Lenders Piggybacking on Fintech Platforms Leaving the Borrower in the Lurch?
Among the disruptive financial technology (fintech) practices, app-based lending is certainly notable. The scenario of an app-based lending is somewhat like this – a prospective borrower goes to an app platform, fills up some information. At the background, the app collects and collates the information including credit scores of the individual, may be the individual’s contact bases in social networks. Finally, the loan is sanctioned in a jiffy, mostly within minutes.
 
The borrower interacts with the platform, but does the borrower know that the loan is actually not coming from the platform but from some non-banking financial company (NBFC)? Whether or not the borrower knows or cares for who the lender is, the fact is that, mostly, the technology-provider (platform) and the funding-provider (lender) are not the same. They may be two entities within the same group; but more often than not, the lender is an NBFC which is simply utilising the platform. 
 
The relationship between the platform and the lender may take one of the following forms: (a) the platform simply is procuring or referring the credit; the platform has no credit exposure at all; (b) the platform is acting as a sourcing agent and is also providing a credit support, say in the form of a first-loss guarantee for a certain proportion of the pool of loans originated through the platform; (c) the platform provides full credit support for all the loans originated through the platform, and, in return, the lender allows the platform to retain all the actual returns realised through the pool of loans, over and above a certain 'portfolio internal rate of return (IRR)'.
 
Option (a) is a pure sourcing arrangement; however, it is quite unlikely that the lender will be willing to trust the platform’s credit scoring, unless there is significant skin-in-the-game on the part of the platform. 
 
If it is a case of option (c), which, incidentally, seems quite common, the loan is actually put on the books of the lender, but the credit exposure is on the platform. The lender’s exposure is, in fact, on the platform, and not the borrower. The situation seems to be quite close to a 'total rate of return swap', a form of a credit derivative, whereby parties synthetically replace the exposure and the actual rate of return in a portfolio of loans by a pre-agreed 'total rate of return'.
 
Our objective in this article is to examine whether there are any regulatory concerns on the practice as in case of option (c). Option (c) is an exaggeration; there may be a case such as option (b). 
 
But since option (b) is also a first loss guarantee with a substantial thickness, it is almost akin to the platform absorbing virtually all the risks of the credit pool originated through the platform.
 
Before we get into the regulatory concerns, it is important to understand what the motivations of each of the parties are, in this bargain.
 
Platform’s Motivations
 
The motivation on the part of the platform is clear—the platform makes the spreads between the agreed portfolio IRR with the lender, and the actual rate of return on the loan pool, after absorbing all the risk of defaults. Assume that the small-ticket personal loan is being given at an interest rate of 30%, and the agreed portfolio IRR with the lender is 14%, the platform is entitled to the spread of 16%.
 
If some of the loans go bad, as they indeed do, the platform is still left with enough juice to be a compensation for the risks taken by it.
 
The readiness on the part of the platform is also explained by the fact that the credibility of the platform’s scoring is best evidenced by the platform agreeing to take the risk—it is like walking the talk.
 
Lender’s Motivations
 
The lender’s motivations are also easy to understand—the lender is able to disburse fast, and at a decent rate of return for itself, while taking the risk in the platform. In fact, several NBFCs and banks have been motivated by the attractiveness of this structure.
 
Are There Any Regulatory Concerns?
 
  • The potential regulatory concerns may be as follows:
  • De-facto, synthetic lending by an entity that is not a regulated NBFC;
  • Undercapitalised entity taking credit risk;
  • Skin-in-the-game issue;
  • A credit default swap (CDS), but not regulated as a CDS;
  • Financial reporting issues;
  • Any issues of conflict of interest or misalignment of incentives;
  • Good borrowers pay for bad borrowers;
  • KYC or outsourcing related issues.
 
These issues are examined below.
 
Synthetic Lending by an Unregulated Entity
 
It is common knowledge that NBFCs in India require registration. The platform in the instant case is not giving a loan. The platform is facilitating a loan—right from origination to credit risk absorption. Correspondingly, the platform is earning a spread, but the activity is technically not a 'financial activity', and the spread is not a 'financial income'; hence, the platform does not require regulatory registration.
 
