GS Paper III

News Excerpt

The fintech sector in India is facing challenges as compliance costs have nearly doubled in the past year, driven by frequent regulatory changes introduced by the RBI.

News in brief:

• Some recent changes that the RBI has announced include new norms such as digital lending guidelines, first loss default guarantee (FLDG), and increased risk weights for unsecured personal loans. 
• Though the players are working towards complying with the required changes, the sudden introduction has meant rethinking of each firm’s growth strategy.
• The minimum cost of compliance has nearly doubled over the past year. These overheads include investments in technology, data protection and privacy, and internal and external audits, among other expenses.
• Smaller players find it difficult to manage the rising compliance costs, potentially leading to consolidation in the industry, with some becoming part of larger regulated entities.
• Companies are adapting their growth strategies in response to these regulatory shifts. Some are exploring diversification into additional financial services, while others are reducing loan disbursements in compliance with tightened norms. For example - Paytm announced the reduction of the disbursement of small-ticket size loans, specifically those less than Rs 50,000.

Default Loss Guarantee (DLG) guidelines by RBI

RBI issued the guidelines on Default Loss Guarantee (DLG). As per the guidelines, any arrangement between Regulated Entities (REs) and Lending Service Providers (LSPs) or between two REs involving DLG or First Loss Default Guarantee (FLDG) will have to adhere to these guidelines.

These guidelines are applicable to NBFCs, Commercial banks, Urban co-operative banks, State co-operative banks, and central co-operative banks.

The guidelines are as follow:

• The overall DLG cover under the upfront guarantee arrangements for any active loan portfolio shall not exceed 5% of that loan portfolio's value. The DLG provider shall not bear a performance risk of more than the equivalent amount of 5% of the underlying loan portfolio for implied guarantee arrangements.
• The RE will accept DLG only in the form of cash deposits, fixed deposits maintained with Scheduled Commercial Banks, and lien marked in favour of RE.
• The Timeline for DLG invocation will be a maximum overdue period of 120 days.
• Disclosure requirements, the RE who has a DLG agreement, can publish their details on the website like the total number of portfolios, number of portfolios, etc.

First loss default guarantee (FLDG)

• In India, banks and non-banking financial companies (‘NBFCs’) are permitted to extend loans, whilst fintechs such as lending service providers (‘LSPs’) specialize in ancillary functions such as customer acquisition, underwriting and pricing support, servicing, recovery and technological support and infrastructure.
• If banks and NBFCs are hesitant to extend loans in certain instances, the LSPs may guarantee a part of the loss (up to a certain percentage), if the borrower defaults in repayment.
• This concept in the digital lending space is called First Loss Default Guarantee (‘FLDG’) or Default Loss Guarantee (‘DLG’).

Other Challenges faced by fintech in India

• Market saturation: Market saturation intensifies competition with traditional financial institutions, hindering fintech firms in distinguishing themselves and acquiring customers.
• Cyber security: The sector grapples with cybersecurity and data privacy concerns, given the heightened risk of cyber-attacks and data breaches due to the sensitive financial information handled.
• Regulatory challenge: The absence of a regulated environment and clear grievance redressal mechanisms policy for fintech players complicates the issue, posing a trade-off between commercial banks and fintech players in redesigning their business models to cater to seamless financial services to customers .
• Shortage of skill: Most of the fintech companies in India report a shortage of skilled employees, mainly in IT, engineering and sales services. 

Way forward:

• Strategic partnerships and collaborations: Fintech companies should actively seek partnerships and collaborations, especially with established NBFCs to drive scale and share compliance costs.
• Utilize regulatory sandboxes and Innovation hubs: Take full advantage of the regulatory sandboxes and innovation hubs provided by the RBI.
• Enhance regulatory dialogue: Advocating for clear communication, more transparent interpretation of regulations, and seeking a formal channel for interaction can help reduce confusion and compliance costs.
• Diversification of services: Exploring additional financial services and value-added offerings can provide alternative revenue streams and mitigate the impact of specific regulatory constraints.
• Invest in regulatory compliance technology: This can help in reducing manual efforts, ensuring accuracy, and adjusting compliance requirements without significantly escalating costs.