First Loss Default Guarantee (FLDG) Scheme [UPSC Notes]

The First Loss Default Guarantee (FLDG) scheme was approved by the Reserve Bank of India (RBI) in June 2023 for use in the world of digital lending. In this article, we explain what the First Loss Default Guarantee Scheme is all about, and its advantages and benefits. This topic is relevant for the IAS exam Indian economy segment.

First Loss Default Guarantee (FLDG) Scheme

FLDG is an arrangement whereby a third party such as a financial technology (fintech) player (LSP or lender service provider) compensates lenders if the borrower defaults. The LSP provides certain credit enhancement features such as a first loss guarantee up to a pre-decided percentage of loans generated by it.

• The total amount of default loss guarantee cover on any outstanding loan portfolio cannot, in accordance with RBI norms, exceed 5% of the portfolio’s value. Unless the debt is repaid by the borrower before that time, the default guarantee must be used within 120 days of the loan falling past due.
• The regulated firms will be in charge of identifying and allocating bad loans.
• In addition to banks and NBFCs, the FLDG framework is anticipated to assist data-tech NBFCs (Non-Banking Financial Companies) and fintech companies by increasing their lending capacity and growing their customer base. The FLDG program would also boost the ecosystem for online lending and advance financial inclusion.

The First Loss Default Guarantee (FLDG) mechanism is as follows:

• Default loss guarantee (DLG) and first loss default guarantee (FLDG) are similar terms.
• A regulated entity and a fintech partner on the FLDG lending model.
• The term “fintech” refers to a brand-new technology that aims to enhance and automate the provision of financial services. 
• It is a safety-net arrangement between banks, non-banking financial institutions (NBFIs), and lending service providers (LSPs), also referred to as fintech firms, in the digital lending market.
• Although they lack a banking license, they provide a range of banking services.
• In this scenario, a third party promises to make up any defaults up to a specific percentage.
• When a customer defaults on a loan, the fintech guarantees to reimburse the partners up to a predetermined percentage.

About Fintech

• The word “fintech” describes the application of technology to the provision of creative and effective financial solutions.
• Fintech can include robo-advisors, blockchain, peer-to-peer financing, mobile payments, and more. Fintech may assist NBFCs by expanding their customer base, lowering expenses, enhancing security, and raising client happiness.
• Fintech can also present NBFCs with new potential and difficulties in terms of regulation, rivalry, and cooperation.

Also read: Digital Lending Apps

FLDG – Advantages for Banks, Fintechs, and NBFCs

• Fintechs can assess the creditworthiness of borrowers and provide specialized goods and services through their data and technological skills.
• They can reach out to new consumer groups like micro, small, and medium-sized firms (MSMEs), the poor in rural and urban areas, women, and young people who might not have access to established credit channels.
• With heritage institutions, they can level the playing field and compete on the basis of innovation, effectiveness, and customer satisfaction.
• With the aid of fintech, banks, and NBFCs can diversify their lending portfolio and access new markets and clients.
• By delegating some tasks to fintech, such as customer acquisition, verification, servicing, and collection, they can lower their operational costs and increase their profitability.
• By using the FLDG offered by fintech, they can reduce their credit risk and raise the quality of their assets. Since the FLDG has been restricted by the RBI to 5% of the loan portfolio, lenders will only be responsible for 95% of the losses in the event of default.
• They can adhere to the regulatory standards and directives set forth by the RBI for digital lending, including openness, ethical business conduct, consumer protection, and data security.

Conclusion:

• The lenders will be able to contact more people, take on less risk, make more money, and abide by the rules thanks to it. 
• The fintechs will be able to demonstrate their creativity, effectiveness, and customer-centricity. The borrowers will be able to readily, inexpensively, and conveniently access credit. 
• Additionally, it will encourage greater cooperation, accountability, and openness in the world of online lending. In India, the FLDG scheme is anticipated to promote financial inclusion, economic expansion, and social advancement.

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