On the other hand, it could be argued that the platform is essentially doing a synthetic lending. The position of the platform is economically similar to an entity that is lending money at 30% rate of interest, and refinancing itself at 14%. There will be a regulatory arbitrage being exploited, if such synthetic lending is not treated at par with formal lending.
 
But then, there are a whole lot of equity-linked or property-linked swaps, where the returns of an investment in equities, properties or commodities, are swapped through a total rate of return swaps, and in regulatory parlance, the floating income recipient is not regarded as investor in equities, properties or commodities. Derivatives do transform one asset into another by using synthetic technology—in fact, insurance-linked securities allow capital market investors to participate in insurance risk, but it cannot be argued that such investors become insurance companies.
 
Undercapitalised Entities Taking Credit Risk
 
It may be argued that the platform is not a regulated entity; yet, that is where the actual credit risk is residing. Unlike NBFCs, the platform does not require any minimum capitalisation norms or risk-weighted capital asset requirements.
 
Therefore, there is a strong potential for risk accumulation at the platform’s level, with no relevant capital requirements. This may lead to a systemic stability issue, if the platforms become large.
 
There is a merit in the issue. If fintech-based lending becomes big, the exposure taken by fintech entities on the loans originated through them, on which they have exposure, may be treated at par with loans actually held on the balance sheet of the fintech. As in the case of financial entities, there are norms for converting off-balance sheet assets into their on-balance sheet equivalents, the same system may be adopted in this case.
 
Skin-in-the-game Issue
 
After the global financial crisis, one of the regulatory concerns was skin-in-the-game. In the light of this, the Reserve Bank of India (RBI) has imposed a minimum holding period, and minimum risk retention requirements in case of direct assignments as well as securitisation. 
 
The transaction of guarantee discussed above may seem like the exposure being shifted by the platform to the NBFC. However, the transaction is not at all comparable with an assignment of a loan. Here, the lending itself is originated on the books of the NBFC/lender. The lender has the ultimate discretion to agree to lend or not. The credit decision is that of the lender; hence, the loan is originated by the lender, and not acquired.
 
The lender is mitigating the risk by backing it up with the guarantee of the platform—but this is not a case of an assignment. 
 
There is a skin-in-the-game on either side. For the platform, the guarantee is the skin-in-the-game; for the NBFC, the exposure in the platform becomes its stake.
 
A CDS, but Not Regulated as a CDS
 
The transaction has an elusive similarity to a credit default swap (CDS) contract. Annexure XIV to the master directions for NBFCs contains RBI’s guidelines on CDS contracts. It may be argued that the guarantee construct is actually a way to execute a derivative contract, without following CDS guidelines.
 
In response, it may be noted that a derivative is a synthetic trading in an exposure, and is not linked with an actual exposure. For example, a protection buyer in a CDS may not be having the exposure for which he is buying protection, in the same way as a person acquiring a put option on 100gm of gold at a certain strike price may not be having 100gm of gold at all. Both the persons above are trying to create a synthetic position on the underlying.
 
Unlike derivatives, in the example of the guarantee above, the platform is giving guarantee against an actual exposure. The losses of the guarantor are limited to actual losses suffered by the lender. Hence, the contract is one of indemnity (see discussion below), and cannot be construed or compared to a derivative contract. There is no intent of synthetic trading in credit exposure in the present case.
 
Financial Reporting Issues
 
It may be argued that the platform is taking same exposure as that of an actual lender; whereas the exposure is not appearing on the balance sheet of the platform. On the other hand, the actual exposure of the lender is on the platform, whereas what is appearing on the balance sheet of the lender is the loan book.
 
The issue is one of financial reporting. International Financial Reporting Standards (IFRSs) clearly address the issue, as a financial guarantee is an on-balance sheet item, at its fair value. If the platform is not covered by IFRSs/IndASes, then the platform will be reflecting the guarantee as a contingent liability on its balance sheet.
 
