RBI Panel Suggests Setting Up Nodal Agency To Verify Lending Apps

A working group set up by the Reserve Bank of India has recommended setting up of a nodal agency to verify digital lending apps, in consultation with stakeholders. It has also recommended that balance sheet lending should only take place via regulated lenders.

Besides, the committee, headed by RBI Executive Director Jayant Kumar Dash, has suggested that a self regulatory organisation be set up for the digital lending ecosystem.

The key areas of recommendation of the committee span verification, technology and consumer protection.

The recommendations act on three levels, the panel's report said. These include entities regulated by the RBI; other regulated/ authorised entities; and unregulated entities, including third-party service providers functioning in the digital financial realm.

The onus of subjecting third-party lending service providers to a certain standard protocol of business would lie with the regulated entities to whom they are attached, the panel said. An institutional mechanism has been suggested to ensure the basic level of customer suitability, appropriateness and protection of data privacy.

The idea, the panel said, is to ensure there is orderly growth in the digital lending ecosystem without it being unduly disruptive towards the existing players in the ecosystem.

Verification Of Apps

The panel has recommended a verification process for digital lending apps (DLAs), specifying that balancesheet lending should happen only via regulated entities.

• The nodal agency will primarily verify the technological credentials of DLAs of the balance sheet lenders and loan service providers operating in the digital lending ecosystem.

• It will also maintain a public register of the verified apps on its website.

• A self regulatory organisation should be constituted covering the participants in the digital lending ecosystem.

• All loan servicing, repayments should be executed directly in a bank account of the balance sheet lender and disbursements should always be made into the bank account of the borrower.

• Borrowers having only wallet or pre-paid instrument account and no bank account can be disbursed a loan if the PPI accounts are fully KYC compliant.

These recommendations should be implemented within a year, the committee said. Over the medium term, the central government should introduce a ‘Banning of Unregulated Lending Activities Act’.

The working group has recommended the creation of an independent agency called Digital India Trust Agency or DIGITA, as a nodal body for verification of apps. Eligible apps not carrying the ‘verified’ signature of DIGITA should be considered as unauthorized for the purpose of law enforcement, the working group has recommended.

A public register of ‘verified’ apps should be maintained by DIGITA with essential details on its website.

"Third party verification is always a good idea," said Jaikrishnan G, partner for financial services consulting at Grant Thornton Bharat. However, we need a framework where the need for approvals kicks in only after a critical threshold so that it doesn’t restrict entry but subsequent scaling is monitored, he said.

Technology Related Recommendations

With regards to technology, the panel recommends:

• Development of certain baseline technology standards and compliance with those standards as a pre-condition for offering digital lending solutions.

• Data collection can be done only with prior and explicit consent of borrowers with verifiable audit trails.

• Storage of data should only be on servers in India.

• Algorithmic features used in digital lending to be documented to ensure necessary transparency.

Consumer Protection

To protect consumer interest, the panel recommends:

• Each digital lender provide a key fact statement in a standardised format.

• There should be an upfront disclosure of all-in, annualized cost of a loan with illustrative examples of loan repayment cost.

• Use of unsolicited commercial communications for digital loans should be governed by a code of conduct to be put in place by the proposed SRO.

• Standardised code of conduct for recovery to be framed by the proposed SRO in consultation with RBI.

• The SRO should maintenance a ‘negative list’ of lending service providers by the proposed SRO.

Responding to the suggestion of disclosing the annualised rate upfront, Jaikrishnan said that this may not work for all products. "Pay day loans, for instance, could be just for five days or a period of ten days and annualised rates would look exorbitant so it (mandatory disclosures) might not be as warranted for real short term products," Jaikrishnan said.

The assumption that because something is technologically possible, it should be allowed, is flawed and needs to be challenged, the working group has argued. According to the report, there are certain areas which deserve immediate regulatory attention, as they could potentially lead to building up of risks in the system.

FLDG: A Risky Business Model

The group in its report has highlighted risky business models such as the first loss default guarantee product (FLDG) offered by certain loan service providers (LSP) to NBFCs they work with.

Here, the LSPs take on a portion of the risk, ensuring skin in the game.

With increasing share of digital lending in retail loans, there is a potential for risk build-up because of these platforms, the working group said. This may also be adding to counterparty risks posed by the platform to its lending partners.

The working group has called for unregulated entities to stop offering FLDG based loans. Regulated entities should not allow their balance sheets to be used by unregulated entities in any form to assume credit risk, it said.

Apart from risky business models, there are two types of entities which need attention too.

Lending Service Providers

The services provided by LSPs include :

• Providing a marketplace for the lenders as well as the borrowers

• Loan sourcing

• Underwriting

• Collection services for repayments

• Data aggregation & analysis

• Rating services

Presently, the LSPs which work with banks and NBFCs are covered under the outsourcing of services guidelines of the RBI. But the LSPs which work with lenders not regulated by the RBI, continue to operate freely without any clear regulation, the working group said.

Fringe Lenders

The second type of entity which requires immediate regulatory attention are fringe lenders, which operate in the informal market, the working group said. Considering the anonymity and velocity provided by technology, it is a challenging task to identify and monitor such fraudulent platforms or applications on real time basis, it said.

Apart from the recommendations made by the committee for implementation over the short and medium term, the panel has laid out some suggestions that it believes need to be debated.

Among them is a suggestion that new digital lending products such as Buy Now Pay Later should be treated as part of balance sheet lending.

The panel suggests:

• Digital lending products such as BNPL should be treated as part of balance sheet lending, unless it is in the form of 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.

Other areas which need to be debated include:

• A blueprint of a forward-looking framework for identifying and managing risks arising from big tech firms and decentralised finance.

• Regulations for the operations of so-called ‘digital banks’/ ‘neo banks’ formulation.

• Encouragement for ‘digital only’ NBFCs and initiation of digital only banks.

"The recommendations are in best interest of customers and goes well in the direction of customer education. As long as it doesn’t kill innovation it’s a welcome change," Jaikrishnan of Grant Thornton Bharat said.

The RBI had set up an internal working group to create a regulatory framework for digital lending firms after a spike in such loans and unscrupulous recovery methods sparked concerns.

The working group was given a mandate to study digital lending activities in the regulated and unregulated financial sector so that an appropriate regulatory approach can be put in place.

The panel included four members from within the RBI and two external. The apex bank has invited comments on the recommendations made by the report by Dec. 31. A final view on regulations will be taken after the comments are reviewed.