The guidelines on first loss default guarantee (FLDG) in digital lending, announced by the Reserve Bank of India (RBI) on June 8, 2023, helps resolve ambiguity around its use by banks and non-banking financial companies (NBFCs) as part of their co-lending arrangements. It also provides much-needed regulatory sanctity, even though there could be a near-term impact on business volume.

Furthermore, permitting lending service providers (LSPs) to offer FLDG will enable lenders to continue working with non-NBFCs and non-regulated entities provided they are incorporated as a company.

However, the RBI has tightened norms on the extent and form of FLDG cover, and recognition of non-performing assets (NPAs) in partnership models. These include limiting FLDG to 5% of loan portfolio and not allowing corporate guarantees as a form of FLDG. This could dampen business volume in segments where FLDGs are currently higher than the permissible limit.

Says Ajit Velonie, Senior Director, CRISIL Ratings, “We estimate that a substantial proportion of partnership/co-lending arrangements where FLDG is present — especially those with unsecured personal loan and business loan lenders - currently carry an FLDG cover of above 5%. These segments would be affected by the new guidelines. On the other hand, secured asset classes such as home loans and loan against property, where FLDG is typically within 5%, may not see much impact.”

Additionally, the guidelines explicitly require recognition of loan assets as NPAs, in line with norms otherwise applicable to such loans, with the attendant provisioning, and irrespective of the FLDG cover available/invoked.

This change will have an impact on the co-lending portfolio of banks, that are acquiring lenders¹ , because reported asset quality metrics and gross credit costs would increase. Some acquiring lenders, that are NBFCs, were already following such NPA recognition under Ind-AS accounting and hence the impact on NPA recognition for these NBFCs should be lower.

But with the FDLG amount invoked and received no longer permitted to be used to reduce provisions, they, too, will see some increase in reported credit costs. However, there won’t be an overall impact on reported profits as the FLDG amount received will now be reckoned as a part of income.  

Consequently, changes such as the cap on FLDG cover and NPA recognition could dissuade some acquiring lenders from entering into partnerships in the higher-yielding segments, thereby leading to a preference for relatively less risky customer and asset segments. That, in turn, would limit growth of assets under management through the partnership mode for sourcing-NBFCs operating in higher yielding segments. 

Another important provision in the new guidelines is that non-cash forms of FLDG - other than bank guarantees -have been disallowed. Given that a reasonable proportion of FLDG is understood to be in the form of corporate guarantees, this could necessitate additional fund-raising by the sourcing-NBFCs involved.

Says Subha Sri Narayanan, Director, CRISIL Ratings, “With the guidelines coming into effect immediately, we expect the co-lending market to see a drop in volumes in segments with relatively higher FLDG as the industry adjusts to the new normal. The market may see sourcing lenders adapting their business models to align with the revised regulations. For instance, in some asset classes, a higher hurdle rate²  could be offered to offset the impact of the cap on the FLDG cover. However, the situation we believe, could take some time to stabilise.”



¹Acquiring lender refers to the Bank or NBFC which takes up a larger share of the loans, typically 80%. Sourcing lender refers to the NBFC which originates and services the loan and holds a smaller share of the loans, typically 20%. 

²The interest rate sought by the acquiring lender from the sourcing lender on their loan share.