The Reserve Bank of India (RBI) has finally cracked the whip on digital lending. Although the central bank has not banned online lending, it has rightly sought to regulate the fast-growing business. The RBI has issued a regulatory framework, aimed at bringing transparency in the digital lending market.

The central bank’s regulatory norms are based on the inputs of a working group on digital lending that it had set up in January 2021. The norms boldly underline the crucial principle of regulation. They mandate that lending business can be carried out only by entities that are either regulated by the central bank or by entities permitted to do so under any other law.

The framework includes all forms of loans disbursed and recovered through web platforms or mobile apps as digital lending. The stakeholders in the online lending business are clearly defined as RBI-regulated entities (REs) – including banks, non-banking financial companies (NBFCs) and other entities that are monitored by the RBI – digital lending apps (DLAs) – innumerable financial services apps that are engaged in lending – and lending service providers (LSPs) – many new-age financial-technology (fintech) entities.

At the heart of the digital lending market is the collaboration of DLAs and LSPs with REs. It is a winning combination that enables REs, who have access to cash, to join hands with technology-savvy and consumer-focused DLAs and LSPs to advance loans, especially to people at the bottom of the economic pyramid. With very little paperwork, speedy disbursal and lower cost of operation, digital lending has emerged as a popular platform to provide credit to a vast section of people who have been out of the formal credit market.

No wonder then that digital lending has picked up pace in recent times. However, presence of a large number of unregulated entities, such as DLAs and LSPs, has sometimes led to reckless practices of lending beyond borrowers’ repayment capacity. There are also concerns over misselling to customers, unethical business conduct, exorbitant interest rates and excessive engagement of third parties, leading to genuine fears of possibility of a large buildup of non-performing assets (NPAs) in digital lending. The RBI’s recent regulatory framework is aimed at addressing these issues.  

“The RBI’s regulatory framework has been long-awaited and much-needed directions that will help support orderly growth of credit delivery via digital lending methods revolutionised by India’s fintech players. Most directives have a direct customer impact and do much to secure customer interests,” stresses BankBazaar.com CEO Adhil Shetty.

New rules

The central bank mandates that all loan disbursals and repayments are required to be executed only between bank accounts of borrowers and the REs. It has strictly prohibited loan amount from getting transferred from any pass-through or pooled accounts of LSPs or any other third party.

All fees and charges payable to LSPs will have to be paid by banks and non-banks and not by borrowers. All-inclusive costs of digital loans will have to be disclosed to borrowers. Entities will have to provide a cooling-off period, during which borrowers can exit digital loans by paying the principal and the proportionate costs without any penalty.

REs will have to ensure that all LSPs engaged by them will have a suitable nodal grievance redress officer to deal with digital lending-related complaints. Banks and non-banks will have to ensure that DLAs on-boarded by them prominently display information relating to product features, loan limit and costs involved.

It is prohibited to increase credit limit automatically without explicit consent of borrowers. If any complaint lodged by borrowers is not resolved by REs within the stipulated period (currently 30 days), borrowers can seek redress under the RBI’s Integrated Ombudsman Scheme.

Data collected by DLAs have to be need based, should have clear audit trails and should only be done with prior explicit consent of borrowers. An option must be provided to borrowers to accept or deny consent for use of specific data, including the option to revoke previously-granted consent.

REs re required to provide Key Fact Statement (KFS) to borrowers before execution of contract in standardised format for all digital lending products. Any fees and charges not mentioned in the KFS cannot be charged by REs to borrowers at any stage during the term of the loan. The RBI has also mandated that information on loans of all tenures, including very short ones, has to be reported to credit bureaus.

Orderly growth

The RBI’s new norms will shake up the online lending business for the better. They will have a direct bearing on the fast-growing Buy Now, Pay Later (BNPL) market. The regulatory framework mandates REs to ensure that fund flow occurs directly between RE and borrowers’ bank account. The digital lending regulations indicate that exceptions will be considered for statutory or regulatory reasons and for co-lending. However, it is unclear whether an exception will be made for BNPL products, where the consumer loan amount is credited directly by the BNPL service provider into the account of the merchant. If not, the fund flow underlying these products will need to be re-worked.

Incidentally, BNPL and many other popular digital lending products are based on the First Loss Default Guarantee (FLDG) model. The FLDG is an arrangement, where a third party – an LSP or a DLA – compensates a lender if a borrower defaults. In other words, in an FLDG setup, credit risk is borne by an LSP or a DLA without maintaining any regulatory capital. With the new norms, the focus now turns to the manner in which the FLDG model will be regulated. The good news is that FLDG has not been entirely junked. On the contrary, the central bank has indicated that the regulation of FLDGs is still under consideration. A likely possibility is that only entities regulated by at least one financial services regulator – NBFCs – may become eligible to issue FLDGs.

There is also the question of allowing fintech entities to continue with their innovation and product development. The relationship between REs and the fintech players (DLAs and LSPs) envisioned in the regulatory framework provides a supervisory role for the REs over the fintech entities. This may allow fintech players to power product development under the REs supervision. Such an arrangement is very necessary for product innovation by fintech players, which have helped bring a large section of people within the formal credit system.

“DLAs, powered by fintechs and REs, have brought in innovation in the financial system. The RBI’s guidelines demarcate the roles and responsibilities of REs and LSPs and will help the overall industry grow in an orderly fashion even as they encourage innovation,” points out Zaggle Chief Business Officer Saurabh Puri. The RBI’s norms have come at the appropriate time to check unbridled growth and foster the right ecosystem for digital lending.