Default Loss Guarantee in Digital Lending

By Swadha Swaroop, 4th year law student at Symbiosis Law School, Noida (Batch of 2025)

Introduction

A regulatory framework has been established by the Reserve Bank of India (RBI) to allow default loss guarantee agreements for digital lenders because of the difficulties encountered during the COVID-19 epidemic, the Reserve Bank of India (“RBI”) was required to supervise the digital lending sector more strictly. Traditional lending and borrowing are heavily regulated by the RBI. The primary difficulties with digital lending are unrestricted third-party involvement, misspelling, data privacy violations, unfair business tactics, the imposition of high interest rates, and unethical recovery techniques. After reviewing the suggestions made by the WGDL, RBI released an official announcement on August 10, 2022 (the “Press Release”). In pursuance of the press release, the RBI published Regulations on Digital Lending in a notification dated September 2, 2022. In these guidelines, it was noted, among other things, that the regulated entities must abide by the Master Direction – RBI (Securitization of Standard Assets) Directions, 2022, which sets forth rules for the industry practise of providing financial products including contracts like First Loss Default Guarantee/ Default Loss Guarantee (“FLDG”/”DLG”), which means that a third party ensures to pay for a specific percentage of default in a loan portfolio of the regulated entities. As per this Master Direction, synthetic securitization was prohibited.

Digital Lending in India

Digital lending is the process of making and collecting loans through websites or mobile applications. Loans are made possible through online services or mobile applications. It allows for faster disbursement and helps to save costs. Lending Service Providers (LSPs) and Non-Banking Financial Companies (NBFCs) collaborate to give credit to clients using the latter’s platform. However, these platforms frequently engage in risky behaviour by lending to borrowers who are unable to repay the money.  

When a borrower defaults on their loan, it means they are unable or unwilling to repay the borrowed amount according to the agreed terms. This can result in financial losses for the lender, such as the principal amount not being repaid, interest payments not received, or other associated costs. In order to protect against these potential losses, lenders may seek a default loss guarantee from a third-party guarantor or insurer. This guarantee serves as a form of risk mitigation, ensuring that the lender will receive compensation to cover some or all of the losses incurred due to borrower default. A default loss guarantee is a type of financial protection or insurance provided by a guarantor or insurer to mitigate the risk of default on a loan or debt obligation. It guarantees the lender or investor that damages will be reimbursed if the borrower or debtor fails to meet their financial obligations.

Scope & Applicability

These guidelines apply to DLG arrangements entered into in ‘Digital Lending’ operations carried out by the following entities: –

(a) All Commercial Banks (including Small Finance Banks)

(b) Primary (Urban) Co-operative Banks, State Co-operative Banks, Central Co-operative Banks and

(c) Non-Banking Financial Companies (including Housing Finance Companies).

Eligibility and Digital Lending Providers

DLG agreements may only be made with regulated businesses and lending service providers (LSPs) with whom they have an outsourced arrangement. The LSP providing DLG services must be incorporated as a company under the Companies Act of 2013. DLG services cannot be provided by entities that are not registered under Companies Act, 2013.

The Circular lays the groundwork for the system to be able to formally handle these loans. Despite the fact that the circular appears straightforward on the surface, there are still some unclear places. Considering this example: Should loan outstanding be calculated daily or monthly? It is still not a win situation for fintech’s and Regulated Entities unless these operational issues are resolved by the RBI.

Digital lenders have been divided into three groups by RBI:

  1. Entities that are regulated by the RBI and are permitted to conduct loan operations.
  2. Entities that are authorised to lend under other statutory or regulatory laws but are not regulated by the RBI.
  3. Entities lending in violation of any law or regulatory provisions.

DLG Guidelines provide that a DLG arrangement that complies with them shall not be deemed a synthetic securitization, hence a DLG arrangement that does not conform with them is prohibited. The RBI set a ceiling of 5% for DLG arrangements on the outstanding loan portfolio from regulated businesses. The means of supplying DLG, such as cash deposits, fixed deposits, bank guarantees, as well as the duration of invocation and the tenor of DLG, are all specifically listed. The fintech sector applauds these DLG Guidelines for putting an end to the market’s ambiguity over FLDG arrangements. Every regulated organisation involved in digital lending will now be required to assess the current FLDG arrangements in accordance with these rules as a first step. 

Requirements of DLG Arrangements

The Regulated Entities and the DLG provider should have a written, binding contract in place to support any DLG agreements. The contract must define the jurisdiction covered by DLG coverage, the manner in which it is maintained, the time period for using DLG, and any other disclosure requirements included in the guidelines.

  • Disclosure requirement 

Regulated parties are required to set up a mechanism to make sure that LSPs with DLG agreements disclose on their websites the total number and value of portfolios to which DLG has been given.

  • Form required for DLG

Regulated entities may only take certain types of DLG, such as cash deposited with the RE, fixed deposits made with a scheduled commercial bank that are secured by a mortgage in the RE’s favour, and bank guarantees in the RE’s favour.