Conflicts of Interest Or Misalignment Of Incentives
 
During the prelude to the global financial crisis, a commonly-noted regulatory concern was misalignment of incentives—for instance, a subprime mortgage lender might find it rewarding to lend to a weak credit and capture more excess spread, while keeping its exposure limited.
 
While that risk may, to some extent, remain in the present guarantee structure as well, but there are at least two important mitigants. First, the ultimate credit decision is that of the NBFC. Secondly, if the platform is taking full credit recourse, then there cannot be a misalignment of incentives.
 
Good Borrowers Pay for Bad Borrowers
 
It may be argued that eventually, the platform is compensating itself for the risk of expected losses by adding to the cost of the lending. Therefore, the good borrowers pay for the bad borrowers. 
 
This is invariably the case in any form of unsecured lending. The mark-up earned by the lender is a compensation for risk of expected losses. The losses arise against the loans that don’t repay, and are compensated by those that do.
 
KYC or Outsourcing Related Issues
 
Regulators may also be concerned with know your customer (KYC) or outsourcing related issues. As per RBI norms “NBFCs which choose to outsource financial services shall, however, not outsource core management functions including internal audit, strategic and compliance functions and decision-making functions such as determining compliance with KYC norms for opening deposit accounts, according sanction for loans (including retail loans) and management of investment portfolio.”
 
Usually the power to take credit decisions vests with the lender. However, in case the arrangement between the lender and the platform is such that the platform performs the decision-making function, the same shall amount to outsourcing of core management function of the NBFC, which is expressly disallowed by the RBI. 
 
Is It Actually a Guarantee?
 
Before closing, it may be relevant to raise a legal issue—is the so-called guarantee by the platform actually a guarantee?
 
In the absence of tripartite agreement between the parties, the arrangement cannot be said to be a contract of guarantee. Here the involvement is of only two parties in the arrangement i.e. the guarantor and the lender. 
 
It was held in the case of KV Periyamianna Marakkayar and others vs Banians And Co that “Section 126 of the Indian Contract Act which defines a contract of guarantee though it does not say expressly that the debtor should be a party to the contract clearly implies, that there should be three parties to it namely the surety, the principal-debtor and the creditor; otherwise it will only be a contract of indemnity. Section 145 which enacts that in every contract of guarantee there is an implied promise by the principal debtor to indemnify the surety clearly shows that the debtor and the surety are both parties to such a contract ; for it will be strange to imply in a contract a promise between persons who are not parties to it.”
 
Accordingly, the said arrangement may be termed as a contract of indemnity wherein the platform agrees to indemnify the lender for the losses incurred on account of default by the borrower.
 
Conclusion
 
Fintech-based lending is here to stay, and grow. Therefore, risk participation by fintech does not defeat the system—rather, it promotes lending and adds to the credibility of the fintech’s risk assessment. Over a period of time, the RBI may evolve appropriate guidelines for treating the credit exposure taken by the platforms as a part of their credit-equivalent assets.
 
(Vinod Kothari is a chartered accountant, trainer and author. Mr Kothari, through his firm, Vinod Kothari & Co, is also engaged in the practice of corporate law for over 25 years)
  • Like this story? Get our top stories by email.

    User

    COMMENTS

    akshiv

    1 month ago

    Found the arguments presented in the article very insightful. Thanks for such an in-depth analysis on the topic.

    Godavari Joshi

    1 month ago

    Liked the article very much. Informative and educative. I wonder if there is any mechanism under any Regulatory mechanisms which keep a tab in the new tools and business models which keep coming up in the ecosystem so that the regulation is proactive rather than being reactive. .... always like bolting the gate after the horse has galloped away !

