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Home Shardul Amarchand Mangaldas & Co New legal framework for default loss
guarantees to boost digital lending
 * Shardul Amarchand Mangaldas & Co


NEW LEGAL FRAMEWORK FOR DEFAULT LOSS GUARANTEES TO BOOST DIGITAL LENDING

By Shubhangi Garg and Arjun Khandelwal, Shardul Amarchand Mangaldas & Co
28 July 2023
0
694

The Reserve Bank of India (RBI) on 8 June 2023, published a new regulatory
framework, permitting the issue of default loss guarantees in digital lending
(DLG guidelines). This is a significant departure from the RBI’s previous
position of restricting default loss guarantees (DLG) by lending service
providers (LSP) in favour of regulated entities (RE), typically banks and
non-banking financial companies.

Shubhangi Garg
Partner
Shardul Amarchand Mangaldas & Co

In the digital lending world, a first loss default guarantee (FLDG) is a
risk-sharing arrangement in which the non-regulated LSP agrees to absorb any
losses, up to an agreed amount, should there be a default by an identified pool
of underlying borrowers who have come together through such LSP. The original
recommendations of the working group on digital lending in August 2022
completely prohibited all forms of FDLGs. The RBI issued a more comprehensive
set of regulations for digital lending in September 2022, disallowing most
common forms of FLDGs, especially structures similar to synthetic
securitisation. Synthetic securitisation is a structure where the credit risk of
an underlying pool of exposures is wholly or partially transferred through
credit derivatives or credit guarantees, hedging the credit risk of the
portfolio remaining on the balance sheet of the lender.

The DLG guidelines now provide a framework for issuing, monitoring and
disclosing DLGs issued by LSPs. Interestingly, implicit guarantees or
contractual arrangements providing credit enhancement or off-balance sheet
support to REs that are linked to the performance of the RE’s loan portfolio
will be treated as DLGs.

The DLG guidelines prescribe key elements that must be included in an express
and legally enforceable contract between the RE and the DLG provider. These
include:

 a. Extent of DLG cover (aggregate DLG cover amount for any outstanding
    portfolio which is specified upfront, cannot exceed five per cent of the
    total loan portfolio amount identified upfront);
 b. DLG cover that is to be maintained with the RE can only be in the form of
    cash deposited directly with the RE, fixed deposits held with a scheduled
    commercial bank and with a lien created in favour of the RE, or a bank
    guarantee issued in favour of the RE;
 c. The time limit for REs to invoke DLGs is 120 days from the date of a
    continuing default.
 d. REs must establish systems ensuring the LSPs with which they have a DLG
    arrangement publicly disclose on their website the number of portfolios and
    the amount in each portfolio on which DLGs have been extended. While this
    will ensure greater transparency, it will also pose practical challenges for
    LSPs as they will have to disclose their commercial DLG arrangements with
    all partners.
    
    
    
    Arjun Khandelwal
    Associate
    Shardul Amarchand Mangaldas & Co

Before concluding any DLG arrangement, REs must establish a board approved
policy. This policy must include essentials such as the eligibility criteria for
DLG providers, the scope and nature of DLG coverage, procedures for monitoring
and evaluating DLG arrangements and the details of any fees payable to DLG
providers.

Whenever REs enter into a new DLG arrangement or renews an existing one, they
must collect sufficient information to ensure that entities offering DLG are
capable of fulfilling their obligations. This should include, at a minimum, a
declaration from the DLG provider, verified by its statutory auditor, of total
outstanding DLG amounts, the number of REs involved, the number of portfolios
covered by DLG and historical default rates on similar portfolios.

The DLG guidelines mark a significant shift in the RBI’s stance towards DLGs.
Under the previous guidelines, several digital lending players began
restructuring their businesses. These regulations will be a lifeline for LSPs
and for borrowers not traditionally serviced by REs because of a lack of
collateral or sureties. The cap of five per cent on DLGs on an upfront
identified portfolio will need some reworking as several LSPs usually provide
and calculate this cap on a running basis on the outstanding portfolio at any
given point in time.

The RBI’s decision to allow limited forms of DLGs and to establish comprehensive
guidelines demonstrates a more nuanced approach to balancing risk and innovation
in the digital lending sector. The guidelines should enhance transparency,
enforceability, and stability, to the ultimate benefit of lenders and borrowers
in the digital lending ecosystem.

Shubhangi Garg is a partner and Arjun Khandelwal is an associate at Shardul
Amarchand Mangaldas & Co.

Shardul Amarchand Mangaldas & Co

Amarchand Towers, 216, Okhla Phase III,
Okhla Industrial Estate Phase III,
New Delhi, Delhi 110020
Executive Chairman:
Shardul Shroff
Managing Partner:
Pallavi Shroff and Akshay Chudasama

Contact details:
T: +91 11 4159 0700
E: Connect@AMSShardul.com

New Delhi | Mumbai | Gurugram | Chennai | Bengaluru | Ahmedabad | Kolkata


 * TAGS
 * Arjun Khandelwal
 * Blockchain
 * Cryptos
 * E-commerce
 * Fintech
 * First Loss Default Guarantee (FLDG)
 * Reserve Bank of India (RBI)
 * Shardul Amarchand Mangaldas & Co
 * Shubhangi Garg

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