FLDG Guidelines: A Game-Changer for the Fintech Industry

The Reserve Bank of India (RBI) has recently introduced a set of guidelines that have the potential to revolutionize the fintech industry in India. These guidelines, known as the First Loss Default Guarantee (FLDG) guidelines, provide a regulatory framework for permitting FLDG arrangements in digital lending. The FLDG system is a popular lending model used by fintech companies to partner with banks and non-banking finance companies (NBFCs) in order to cover potential losses that occur when customers default on payments. In this article, we will explore the impact of the FLDG guidelines on lenders, borrowers, and fintech companies, and examine the potential opportunities and challenges that lie ahead.

What is FLDG?

First Loss Default Guarantee (FLDG):

FLDG is a risk-sharing arrangement in the digital lending space. It's a legally-enforceable contract where a fintech company (also known as a Loan Service Provider or LSP) promises to compensate a lender (a Regulated Entity or RE) for a pre-determined loss incurred in the event of a loan default. The idea behind FLDG is to encourage banks and other lending institutions to extend loans to categories they consider high-risk, such as MSMEs, agriculture companies, the blue-collar segment, and borrowers with limited credit history.

The FLDG model works on the principle of risk-sharing. The fintech company, which sources clients for the bank and performs services like loan sourcing, monitoring, pricing, and recovery, also guarantees a portion of the loss if a loan defaults. This guarantee is capped at a certain percentage of the loan portfolio.

Participants in an FLDG Arrangement:

Regulated Entities (REs): These are institutions that have the capital and license to lend money. They are regulated by a governing body, such as the Reserve Bank of India (RBI) in the case of India. REs include banks and non-bank financial companies (NBFCs). They have the financial resources to lend but may lack the technology and client reach to extend their services to certain segments of the market.
Loan Service Providers (LSPs): These are fintech companies that have the technology and client reach to facilitate lending. They use their technological capabilities to source clients, monitor loans, and perform other related services. However, they cannot lend directly as they are not licensed to do so. In an FLDG arrangement, they act as intermediaries between the borrower and the lender (RE). They also provide a guarantee to the lender for a portion of the loss if a loan defaults.

The FLDG arrangement is beneficial for both parties. For REs, it provides a safety net and encourages them to extend loans to high-risk categories. For LSPs, it allows them to participate in the lending process and earn revenue from the services they provide. The end borrower also benefits as they get access to loans they might not have been able to secure otherwise.

REGULATED ENTITES	Lending Service Providers LSP/Fintech
RBI regulated financial institutions that give out loans	RE’s agent that carries one or more of the lenders functions as a part of :
Commercial Banks (including Small Finance Banks)	Customer Acquisition
Primary (Urban) Co-Operative Banks	Underwriting Support
State Co-Operative banks	Pricing Support
Central Co-Operative Banks	Servicing
NBFC (including Housing Finance Companies)	Monitoring
	Recovery

Digital Lending Apps/Platforms (DLA’s)

Mobile/Web-based applications that facilitate digital lending. Includes apps of RE’s as well as those operated by LSP engaged with RE’s for extending credit facilitation services.

Why did RBI stop FLDG earlier?

When the First Loss Default Guarantee (FLDG) scheme was initially introduced, it faced several challenges. Fintech companies, mostly unregulated, were offering banks guarantees that could reach up to 100% of the loan pool. For instance, if a fintech company facilitated a bank with a loan pool of Rs 10 crore, it could offer FLDG to cover up to 10% of the credit risk associated with the loan pool, which is Rs 1 crore. This credit risk guarantee could even reach up to 100%, undertaken by most unregulated fintech companies, without the supervision of the Reserve Bank of India (RBI) as per the outsourcing arrangement.

However, questions arose regarding the fintech companies' ability to handle such high credit risk. Did they have the necessary risk management, debt-to-equity ratio requirement, capital adequacy norms, etc.? Were they prepared for bad loans? According to the regulator, the answer was no. As a result, the RBI imposed a complete ban on FLDGs in August 2022, labeling them as 'synthetic securitisation’.

Nevertheless, less than a year later, the RBI has reintroduced the FLDG model, this time with a new framework and stricter restrictions on how banks and fintech companies can collaborate. The new guidelines have been in effect since June 8, 2023. The impact of these changes is expected to be significant for all stakeholders, including the end borrower.

Understanding FLDG and its Importance

FLDG is a credit-risk sharing arrangement between fintech firms and regulated lenders. It enables fintech companies to partner with banks and NBFCs to extend loans to customers who may not have access to traditional banking services. The fintech firms, with their advanced technology and underwriting capabilities, identify and underwrite the credit risk associated with these customers. In the event of default, the fintech firm covers a portion of the loss incurred by the lender, providing a safety net for both the lender and the borrower.

