Digital ready — back to the drawing board

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The Reserve Bank of India’s new digital lending rules focus on three prongs: customer protection and conduct; technology and data requirements; and regulatory framework. To some extent, this will change the short-term digital lending paradigm. They also underline the central bank’s determination to protect the interests of consumers.

Over the past two years, digital lending has taken off in India with the influx of a number of “fintechs”. Due to the market opportunity, most have attracted quality equity investors and built up sufficient capital reserves. This should help them overcome the challenges ahead as they comply with the plethora of guidelines.

In terms of consumer protection and good conduct, the RBI has ensured that transparency and consumer awareness take center stage. While many of the guidelines were already enforced by players, some will require an overhaul of the business model.

For example, the mandatory direct transfer of funds between lender and borrower accounts without the intermediary of an escrow or a third party will lead to a change in “buy now, pay later” models and prepaid cards in a number of cases, which have been exploited by lenders through escrow accounts.

The RBI has also stated unequivocally that the responsibility for storing customer data rests with the regulated entities and that they must obtain prior consent from the borrowers.

Disclosure of charges

While clear disclosure of all fees as well as the annual percentage rate (APR) to the end borrower will improve transparency, the availability of APRs in advance could affect disbursements from some lenders. To be fair, many of them disclose most of their fees up front.

It should be noted that the target borrower segment of these lenders is not widely supported by larger banks/NBFCs. Thus, sensitivity to interest rates remains low for these borrowers. The availability of information in advance, however, could make it difficult for lenders to retain customers, as it will allow borrowers to check the total annual costs charged to them and compare them effectively with other alternatives.

What will also be tricky is the cooling off period which will allow the borrower to exit the loan without any penalty while paying the proportional APR and principal. Nevertheless, given that the majority of loans granted by digital lenders are of short duration, the cooling-off period, which will be defined by the board of directors of the regulated entity, is unlikely to have a significant impact on the economic model.

That said, some changes will need to be made regarding the Lending Service Providers (LSPs) that these lenders partner with. In general, the industry operates on a parent-subsidiary model in which the technology platform, which forms the heart of the loan as well as the market in some cases, is housed at the level of the parent company with the lending entity as as subsidiary.

Lenders will also need to incorporate changes in terms of data and data sharing, which, while operationally intensive, are unlikely to cause fundamental changes in the business.

Certainly, restricting lenders’ ability to wipe borrowers’ cellphones will lead to a major overhaul of credit underwriting practices. The whole philosophy of lending via the digital path relies on the ability to consult alternative data sources, some of which are unstructured, to arrive at a lending decision.

Therefore, these lenders consider many variables and cleaning the phone was an integral part of a borrower’s underwriting journey, especially in the context of consumer loans. Underwriting processes will now need to be adjusted to better align with regulations.

Regulations on reporting defaulting borrowers to credit bureaus are already followed by most lenders.

The RBI is clearly focused on the stability of Indian financial markets and the regulation of digital lending aims to usher in orderly growth and financial stability, control abusive practices, enhance transparency and protect the interests of customers.

The author is Senior Director and Deputy Director of Ratings, CRISIL Ratings Ltd

Published on

September 01, 2022

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