    B. Yerram Raju

    1 month ago

    Congratulations for an insightful article to both the Author and Money Life. If credit risk has to be assessed, the analyst must have knowledge of the three Es: Environment; Enterprise, and Entrepreneur. In the instant case, these three are absent and the machine decides the eligibility. When the principal is a defective product, derivative cannot be expected to be better. This derivative is adding to numbers in performance. Banks have posited 82000 loans in ten days' and made the FM believe this figure!! Lending to the target is different from target groups getting credit. The next NPA bomb ticking fast is in retail lending. This will not be easy to tackle because of its spread, space and sensitivity.

    SANDESH PAWAR

    1 month ago

    Appreciate the Article. I believe Fin-tech disruption in round the corner. Alipay and We-chat in China are lending more than most of the banks in China, this happened in mere two years.
    It would be good to know if Bank can be entirely displaced in the coming future. I don;t see there would be any need of Branches/ATM's. the Likes of SBI which are considered moats today due to its presence should be the biggest losers. I believe any Indian Bank that ties up with a really huge technology company at a very early stage would gain tremendously.

    Amit Gupta

    1 month ago

    A very well written article, in extremely easy to understand lingo. Thanks!

    PSBs disbursed Rs 82K cr retail loans in 9 days: FM
    Finance Minister Nirmala Sitharaman on Monday said PSBs have disbursed about Rs 82,000 crore in the nine-day outreach programme to push up retail credit and banks have witnessed robust demand during that period and she has asked the banks to look at the scope of MSMEs' demand for bill discounting.
     
    Bill discounting is a discount/fee which a bank takes from a seller to release funds before the credit period ends. Bill discounting is mostly applicable in scenarios when a buyer buys goods from the seller and the payment is to be made through letter of credit. 
     
    Earlier Finance Secretary Rajeev Kumar said "Finance Minister Nirmala Sitharaman today reviewed the credit growth progress in the public sector banks and they have reported that they have disbursed Rs 81,781 crore in retail in the nine days of the outreach programme and have followed the prudential norms in the credit outreach. During this period of nine days, PSBs have given Rs 34,342 crore to new businesses. PSBs have said they have sufficient liquidity."
     
    The second outreach programme will start on October 21. In the meeting, Kumar said big corporates owe Rs 40,000 crore to MSMEs and banks have been told to look at the option of doing bill discounting for MSMEs.
     
    "Big corporates owe Rs 40,000 crore to MSMEs. PSBs will have an outreach programme on bill discounting. MCA (Ministry of Corporate Affairs) has a list of big companies who owe money to MSMEs. PSBs will ask concerned MSMEs if they are interested in bill discounting," Kumar said.
     
    Sitharaman said "We have asked and will push for big companies to expedite payments to MSMEs and have asked the banks to come back to us on MSMEs' payment by October 22 on demand for bill discounting".
     
    Disclaimer: Information, facts or opinions expressed in this news article are presented as sourced from IANS and do not reflect views of Moneylife and hence Moneylife is not responsible or liable for the same. As a source and news provider, IANS is responsible for accuracy, completeness, suitability and validity of any information in this article.
  • Like this story? Get our top stories by email.

    User

    COMMENTS

    Ramesh B Mhadlekar

    1 month ago

    The retired Regional director Mr. J.B. Bhoria now an administrator of PMC Bank was claiming bogus overtime for his driver continuously for five months including Saturday Sunday when RBI was closed and Public holidays and also while absent from headquarters on tour. Can his report be relied upon? The said submission is based on RTI received from RBI. Also a newspaper cutting received on whatsapp reveals that the members of Nasik Merchant Bank have demanded an inquiry of Mr. Bhoria for the 5 years of his tenure while he being appointed by RBI. His son was also illegally involved in possession of an RBI official Vehicle which met with an accident and was a police case with Malabar Hill as per RTI. His integrity is probably doubtful.

    Banks May Need To Report HDIL's Dues, Provisioning Status
    Public sector banks (PSBs) having fund exposure to the bankrupt real estate firm HDIL may have to classify the loans given to it as non-performing assets (NPA or bad loans) under the RBI (Reserve Bank of India) norms, make provisions for them and report these to the exchanges, according to official sources here.
     
