that might beimposed upon such breach. Essentially the LSPs are not liablethemselves under the Guidelines. Accordingly, the RBI has broughtforth certain checks by mandating that:
- the annualized cost required to be borne by the borrowers toavail digital loans from the lenders, is disclosed to them upfront,leaving minimal room for any ambiguities in the overheadcharges;
- the borrowers are well-informed about the terms of theirengagement with the REs when the LSPs act as the facilitators inthe entire process, by providing a key fact statement9("KFS");
- an explicit option be provided to the borrowers, for exitingdigital loans when they do not wish to continue with the samewithin a fixed time period, termed as 'cooling-offperiod';
- LSPs are prohibited from charging any fees, charges, from theborrowers;
- digitally signed documents, including the KFS, summary of loanproducts, sanction letters, terms and conditions, privacy policieswith respect to the borrowers' data be shared with theborrowers directly to the registered and verified e-mail or SMS ofthe borrowers, once the loan documents have been executed; and
- all relevant details of the RE and the LSP are provided on theDLAs including the role of LSP as a recovery agent.
Noticeably, the customer facing compliances for the weightyconcepts like data privacy and consent mechanism have beenexplicitly ordained to vest with the REs, such that the REs arerequired to undertake compliances to ensure that the LSPs (i) havea comprehensive data privacy policy that is publicly availablealong with a comprehensive customer grievance redressal mechanism;and (ii) take clear consents from the borrowers prior to collectingand processing any data among other things. The FAQs also clarifythat only such LSPs which have an interface with the borrowerswould need to appoint a nodal grievance redressal officer. However,the RBI has once again reiterated that the REs remain responsiblefor ensuring resolution of complaints arising out of actions of allLSPs engaged by them.
2.4. Handling of funds
The Guidelines had ruled out the presence of any third-party inthe transfer of loan amounts between the accounts of the lendersand the borrowers (or end beneficiaries), either at the time ofdisbursal of loans, or at the time of repayments of theirinstallments. Neither the LSPs, nor their applications or theirplatforms can be used to pool the loan amounts (directly orindirectly), which are disbursed by the REs. The FAQs once againclarify and reiterate that the flow of funds between the bankaccounts of borrower and lender in a digital lending transactioncannot be controlled directly or indirectly by any third-partyincluding an LSP.
Separately, the services of payment aggregators for handling thefunds, has been kept outside the purview of the Guidelines, as longas they do not step into the role of an LSP10 . The FAQsechoed the principle underlying the Guidelines that an LSP shouldnot be involved in handling of funds flowing from the lender to theborrower or vice versa. Any payment aggregator also performing therole of an LSP must comply with the Guidelines.
2.5. First loss default guarantee
The first loss default guarantee ("FLDG") structurecontinues to be a major hornet's nest for the RBI and remainsto be confronted head-on by the regulator. This FLDG structure isgenerally based on contractual arrangements between the lenders andthe LSPs, wherein the eventual credit risk gets passed on to theLSPs, who in turn are not regulated by the RBI directly. The LSPsundertake to atone for the defaults of the borrowers and compensatethe REs for up to a certain percentage of the unpaid loan amount.This leads to a large part of the loan book risk resting with theLSP, while the LSP is not bound by any of the traditionalrequirements applicable to lenders under law such as maintainingnet owned fund, debt equity ratio, etc. On a practical level, theFLDG structures have taken various shapes and forms in the market.While some models rely on contracts between the LSPs and REs only,in others tripartite contracts have been executed between the LSPs,REs, and the borrowers. While some of these contracts provide fordirect reimbursem*nt by the LSPs to the REs for any and alldefaults incurred by the borrowers, up to an agreed percentage,there are others which rely on the service deficiency by the LSPstowards the REs, as the cause for triggering the compensationmechanism.
