Demystifying RBI's Digital Lending Framework

Digital lending has changed the way customers borrow money in India. There was an inclusion of many unregulated individuals in the banking sphere, leading to issues around guarantee arrangement limits which LSPs provided to REs (which could go up to almost 100%). To regulate the previously unregulated default loss guarantee arrangements, RBI issued Guidelines on Digital Lending in 2022 and subsequently in June 2023, released the Guidelines on Default Loss Guarantee in Digital Lending (“DLG Guidelines”). The DLG Guidelines apply to all banks and non-banking financial companies (including housing finance companies) (“REs”). Now, REs or agents of REs (“LSPs”) can operate digital lending applications which can be mobile or web-based applications (DLAs”) that have a user interface providing digital lending services. REs either provide digital lending services themselves on the DLA or through an LSP which can carry out part of the RE’s duties such as customer acquisition, underwriting, pricing, monitoring and recovery. The DLG Guidelines are principally aimed at providing a framework for the RE-LSP partnership model for digital lending.

The first key objective of the DLG Guidelines is to protect borrowers by requiring REs to conduct due diligence before partnering with LSPs and ensuring that they are compliant with relevant laws and technological standards. The DLG Guidelines have stringent provisions on data collection processing and storage. Only data as required for a specific purpose, can be collected on any DLA, which should be accompanied by informing the borrower about the purpose of collection and obtaining their consent (which the borrower shall be able to revoke or deny) for the use of any specific data, third-party access and data retention. Third party access is also strictly limited and can be given only with the consent of the borrower. DLAs can store data for the minimal purpose of carrying out operation and all data must be mandatorily stored on servers in India. Every borrower shall be provided detailed terms of availing the digital lending product. REs must ensure that their privacy policy and a list of the LSPs they have engaged are disclosed on their DLAs and shall inform the borrower about the details of the recovery agent.

The other key objective of the DLG Guidelines is to tighten the framework around default loss guarantees. The DLG guidelines provide the framework for loss sharing agreements between REs and DLG providers. DLGs are defined by the RBI as an agreement between an RE and an LSP or other REs with which it has an outsourcing arrangement, where the LSP compensates the RE for loss due to default up to 5% of the loan portfolio and it includes implicit guarantees. These arrangements are required to be backed by an explicit contract which covers the extent of DLG cover, forms, timelines, and disclosure requirements. DLGs can be invoked within a maximum overdue period of 120 days. Every DLG arrangement should remain in force at least as long as the longest tenor in the underlying loan portfolio. DLGs shall now only be accepted in the form of: (i) cash deposits with RE; (ii) fixed deposits maintained with a scheduled commercial bank with a lien in favour of the RE; and (iii) bank guarantee in favour of the RE.

The DLG Guidelines grant a much-needed regulatory sanctity to arrangements involving default loss guarantees.

The guidelines promote increased transparency in digital lending ensuring that borrowers do not avail digital lending from fraudulent or unauthorised platforms and ensures privacy of borrowers’ data by avoiding the risks of exposure of sensitive information of the borrowers. There is also increased transparency is assessing creditworthiness of the borrower, as REs are now mandated to assess them in an auditable manner. 

While the DLG guidelines help promote digital lending in general, there may be a short-term impact on REs and LSPs. The form of DLGs now requires LSPs to earmark funds up to 5% of the loan portfolio, the impact of which remains to be seen since LSPs would need to be able to provide the DLG in the manner provided under the DLG Guidelines. This may result in a down-turn in the disbursements provided by REs.

The recognition of NPAs in individual loan assets in the portfolio by the RE and consequent provisioning remains in accordance with the extant asset classification and provisioning norms, irrespective of DLG cover available at the portfolio level. The amount of DLG invoked is not permitted to be set off against the underlying individual loans. This may increase the NPAs in the books of certain REs which may lead to an increase in credit costs. This, along with the cap on the DLG may dissuade certain REs from entering into DLG arrangements in sectors which REs may perceive as ‘risky’. In light of the above, whether the DLG arrangements between the REs and LSPs increases exponentially, remains to be seen, however, the DLG Guidelines are a welcome move in providing necessary regulatory clarifications and push to an evolving digital lending industry and economy.

Zeeshan Khan is a Partner and Mallika Jain is Associate at Krishnamurthy & Co (KLaw)