  • Maximum limit of DLG

            According to the RE’s guidelines, the DLG cover on any outstanding portfolio shouldn’t be higher than 5% of the overall loan portfolio. The DLG provider may not assume more than 5% of the performance risk related to the base loan portfolio when implicit guarantees are applied.

  • Treatment of DLG for regulatory Capital

DLG arrangements are subject to the current criteria for capital computation, covering     exposure computation and the advantages of credit risk mitigation.

  • DLG Invocation

The RE requires a maximum overdue duration of 120 days before initiating DLG, providing the borrower makes good on the loss before.

  • Tenure of DLG

The DLG agreement’s tenure shouldn’t be shorter than the tenure of the loan in the underlying loan portfolio with the longest term.

Due Diligence

Before entering into any DLG arrangement, REs must implement a Board-approved policy that covers topics including eligibility requirements for DLG providers, the type and scope of DLG coverage, the monitoring and review procedure, etc. The RBI has specifically indicated that DLG arrangements should not be used as a substitute for credit evaluation procedures and strong credit underwriting norms. The guidelines are unquestionably a step in the direction of a controlled expansion of the digital lending market and an increase in credit penetration via digital lending. It is unclear whether and how much the space will be boosted by REs’ limited capacity to rely on DLG due to the 5% constraint.

Exceptions

Understanding what has been left out is crucial as we examine what the DLG Guidelines clearly and implicitly include under their purview. According to RBI’s clarification, the following guarantees are not included in the definition of DLG:

  • Credit Risk Guarantee Fund Trust for Low Income Housing (CRGFTLIH), individual schemes under National Credit Guarantee Trustee Company Ltd (NCGTC) and Guarantee schemes of Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) 
  • International Monetary Fund (IMF) as well as Multilateral Development Banks as referred to in RBI Master Circular on Basel III Capital Regulation dated May 12, 2023 and Credit guarantee provided by Bank for International Settlements (BIS).

Additionally, Reserve Bank India has made it clear that DLG arrangements that follow the DLG Guidelines won’t be considered “synthetic securitization” or won’t be subject to the “loan participation” requirements.

Operalisation of DLG Agreements

The longest term of the loans in the underlying loan portfolio should not be shorter than the DLG tenor. Prior to engaging into DLG arrangements, REs must make sure that specific due diligence processes, in likewise with a board-approved policy, are carried out (this may also apply to renewals of DLG arrangements). These due diligence procedures must cover (a) the LSP’s eligibility requirements, (b) the scope of DLG coverage, (c) the process of evaluating and reviewing the DLG arrangements, (d) the specifics of any fees (if any) that RE may be required to pay the LSP, and (e) obtaining sufficient information to allow the RE to be confident that the LSP will be able to honour the DLG it has guaranteed(document must contain a declaration from the LSP that is confirmed by a statutory auditor, detailing the total amount of outstanding DLG, the number of Regulated Entities and the number of loan portfolios where DLG offered services, as well as historical default rates on portfolios of loans that are precisely like the one). As a result, REs is able to implement additional due diligence steps over and beyond the aforementioned basic measures since these are effectively the absolute minimum that the RE is required to conduct.

Balance of Risk

The contract length for DLG should be a minimum equal to the loan with the longest tenor in the underlying loan portfolio. Moreover, the total DLG cover for every active portfolio must not be more than 5% of the portfolio’s value. A performance risk for the Eligible DLG Provider that exceeds 5% of the underlying loan portfolio should not be assumed in the case of implicit DLG arrangements. These rules seek to strike a compromise between ensuring that REs bear the majority of the credit risk related to the loan portfolio and giving them a level of comfort that is reasonable throughout the co-terminus period of DLG. The RBI hopes to deter risky lending practices in the market by requiring REs to thoroughly analyse borrowers rather than depending merely on the Eligible DLG Provider. Additionally, risks related to DLG arrangements are supposed to be reduced by the upfront specification and total funding of DLG protection. It is significant to remember that REs continues to be in charge of loan provisioning and NPA classification. The underlying individual loans cannot be offset by the amount of DLG invoked. However, under the provisions of the contract, the RE may share alongside the Eligible DLG Provider the sums successfully recovered from the loans on which DLG has been caused.

Conclusion

The DLG Guidelines are a significant step towards non-disruptive innovation and growth in the lending sector. The RBI has worked hard to support fintech and innovation that are helped by digital lending on the one hand while maintaining its requirements to guarantee there is no systemic risk by reiterating that the RE’s obligations are not weakened in the process. Medium-sized enterprises and small borrowers with poor credit ratings, who were previously unable to access regular bank financing, would also profit from this well-considered decision.

Overall, the DLG rules provide an unambiguous process for loss-sharing agreements and inspires goodwill among stakeholders, marking a significant turning point in the growth of digital lending in India. It will be interesting to see how these rules develop over time and how they affect the stability and expansion of the digital lending sector. Under this arrangement the fintech companies originate to loans and promises to compensate a partner up to a pre-decided percentage if the customer fails to repay. However, the bank NBFC partners lend through the fintech but from their own books. 

REFERENCES

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