The introduction of the FLDG guidelines by the RBI is a significant development for the fintech industry. It provides much-needed clarity and regulatory oversight to the FLDG model, ensuring that the risks associated with these arrangements are managed effectively. The guidelines aim to strike a balance between innovation and prudent risk management, promoting responsible lending practices while fostering the growth of the fintech ecosystem.

The Impact on Lenders

The FLDG guidelines have important implications for lenders, particularly banks and NBFCs. These entities can now enter into FLDG arrangements with fintech firms, allowing them to extend loans to customers they may have previously considered high risk or outside their underwriting models. This expands their customer base, improves credit penetration, and promotes financial inclusion.

However, the guidelines also introduce certain limitations and requirements for lenders. One key limitation is the cap on FLDG coverage, which is set at 5% of the loan portfolio amount. This means that fintech firms can guarantee a maximum of 5% of the potential losses incurred by the lender. While this cap provides a measure of protection for lenders, it may limit the extent to which they can rely on FLDG coverage to mitigate risks.

To ensure the validity and enforceability of FLDG arrangements, the guidelines mandate fintech firms to provide hard guarantees to lenders. These guarantees can take the form of cash deposits, fixed deposits maintained with scheduled commercial banks, or bank guarantees. By requiring fintech firms to provide such guarantees, the RBI aims to mitigate the risks associated with the failure of fintech firms and ensure that lenders are adequately protected.

The Impact on Borrowers

The FLDG guidelines have the potential to enhance access to credit for borrowers, especially those who are underserved by traditional financial institutions. Fintech firms, with their advanced technology and alternative underwriting models, can cater to borrowers with limited credit history or those who belong to segments that are considered high risk by traditional lenders.

By partnering with fintech firms, lenders can leverage their underwriting capabilities to assess the creditworthiness of these borrowers and extend loans to them. The FLDG coverage provided by fintech firms acts as a safety net, mitigating the risks associated with lending to these segments. This opens up new opportunities for borrowers who were previously excluded from the formal credit system, enabling them to access much-needed financial services.

However, it is important to note that the FLDG guidelines also emphasize the responsibility of lenders in identifying individual loan assets as non-performing assets (NPAs), irrespective of the FLDG cover. This ensures that lenders maintain rigorous risk management practices and accurately assess the performance of their loan portfolios. Borrowers should be aware that the FLDG coverage does not absolve them of their obligation to repay the loans and meet their financial commitments.

The Impact on Fintech Companies

The FLDG guidelines have both positive and negative implications for fintech companies. On the positive side, these guidelines provide a clear regulatory framework for FLDG arrangements, enhancing the credibility and trustworthiness of fintech firms. This regulatory oversight is crucial for establishing partnerships with regulated lenders and attracting investments from domestic and international sources.

However, the cap on FLDG coverage at 5% poses challenges for fintech firms, particularly smaller players in the industry. This limitation may restrict their ability to underwrite loans to higher-risk borrowers or those with limited credit history. Fintech firms may need to reassess their business models and strategies to align with the new regulations and find innovative ways to manage risks within the prescribed limits.

The FLDG guidelines also require fintech firms to make strict disclosures regarding their guarantees. This promotes transparency and accountability in the industry, ensuring that borrowers and lenders have access to accurate information about the FLDG coverage provided by fintech firms. These disclosures enable borrowers to make informed decisions and lenders to assess the risks associated with FLDG arrangements.

Prospective Outlook

The introduction of the FLDG guidelines by the RBI marks a significant milestone for the fintech industry in India. While these guidelines bring some challenges, they also open up new opportunities for lenders, borrowers, and fintech companies. The guidelines promote responsible lending practices, enhance credit penetration, and foster financial inclusion. They provide a regulatory framework for FLDG arrangements, ensuring that risks are managed effectively and that borrowers and lenders are protected.

As the fintech industry adapts to the new regulations, we can expect to see innovative solutions and partnerships emerge. Fintech firms will need to develop strategies to operate within the prescribed limits of FLDG coverage while continuing to serve underserved segments and cater to the evolving needs of borrowers. Lenders will have the opportunity to expand their customer base and improve credit penetration by leveraging the underwriting capabilities of fintech firms. Overall, the FLDG guidelines have the potential to reshape the fintech landscape in India, promoting sustainable growth and financial inclusion.

In conclusion, the FLDG guidelines introduced by the RBI are a game-changer for the fintech industry. These guidelines provide a regulatory framework for FLDG arrangements, enhancing transparency, accountability, and risk management in the lending ecosystem. While there are challenges to navigate, the guidelines offer opportunities for lenders to extend credit to underserved segments, borrowers to access financial services, and fintech companies to innovate and grow. As the fintech industry adapts to the new regulations, it is poised to make a significant impact on the Indian financial landscape, driving financial inclusion and fostering economic growth.

RBI's FLDG Guidelines: A Revolutionary Leap for India's Fintech Industry