    So far, RBI has not given any directions in this regard as fund exposure of individual banks are their autonomous commercial decisions even when an account has gone into default and the promoter of the defaulting company is arrested.
     
    The sources, however, said that RBI norms on NPA classifications and provisionin are clear and PSBs must know when to implement these.
     
    Though PSBs are yet to reveal their exposures in HDIL, the real estate firm''s annual report says it has a debt of Rs1,500 crore and mentions Allahabad Bank, Andhra Bank, Bank of India, UCO Bank, Union Bank of India, Central Bank of India, LIC and IDBI Bank among its lenders.
     
    Some private banks are also believed to have lent to HDIL and the loans were raised by the company on the personal guarantee of the chairman and MD, who has been arrested.
     
    Last week, Mumbai Police arrested HDIL directors, Rakesh Wadhawan and his son Sarang Wadhawan, in relation to the Rs4,355-crore fraud at the Punjab and Maharashtra Cooperative (PMC) Bank .
     
    The RBI guidelines on NPAs mandate lenders to start the resolution process even if there was a one-day default.
     
    HDIL is currently in default with various banks and Bank of India had taken the real estate firm to the National Company Law Tribunal (NCLT) for recovering dues of Rs522 crore before the alleged role of HDILin the PMC Bank fraudulent deals came to light. The case is currently under Insolvency and Bankruptcy Code (IBC).
     
    According to an official source, multiple investigative agencies probing the company also limits the recovery prospects for banks of their loans to HDIL as it limits their rights to the assets of the defaulting company.
     
    On the impact of the concurrent processes of the NCLT and the Enforcement Directorate (ED) on banks recovering their loans, disputes practitioner and partner at Khaitan and Company, Diwakar Maheshwari, said: "NCLT's mandate under the insolvency law is to judicially determine the aspect of default on part of the debtor to its financial creditors. Any antecedent wrongdoing amounting to attracting any criminal proceedings is the exclusive domain of the respective agency, be it CBI, ED or SFIO and NCLT, does not seem to have much of a say in this aspect under the insolvency law." 
     
    "It is imperative to have a high degree of coherence between the various independent investigating bodies and the judicial process under the insolvency law to obviate any inter se conflict of interest. This can largely be achieved either by legislative guidance or by judicial determination," he added.
     
    Regarding the duty of banks to provide details to exchanges on their amount of dues pending, Mr Maheshwari said that "banks should completely adhere to all its reporting requirements mandated by law as breaching of the same has severe legal consequences."
     
    Disclaimer: Information, facts or opinions expressed in this news article are presented as sourced from IANS and do not reflect views of Moneylife and hence Moneylife is not responsible or liable for the same. As a source and news provider, IANS is responsible for accuracy, completeness, suitability and validity of any information in this article.
  • Like this story? Get our top stories by email.

    User

    We are listening!

    Solve the equation and enter in the Captcha field.
      Loading...
    Close

    To continue


    Please
    Sign Up or Sign In
    with

    Email
    Close

    To continue


    Please
    Sign Up or Sign In
    with

    Email

    BUY NOW

    online financial advisory
    Pathbreakers
    Pathbreakers 1 & Pathbreakers 2 contain deep insights, unknown facts and captivating events in the life of 51 top achievers, in their own words.
    online financia advisory
    The Scam
    24 Year Of The Scam: The Perennial Bestseller, reads like a Thriller!
    Moneylife Online Magazine
    Fiercely independent and pro-consumer information on personal finance
    financial magazines online
    Stockletters in 3 Flavours
    Outstanding research that beats mutual funds year after year
    financial magazines in india
    MAS: Complete Online Financial Advisory
    (Includes Moneylife Online Magazine)
    FREE: Your Complete Family Record Book
    Keep all the Personal and Financial Details of You & Your Family. In One Place So That`s Its Easy for Anyone to Find Anytime
    We promise not to share your email id with anyone