The Reserve Bank of India (RBI) has proposed new norms and asked the government to frame a new legislation to curb illegal digital lending in the country. The proposals come after a panel set up by the regulator found that there are 1,100 loan apps in various app stores, of which 600 are illegal.

Digital lending in India is growing at a cracking pace, second only to payments in the Indian fintech space. However, the rapid growth in usage as well as innovation has come with its own challenges.

After multiple reports of harassment and high-handed recovery methods used by agents of several digital lending app platforms, even pushing customers to suicide, the Reserve Bank of India (RBI) was forced to swing into action.

The suggestions come in the wake of complaints of harassment by digital lending apps, many of which have turned out to be unauthorized and operated by offshore entities. Some of the borrowers have also committed suicide, blaming the apps of harassment. There have also been reports of digital lenders repatriating unlawful profits outside the country.

The recommendations, submitted by a working group on digital lending including lending through online platforms and mobile apps chaired by Jayant Kumar Dash, executive director, RBI, include having a nodal agency to verify all the digital lending apps and setting up a self-regulatory organisation.

The group has also suggested tighter norms for “buy now pay later” loans, a form of credit given at time of purchase. The proposal is to treat them as part of balance sheet lending, if it is not in the form of operational credit by merchants. Since these products do not meet the requirements of traditional credit facilities, a suitable notification may be issued by the government of India in this regard.

The recommendations seek to protect the integrity of the system against entities that are not regulated and are not authorized to carry out lending business. The onus of subjecting third-party lending service providers to a standard protocol of business conduct would lie with the regulated entities to whom they are attached. Further, an institutional mechanism is envisaged to ensure the basic level of customer suitability, appropriateness and protection of data privacy.

The panel said that the digital lending ecosystem comprises both balance sheet lenders (those who lend their own money) and marketplace lending (a platform that allows others to lend). Within these two forms of lending, there are peer-to-peer lending platforms, neo banks, and “buy now pay later.

It is observed that lending through digital mode relative to physical mode is still at a nascent stage in case of banks (Rs 1.1 lakh crore via digital mode vis-à-vis Rs 53.1 lakh crore via physical mode) whereas for NBFCs, a higher proportion of lending (Rs 0.2 lakh crore via digital mode vis-à-vis Rs1.9 lakh crore via physical mode) is happening through digital mode,” the report said.

SRO is the call of the hour to structure the industry and to set the rules for the fintech members and customers. FACE members have always abided with the disclosure of all relevant information including the interest rates, as it believes in transparency and proactive commitment to consumers builds brand trust. Data privacy is of utmost importance and should be strictly adhered to.

Experts, however, cautioned at regulations stifling innovation. While subjecting third-party digital lending providers to certain standard protocols and regulations is key to protecting customer’s interest, this should not come at the cost of innovation and create entry barriers for startups in the fintech space, said Jaikrishnan G, Partner, Financial Services Consulting at Grant Thornton Bharat. He added that new-age short-term liquid lending products have created a niche and are now filling in a critical credit void in the ecosystem. “A traditional lending framework cannot be applied on these products.

Cause for Concern?

The report by the RBI working group recommends stringent crackdown on digital lending apps engaging in malpractices through various regulations. However, throughout the report there is a clear distinction made between regulated and unregulated entities and what each of those can be allowed to do.

For example, the working group suggested that lending should happen only through the books of regulated and recognised entities. What is not legal in the physical world cannot be considered legal only because it is happening online, it says.

In the case of known online credit players like Capital Float, ZestMoney, Slice, etc., most fall under the category of regulated entities as they possess an NBFC licence from the RBI. However, BNPL players like Simpl that do not have an NBFC licence face being barred if these recommendations turn into norms.

In lending, today’s uncalibrated growth is tomorrow’s NPA (non-performing asset). Once these guidelines come in, they will keep a check on this frenzied pace of lending and capital.

The concerns over unchecked growth in NPAs arise when it comes to credit and innovation driving the growth as well. BNPL app LazyPay’s gross non-performing loans, for example, stood at 19 percent in FY21, as per a Macquarie report.

The question to ask is, are these BNPL players lending to subprime customers or the ones we call thin file customers who we have no data on? We need to see how this lending data is reported to credit bureaus.

What these registered entities will also have to be more mindful of is the recommendations on the tech front. The report suggests that digital lending apps must have data stored in servers in India, their data storage and usage policies must be publicly available and they must document the rationale for the algorithmic features behind lending decisions.

In what surprises some observers, the report also recommends that not only lending fintechs but neobanks too should be brought under the umbrella of these regulations.

India’s Digital Lending Market

With the increase in penetration of the internet and smartphones, India has emerged as the country with the highest fintech adoption rate of 87 percent as of 2020, as per a Research and Markets report. Of that, digital lending has been largely led by NBFCs, with digital loans accounting for 53 percent of total loans disbursed between March and December 2020.

Investors, fintech players and analysts see this as only the beginning. The digital lending space is expected to see growth led by the BNPL model of credit as Indians increasingly access small-ticket credit. And with the market set to expand, the industry believes this is the right time to bring in regulations and structure to how the industry functions and eliminate bad players.

The West saw huge growth in digital lending and BNPL through unregulated players. Once these industries became multibillion-dollar industries, now they are trying to regulate them. We in India have an opportunity to get it right from day one and ensure that when these models reach scale, they are already operating in a compliant manner when it comes to customer protection.

The BNPL market in India, made up of players like Bajaj Finance, PayU’s LazyPay, Mobikwik, Capital Float, ZestMoney, KrazyBee, Simpl, etc., is set to grow from a $15-billion market in 2020 to $100 billion in 2025, according to a report by Bernstein.

The First Loan Default Guarantee Factor

First loan default guarantee (FLDG) is an arrangement that fintech lenders enter into with their banking partners promising to compensate their partners in case a customer fails to repay the loan. While the report does not suggest abolishing FLDG agreements as a whole, it recommends prohibiting any regulated entity from entering into such agreements with unregulated entities. That will mean that NBFC digital lenders can continue to forge FLDG agreements with partner banks.

It also says that the maximum FLDG amount can be capped so that partner banks and NBFCs that are the actual lenders will actively participate in credit assessments.

While fintechs are providing FLDG, the underwriting and exposure is still managed by regulated entities. One should ensure appropriate reporting and disclosures in this regard. Doing away with the FLDG mechanism will not help the cause.

The Neobanks Angle

Digital-only neobanks essentially serve as a layer of an interface between banks and NBFCs to allow customers to access banking services digitally. Another growing segment, it has received total funding to the tune of $163 million as of the first quarter of 2021, according to PwC data. In just the past two months, neobanks Open and Fi raised $100 million and $50 million, respectively.

The report itself does not delve much into recommendations for neobanks, except to say that these entities should also be covered under RBI regulations.

The RBI has always viewed neobanks quite favourably as they operate as technology intermediaries as opposed to banks. But in time, the RBI will seek to regulate them as they become important players in the banking chain.

Neobanks as a segment walk a fine line between technology companies and banks, and it is imperative from a regulator’s view that the difference is communicated clearly to consumers. “The larger neobanks understand this balance well, but some neobanks are blurring the lines. The Banking Regulation Act also states that the term ‘banking’ or ‘bank’ cannot be used by those who are not registered as banks with the RBI, with the RBI being very sensitive about it.

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