Relevance: GS-3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment; Inclusive growth and issues arising from it;/ GS-3:Awareness in the fields of IT.

Key Phrases: Digital Lending, Neo Banks, Self Regulatory Organisation, Fintech companies, NBFCs, Digital platforms.

Why in News?

• In November 2021, a working group constituted by RBI on digital lending recommended regulatory, technology and consumer related changes to Digital lending.

Key Points:

• A spate of suicides in Hyderabad, in December 2020 led RBI constitute a working group (WG) to study all aspects of digital lending, so that appropriate regulations can be put in place, and bring digital lending into regulatory spotlight.

• Algorithmic features used in digital lending to be documented to ensure necessary transparency.The incident has brought the digital lending sector into the regulatory spotlight and hence RBI has constituted the working group.

Digital Landing in India:

The digital lending ecosystem has evolved into two broad categories of firms — balance sheet lenders (BSLs), or companies which lend on their own books online, and lending service providers (LSPs), which provide their platform to source loans for banks or NBFCs for a fee. However, these lenders form a minuscule part of the lending ecosystem in India. Moreover, even among banks, lending through digital means forms a tiny part of the loan portfolio.

• The WG analysed a representative sample of banks and NBFCs and observed that lending through digital mode relative to physical mode is still at a nascent stage in case of banks (Rs 1.12 lakh crore via digital mode vis-à-vis Rs 53.08 lakh crore via physical mode) whereas for NBFCs, the comparative figures are Rs 0.23 lakh crore vis-à-vis Rs 1.93 lakh crore.
• However, the overall volume of disbursement through digital mode for the sampled entities has exhibited a growth of more than twelve-fold between 2017 and 2020 (from Rs 11,671 crore to Rs 1.41 lakh crore).
• This strong growth in digital lending indicates the huge untapped credit potential in India which can be bridged efficiently through the use of technology.
  • India is country of 1.25 billion with only about 35 to 40 million credit cards. Digital lenders are eyeing to expand the credit base just like NBFCs.

Need for Regulation:

• Digital lending has taken off over the last couple of years, also helped by the distress in the salaried class segment after Covid — and led by shady deep pocketed mobile applications.
• The typical modus operandi of these companies is to lure customers by small-size loans of Rs 5,000, which can be paid back in a couple of weeks with some interest.
  • However, if the borrower fails to re pay this amount, it gets compounded at 120% per annum (10% per month), making it difficult for the borrower to repay.
• This loan is sometimes masked as a service called Buy Now, Pay Later (BNPL), which allows shoppers to buy something but pay for it later within a stipulated interest-free period in three or more instalments. These loans mostly target young, new-to-credit, cash-strapped millennials.
  • However, if a buyer fails to pay the amount within the defined repayment window, the lender will charge interest on the unpaid amount along with a hefty late payment fee.
• Until the RBI crackdown earlier this year, many applications used to offer loans without any credit checks or loan agreements for small ticket sizes.
• These loans would be booked by little known NBFCs and backed by deep pocketed investors — sometimes originating from China or registered in other developed markets.
• These foreign investors either took over an NBFC by installing dummy directors or offered huge incentives for small NBFCs to use their loan books for lending.
• These investors offered a First-Loss Default Guarantee (FLDG) of 80% when the industry trend was 10%. Such a high guarantee for defaults, lucrative fees and a growing market meant that many small NBFCs joined the bandwagon and lending practices went out of hand.
  • FLDG is offered to a small partner or a co-lender to cover initial defaults.
  • For example, in a business correspondent model, banks used to provide a 6% to 7% FLDG to insulate partners against any defaults.
  • However, an 80% guarantee means that a small NBFC may never make a loss, making them compromise on underwriting standards.
• India is not the first market where these deep pocketed investors have made a dent.
  • About a year earlier, the story was similar in Indonesia. When the regulatory heat increased there, they came to India. It was China before Indonesia.
• Bringing digital lenders under RBI regulation will help weed out the fraudsters and ensure only serious players survive as cost compliance may be too high.

Conclusion:

• The report of the working group could form the crux of digital lending regulations by the central bank in the future. As neo banks and digital platforms flourish, these entities can only expect more regulatory attention which could mean less than desired growth rate, but a stable long term smooth runway.

Source: Economic Times

Mains Question:

Q. While Neo-banks don’t have the funds or customer base to overthrow traditional banks, they bank on innovation and hence can tackle to needs of underserved. In this light, suggest the need for regulating digital lending ecosystem.