Explained– RBI’s New FLDG Guidelines

The Reserve Bank of India (RBI) has recently issued fresh guidelines pertaining to First Loss Default Guarantees (FLDGs). These guarantees serve as credit risk mitigation instruments, offering effective risk reduction for borrowers, fintech firms, and banks, safeguarding them against potential defaults.

In an FLDG arrangement, a Regulated Entity (RE), such as a financial institution or insurance company, agrees to absorb the first losses on a loan sourced by a Lending Service Provider if the borrower defaults. This can help to protect the borrower from defaulting on their loan, and it can also help to make loans more affordable for borrowers.

The Framework

The RBI’s FLDG framework operates in the following way:

1. An LSP originates a loan to a borrower.
2. The fintech/LSP enters into an FLDG arrangement with an RE.
3. The RE agrees to absorb the first losses on the loan if the borrower defaults.
4. The borrower repays the loan to the LSP, plus interest.
5. If the borrower defaults on the loan, the RE pays the first losses to the LSP.

The RBI’s new FLDG framework has a number of features that are designed to protect borrowers, fintechs, and banks. These features include:

• Limits on the amount of the FLDG: The total amount of the FLDG cannot exceed 5% of the underlying loan portfolio. This helps to ensure that the risk of default is not transferred to borrowers in an excessive way. 
• The RE is required to initiate the DLG within a maximum overdue period of 120 days, unless the borrower rectifies the situation before that deadline.
• Transparency requirements: The LSP must disclose the terms of the FLDG arrangement to the borrower before the loan is originated. This helps to ensure that borrowers are aware of the risks and benefits of FLDGs.
• Risk management: The LSP must have a robust risk management framework in place to manage the risk of default on the loan. This helps to ensure that they are not exposed to excessive risk.

How FLDGs Will Benefit Borrowers

For borrowers, FLDGs can provide several benefits. First, FLDGs can help to reduce the risk of default. If a borrower defaults on their loan, the FLDG provider will absorb the first losses. This can help to protect the borrower from financial hardship, and it can also help to preserve their credit score.

Second, FLDGs can make loans more affordable for borrowers. The cost of an FLDG is typically passed on to the borrower in the form of a higher interest rate. However, the higher interest rate may be offset by the lower risk of default.

How FLDGs Will Benefit Fintechs

As LSPs, fintechs can also benefit from FLDGs. FLDGs can help to reduce the risk of default for fintech, which can make it easier for them to obtain funding. This can lead to increased lending activity by fintech, which can benefit borrowers.

In addition, FLDGs can help to improve the credit risk profile of fintech. This can make it easier for fintech to obtain higher credit ratings, which can lead to lower borrowing costs.

How FLDGs Will Benefit Banks

Banks can also benefit from FLDGs. FLDGs can help to reduce the risk of default for banks, which can make it easier for them to lend money to borrowers. This can lead to increased lending activity by banks, which can benefit the economy.

In addition, FLDGs can help to improve the credit risk profile of banks. This can make it easier for banks to obtain higher credit ratings, which can lead to lower borrowing costs.

Overall, the introduction of FLDGs is a positive development for the Indian fintech industry, borrowers, and banks. FLDGs can help to make loans more affordable for borrowers, reduce the risk of default, and improve the credit risk profile of fintech and banks.

What Are the Next Steps?

The RBI’s new FLDG guidelines are a positive step, but there are still some challenges that need to be addressed. For example, the cost of FLDGs needs to be reduced in order to make them more accessible to borrowers. Additionally, the regulatory framework for FLDGs needs to be further clarified.

Despite these challenges, FLDGs have the potential to be a valuable tool for the Indian fintech industry. FLDGs can help to make loans more affordable for borrowers, reduce the risk of default, and improve the credit risk profile of fintech and banks. The new guidelines ensure a regulatory framework for FLDGs, which will help to reduce uncertainty and risk for all parties involved and ensure India’s progress in the digital banking space. 

Sources:
https://www.livemint.com/companies/news/rbi-gives-green-signal-to-first-loss-default-guarantee-fldg-framework-heres-how-will-fintech-banks-nbfcs-benefit-11686244184070.html