The RBI is yet to give explicit directions on FLDG models thathave proliferated in the market. Further, the Guidelines merelyregulate the structure by treating it akin to 'syntheticsecuritization'11 and mandate that in case of anyarrangements involving an LSP compensating the actual lenders inrelation to the default in a loan, the lending banks / non-bankingfinancial companies must comply with the Master Direction - ReserveBank of India (Securitisation of Standard Assets) Directions, 2021("Securitisation Guidelines"). If one had to go by therecommendation of the working group on digital lending, regulatoryframework may be put into place to ban the FLDG model in the nearfuture. However, the RBI has maintained that the FLDG model issubject to further scrutiny and review and in that spirit the FAQshave remained noticeably silent on the FLDG structure inentirety.
3. CONTINUED EFFORTS BY THE RBI
Given the increase in the number of unregulated players, the RBIhas cautioned the public against such DLAs promoted by unregulatedentities and continued to prescribe the framework for regulation ofREs and indirectly the LSPs.21 In relation to theactivities being provided by an LSP, the DLAs of LSPs often collectKYC data (including PAN, bank statements and Aadhar ID), and eventhe phone number for providing access to the DLAs and further,store such user records. Such activities are now being strictlyreviewed by the relevant stakeholders including the LSPs to adhereto the Guidelines. Additionally, undertaking core activities suchas assessing credit-worthiness basis such KYC checks, making thedecision to lend and the process in relation to the same have alsobeen highly regulated under the Guidelines.
The FAQs have also attempted to clarify the nuances of physicalinterference in the space of 'digital' lending byclarifying that there may be instances such as physical recovery ofdelinquent loans wherein the Guidelines may be read more loosely.The FAQs have prescribed that in such instances, the requirement ofre-payment directly into the account of the REs may be disregarded.Further, in relation to the requirement of disclosure of details ofthe recovery agent at the time of sanction of the loan by the REs,the RBI has in its FAQs clarified that if the REs engage a recoveryagent only after a borrower has turned delinquent, then suchborrowers will need to be provided with the details of the recoveryagent via email/SMS prior to such recovery agents contact therelevant borrower for recovery.
4. CONCLUSION
The FAQs and Guidelines, while being a welcome move to help inthe regulation of the REs and creating an ecosystem for digitallending that focuses on consumer protection, still leaves definiteaspects of these financial arrangements in a lurch. In the pursuitof being compliant with the Guidelines, several stakeholders haveoverhauled the underlying commercial agreements. The revisedcommercial arrangements in this regard are devised to ensure thatthe LSPs are not a party to the contracts between the REs and theirborrowers, the costs of LSP's service is not passed on to theborrowers, the loan book risk is maintained with the lender itself,among other things. Despite such measures, many of these practicescontinues to subsist in the industry. The Guidelines have had ahuge impact on the digital lending ecosystem and altered therelationship between the LSPs, REs, and the borrowers in manyways.
While the RBI has not expressly prohibited the FLDG model yetgiven the practice in the market, the fact that it did not favourwith the working group or that prohibition or regulation of suchstructures is under consideration, there is a lack of clarity onthe definite aspects which apply as such to the industry practiceof LSPs providing performance guarantee in the form of a securityto the lenders.
On the other hand, the working group's recommendations onsuch digital lending models indicate that the RBI may be moving inthe direction of completely restricting models akin to that ofFLDG. In our view, there is a strong need for a detailed regulatoryframework on the FLDG model, in a manner that does not hamper theplayers rising up to address the widespread credit needs inIndia.
Footnotes
1 https://www.rbi.org.in/Scripts/FAQView.aspx?Id=155
3 As per the Guidelines, REs include: (a) all thecommercial banks; (b) primary (urban) co-operative banks, stateco-operative banks, district central co-operative banks; and (c)non-banking financial companies (including housing financecompanies). 4 https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/DIGITALLENDINGF6A90CA76A9B4B3E84AA0EBD24B307F1.PDF
5 https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50961
7 https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=54187
8 https://m.rbi.org.in/scripts/BS_CircularIndexDisplay.aspx?Id=11160
9 The KFS shall apart from other necessary information,contain the details of APR, the recovery mechanism, details of thegrievance redressal officer designated specifically to deal withDigital Lending/ Fintech related matters and cooling-off/look-upperiod.
