On Thursday, the Reserve Bank of India (RBI) published a circular on something called a First Loss Default Guarantee (FLDG). And in today’s Finshots, we tell you everything you need to know about it and why fintech startups are breathing a sigh of relief.

The Story

Imagine you’re a lender and you have ₹10 crores to dole out. You’ll be a little cautious about who you lend to. You’ll do a proper risk assessment and run background checks. Because if the borrowers default, you’ll be in a soup.

But imagine someone comes to you and says, “Look, I’ll find people for you. I'll do my due diligence to make sure everything is solid. And if you lend to them, you won’t have to worry about a thing. Also, let me put your mind at ease. I take responsibility if anyone fails to pay up. I’ll compensate you for the loss.”

That guarantee sounds fantastic, right? And you’ll be more than happy to lend out the ₹10 crores in such a case.

But why would such an arrangement even exist, you ask?

Okay, let us backtrack a bit.

See, when the fintech boom began in India a few years ago, startups realized quickly that lending was how they’d make money. Interest, late fees, it was all quite lucrative. But first, they needed permission from the RBI to lend. And if there’s one thing you should know about the RBI, it’s that it’s quite conservative. "License to lend" is hard to come by.

So startups did everything they could to get around this.

Some of them used the money raised from VCs to simply acquire existing non-banking financial companies (NBFCs). It was simple and quick. And then they could lend money straightaway.

Others decided to simply enter into partnerships with established players. They became an agent of sorts or basically what’s known as a ‘loan service provider’ (LSP). These fintech startups would do the hard work of acquiring or sourcing potential customers. They’d run checks and use technology to scan through the customers’ transaction history to determine if they’re creditworthy. And then, they’d pass along the details to the partner NBFC or bank. In return, they’d pocket a nice commission.

Basically, they rented out banks and NBFCs for lending purposes.

And then, fintech startups found 3 loopholes to exploit and grow their business.

#1 Prepaid Instruments

See, the RBI only allowed licensed banks to issue credit cards. Even NBFCs can’t issue one. So fintechs decided to use something called Prepaid Payment Instruments (PPI). It would get a bank to issue a card and stamp its logo on it. Then, instead of storing money in the card, the fintech would use an NBFC to add a loan like feature. So when customers would swipe the card, it would behave like a credit card and not a debit card. The business idea was a huge hit.

#2 Pooled Lending

Fintechs didn’t just partner with one NBFC for their lending needs. They had multiple tie-ups. So they’d take all the money and pool it together. Then they’d lend it out to customers from their account. So customers really thought it was the fintech who was lending it money. This way, the fintech could also earn a float or an interest on all the money lying in the pool account. It was quite ingenious.

#3 FLDG

The infamous guarantee system that led to this story.

So, when fintechs handed over customers to banks or NBFCs, some of them offered to guarantee defaults up to 20%. If they sourced loans from the NBFC worth ₹10 crores, the fintech would take the hit for up to ₹2 crores of defaults. That was the ‘first loss’ that was guaranteed. The fintechs wanted the NBFCs to know that they’d done their due diligence and that they trusted their process.

But others even offered guarantees of 100%. It was a humble brag of sorts. A statement of how confident they were in their credit underwriting methods. Fintechs wanted business, and obviously, if banks and NBFCs were guaranteed protection against losses, they’d lend. Everyone won.

But the RBI was quietly watching all these developments from the side. Until they realised it could not go on like this anymore. And slowly but surely, it began to clamp down.

In June 2022, it told fintechs that they can’t load PPIs with credit. It was called ‘prepaid’ for a reason. Some fintechs lost their mojo after the RBI announcement.

It then said that this pooled lending business can’t keep happening. Money has to flow directly from the lender to the borrower and the fintech has no role in between. It was simply a ‘sourcer’. Again, some fintechs were hurt.

And then in September 2022, it said, “Look, this FLDG business has gone on for far too long. Our rules don’t allow this. Please stop.” Overnight, the deals froze.

Fintechs panicked. All the loopholes were being closed. And their business models were being questioned.

But wait, why did RBI not like the FLDG model in the first place? Doesn't the model actually offer banks extra protection in the event of a default? Isn't it stabilizing the banking system as a whole?

Not quite. When everything works well, FLDGs do offer an extra level of protection to banks and NBFCs. Because you know that fintechs will have to bear the loss if they go about their business in a reckless manner. So they have an added incentive to lend prudently. All of which should ideally make RBI very happy. But what happens when things don't go well? What if banks turn lax when lending, considering the FLDG protection? What if the fintech company goes bust? And what happens when fintechs begin losing money and try to compensate for it by passing on most of their costs to the customers? Who bears responsibility then? The RBI will struggle because these fintech companies aren't as tightly regulated. So you can see why the central bank was skeptical of the whole program.

But then it had a change of heart about FLDG. It realized that all fintechs weren’t bad. And that they were actually helping to expand the credit pool by catering to folks that banks and NBFCs otherwise wouldn’t have lent money to.

So it decided to mull it over. It sat and pondered for nearly a year. And finally, it gave the green signal to the FLDG system. Fintechs breathed again!

So, what do the FLDG rules say now?

For starters, a fintech can only guarantee losses up to 5% of the loan size. Not 20% or 100% like before. But at least there’s some clarity now of what is allowed. So, if a bank or NBFC doles out ₹10 crores to customers sourced from these fintechs, the fintechs can now guarantee up to ₹50 lakhs of losses on these loans.

Something is better than nothing, right?

And this might mean that NBFCs and banks could pay a bit more attention to the credit quality of customers that fintechs source. They might add their own inputs. And who knows, it could improve the whole credit check process itself.

Also, fintechs can’t just say, “Hey, if these folks default, come to us and we’ll pay you.” The RBI thinks that if fintechs are so confident about their underwriting, they might as well hand over this guarantee to the bank/NBFC upfront. Maybe in cash. Or even open up a fixed deposit and sign over over the rights of the FD to the NBFC. That way, the NBFC doesn’t have to run around in an attempt to get what was promised.

But, there’s a tricky thing that the bank or NBFC will have to deal with. If a borrower defaults, it’ll still have to classify it as a non-performing asset (NPA). It doesn’t matter if there’s a guarantee from the fintech. On its books, it’s still an NPA. And that won’t make them happy. Their investors won’t like it when they see higher NPAs too. And this could make the lives of banks and NBFCs a little bit tougher. But that’s just the way it’s going to be now.

The FLDG circular is out and everyone will have to play ball.

Until then…

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