Guidelines on Default Loss Guarantee (DLG) issued on June 8, 2023 comes after much deliberation on recommendation provided in the report of the working group on digital lending in Nov ’21 and industry representations.

In the report the group recommended that to prevent loan origination by unregulated entities, regulated entities (REs) should not be allowed to extend any arrangement involving a synthetic structure like FLDG and that REs should not allow their balance sheets to be used by unregulated entities in any form. The report also recommended for providing cap on the FLDG. The recommendation, which was anticipated to turn into regulation, stirred the entire lending ecosystem and uncertainty loomed over fate of FLDG backed loans as the industry awaited formal guidelines from RBI in this regard.

The Digital Lending guidelines issued in Sept ’22, advised that for loans involving FLDG, regulated entities should adhere to the provisions of synthetic securitization contained in the master directions for securitization of standard assets.

These new guidelines provide much needed relief by allowing such DLG arrangements within defined regulatory corners and in consonance with the guidelines on digital lending issued last year.

This write-up aims to cover in brief the key aspects of the guidelines and its impact.

Key aspects of the DLG guidelines

1. DLG (Default Loss Guarantee) arrangements can be entered with LSPs (Loan Service Providers) and other Regulated Entities (REs) with which it has outsourcing arrangement
2. DLG agreement must contain: extent of DLG cover, form of maintaining it with the RE, timeline for DLG invocation, disclosures to be made by LSPs on their website
3. DLG can be in either of the following forms: cash deposit with RE, Fixed Deposit lien marked in favor of RE or, bank guarantee in favor of RE
4. DLG cover on any outstanding portfolio shall not exceed 5% of the loan portfolio
5. Recognition of loan assets as NPA and consequent provisioning to be done irrespective of any DLG cover available at the portfolio level
6. Amount of DLG invoked shall not be set-off against the underlying individual loans
7. Computation of exposure and application of credit risk mitigation benefits on individual loan assets shall continue to be governed by the extant norms
8. DLG to be invoked within a maximum overdue period of 120 days unless made good by the borrower before that
9. Tenor of DLG agreement shall not be less than the longest tenor of the loan in the underlying loan portfolio
10. LSPs which are party to the DLG agreement shall publish on their website- total number of portfolios and respective amount of each portfolio on which DLG has been offered
11. Board approved policy to be put in place before entering into any DLG arrangement
12. Credit underwriting standards should be independent of any DLG cover on the loan portfolio
13. DLG provider to satisfy that it would be able to honor the DLG for which it would have to furnish certificate by statutory auditor confirming the aggregate DLG amount outstanding, number of REs and respective amount and number of portfolios against which DLG has been provided
14. Customer protection and grievance redressal measures of DLG arrangements to be as per extant norms

Impact

• By not allowing the amount of DLG invoked to be set-off against underlying individual loans, entities which earlier could project clean portfolio on the basis of higher coverage/ guarantee of the portfolio, will now have to disclose the actual status of the account irrespective of the guarantee coverage, which might eventually impact the overall credit standing and valuation of the entity
• Restriction on quantum of DLG cover of only up to 5% of loan portfolio might impact their capacity to venture into high risk products and borrowers which otherwise might have potential of higher returns.
• Credit underwriting standards which considered the guarantee attached to the portfolio, would now lead to strict appraisal norms and might eventually lead to increase in the cost of the loan or credit
• Providing for a time limit within which FLDG can be invoked would reduce the probability of non-performance of such contracts and ensure timely enforcement of the guarantee and closure in the books of accounts and portfolio statement of the lender
• With cap on maximum amount of guarantee of up to 5%, the incentive to enter into such arrangements by guarantee providers would be a thing to watch out for

Lenders who were thriving by utilizing such model might look for alternate or additional methods of securing or guaranteeing their portfolio by taking into consideration, the cost, risk and process involved in each such method.

These new guidelines are indeed a relief for entities whose portfolios were built on the basis of such guarantees however; restrictions like not allowing set-off of DLG amount against individual loans, capping of 5% guarantee on total portfolio etc., practical implication and corresponding benefits and challenges of these guidelines will unfold with time.