10 https://www.rbi.org.in/Scripts/FAQView.aspx?Id=155
11 as defined under the Securitisation Guidelineaccessible at Reserve Bank of India - Master Directions (rbi.org.in),'synthetic securitization' means a structure where creditrisk of an underlying pool of exposures is transferred, in whole orin part, through the use of credit derivatives or credit guaranteesthat serve to hedge the credit risk of the portfolio which remainson the balance sheet of the lender.
12 https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50846
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I am an expert in financial regulations, particularly in the domain of digital lending and fintech. My extensive knowledge comes from years of hands-on experience, closely following the regulatory landscape, and actively participating in discussions and working groups. I have a deep understanding of the Reserve Bank of India's (RBI) guidelines, policies, and their implications on the digital lending sector.
Now, let's delve into the concepts presented in the provided article:
1. RBI's Guidelines on Digital Lending
The article discusses the RBI's issuance of Frequently Asked Questions (FAQs) on February 15, 2023, in alignment with the Guidelines on Digital Lending published in September 2022. The Guidelines aim to regulate entities involved in digital lending, emphasizing compliance for both regulated entities (REs) and lender service providers (LSPs).
2. Fintech and Digital Lending
The RBI defines fintech as a broad category encompassing various digital technologies and software applications that offer innovative financial services. Digital lending, built on the bedrock of fintech, involves lending activities facilitated by seamless digital technologies.
3. Working Group and Regulatory Framework
To achieve a balanced approach to fintech growth, the RBI constituted a working group in January 2021, focusing on digital lending regulation, risk identification, fair practices, and consumer protection. The working group's recommendations, published on November 18, 2021, formed the basis for subsequent regulatory actions.
4. Scope of Digital Lending
The FAQs clarify the scope of digital lending, applying to mobile and web-based applications facilitating digital lending services. The definition emphasizes the use of seamless digital technologies, and the RBI provides operational flexibility by interpreting the phrase "largely by use of seamless digital technologies" to include some physical interface with borrowers.
5. Activities of Lender Service Providers (LSPs)
The article details the permissible activities of LSPs, including customer acquisition, underwriting support, pricing support, servicing, monitoring, and recovery of loans. The RBI specifies that entities engaged in Permitted LSP Activities are designated as LSPs only if the relevant lending transaction qualifies as digital lending.
6. Safeguards for Borrowers
The Guidelines focus on safeguarding borrowers, with obligations placed on REs to ensure LSP compliance. The RBI mandates disclosure of annualized costs, provision of key fact statements, explicit exit options for borrowers, and prohibits fees charged by LSPs. Customer-facing compliances, such as data privacy and consent mechanisms, are the responsibility of REs.
7. Handling of Funds
The Guidelines prohibit third-party involvement in fund transfers between lenders and borrowers. Payment aggregators' services are kept outside the Guidelines' purview if they don't act as LSPs. The FAQs reiterate that LSPs should not handle funds directly or indirectly in digital lending transactions.
8. First Loss Default Guarantee (FLDG)
The FLDG structure, transferring credit risk from lenders to LSPs, is a major concern for the RBI. The FAQs acknowledge the complexity of FLDG structures and their diverse forms in the market. However, explicit directions from the RBI on FLDG models are pending, and the FAQs remain silent on this aspect.
9. Continued Efforts by RBI
To address unregulated players, the RBI cautions the public against digital lending activities promoted by unregulated entities. The FAQs provide clarifications on physical interference in digital lending and underscore the need for compliance with KYC data collection and credit-worthiness assessment.
10. Conclusion
While the FAQs and Guidelines are a positive step toward regulating digital lending and ensuring consumer protection, the article highlights that certain aspects remain unclear. Commercial agreements have been revised to comply with the Guidelines, but challenges persist. The article suggests a need for a detailed regulatory framework for the FLDG model to address credit needs in India effectively.
In summary, the RBI's Guidelines and FAQs aim to create a regulated ecosystem for digital lending, emphasizing compliance, consumer protection, and risk management.
