Regulate Now versus Pay Later

The Master Direction

The Reserve Bank of India (RBI) recently released a master direction on the issuance and conduct of credit card and debit cards (Master Direction). The Master Direction has repealed several earlier circulars and directions issued by the RBI on the subject matter and is slated to come into effect from 01 July 2022. Apart from enumerating the eligibility criteria and operational guidelines in relation to issuance of credit cards and debit cards by banks in India, the Master Direction also provides the pre-requisites that must be fulfilled by non-banking financial companies (NBFCs) before undertaking a credit business.

As per the Master Direction, NBFCs may undertake credit business if the following conditions are fulfilled: (a) prior approval is obtained from the RBI; (b) a certificate of registration with the RBI is obtained; (c) the NBFC has a minimum net owned fund of INR 1 billion; and (d) other terms and conditions as may be prescribed by the RBI. The Master Direction while stipulating the above states that ‘Without obtaining prior approval from the Reserve Bank, NBFCs shall not issue any debit cards, credit cards, charge cards[1], or similar products virtually or physically’.

Additionally, the Master Direction prescribes key norms in relation to co-branding arrangements between card issuer entities and their co-branding partners. The Master Direction sets out the primary liability of the card issuers under such arrangements, as well as the limited role of the co-branding partners. The Master Direction also provides that the card issuer shall be primarily responsible to conduct an independent underwriting process of any credit business to be undertaken by it.

Express prohibitions imposed by the Master Direction also include confidentiality obligations on card issuers. Card issuers will not be permitted to share any information collected by them, with any other entity or person without obtaining the explicit consent of the end user to whom the information pertains.

Fintech and the digital lending business

The Master Direction especially the above terms, may be of considerable significance to a number of new-age financial technology (Fintech) firms that have entered the digital lending space including entities that provide Buy Now Pay Later (BNPL) services. Fintech firms participating in the lending business using cards, virtual or otherwise, appear to be impacted by the Master Direction as they may fall within the ambit of the restriction imposed by RBI as stated above.

Fintech firms engaged in digital lending business including BNPL business may use various methods to conduct their business. The common ones being as follows:

a.  Fintech firms obtain a license for issuance of prepaid cards, which is pre-loaded with funds through tie-up arrangements with banks or NBFCs (Traditional Lending Entities). These prepaid cards are then subsequently issued to end users as a credit product (Pre-Paid Credit Mechanism); or

b. Fintech firms may enter into co-branding arrangements with Traditional Lending Entities who are eligible to issue credit cards, where the Fintech firm is merely front-ending the credit facility. In such arrangements, the Traditional Lending Entity is entirely responsible for the issuance and operation of the credit facility (Co-Branding Mechanism).

Under both mechanisms, the Fintech firms play a key role in the implementation of technology focused processes to quickly and effectively analyze whether a credit facility should be extended to the concerned end user (also known as underwriting of the credit facility), on the basis of the information available or accessible to the Fintech firms. Further, any information and data collected or generated by the Fintech firms may also be subsequently used for cross-selling of other products and services to the end users. Thus, underwriting of the credit facility and data collection / generation are key aspects of the other business activities of such Fintech firms involved in the digital lending space.

Out of the two mechanisms mentioned above, most Fintech firms may prefer to operate under the Co-Branding Mechanism due to the absence of any regulatory or license requirements. Under the Co-Branding Mechanism, Fintech firms merely act as service providers to the Traditional Lending Entities. In this write-up, we have analysed the potential adverse impact of the Master Direction on arrangements under the Co-Branding Mechanism.

Potential issues under Co-Branding Mechanism structure

The Master Direction has expressly provided that the role of the co-branding partner, i.e., the Fintech firm in the present scenario, in a co-branding arrangement should be limited to (i) the marketing and distribution of the cards, and (ii) to provide to the cardholder, the access to the offered goods and services. Further, the Master Direction also provides that the card issuer, i.e., the Traditional Lending Entity, must ensure prudence while issuing credit cards, and independently assess the credit risk for providing such facilities. Additionally, the RBI directions on ‘Managing Risks and Code of Conduct in Outsourcing of Financial Services’ applicable to Traditional Lending Entities provide that the process of sanctioning loans cannot be outsourced to third party service providers. Accordingly, it appears that Fintech firms providing digital lending services may not be permitted to underwrite credit facilities to be disbursed by Traditional Lending Entities to the end consumer. In such a situation, Traditional Lending Entities may not be interested in continuing such co-branding arrangements. Further, if the Traditional Lending Entity is forced to conduct an independent underwriting exercise, it may adversely affect the Traditional Lending Entities’ ability to issue such credit facilities in a seamless manner, which is the flagship feature of digital lending services and especially BNPL services.

Further, the Master Direction also places restrictions on the sharing of the end user’s information by the Traditional Lending Entities to other entities or persons without obtaining the prior express consent of the end user. The receiving and analysis of information by the Fintech firms to underwrite the credit risk is the core of the services provided by the Fintech firms. Any restrictions on the sharing of consumer information will severely impact the ability of the Fintech firms to provide their services. Further, the commercialization of the data collected and generated by the Fintech firms, by other means, is also an important consideration for the Fintech firms, and restrictions on receiving information and the subsequent commercialization of the same may result in considerable limitation of participation by the Fintech firms in the digital lending space.

Credit Risk Sharing Arrangements

One of the other key features of current Co-Branding Mechanisms is that while the credit risk of the lending facility is retained in the balance sheets of the Traditional Lending Entity, the Traditional Lending Entity and the Fintech firms also enter into certain credit risk sharing arrangements, pursuant to which Fintech firms provide certain guarantees to the Traditional Lending Entity. Such guarantees are commonly known as ‘First Loss Default Guarantee’ (FLDG) under which the Fintech firms undertake to make good the losses suffered by the Traditional Lending Entity in case of a default by the end user, up to a certain pre-decided percentage of the total credit facilities sourced by the Fintech firm. The offering of FLDG demonstrates the Fintech firm’s skin in the game and incentivizes the Traditional Lending Entities to provide the credit facilities. The offering of FLDG may in certain circumstances be deemed to be a mechanism through which the Fintech firm actually undertakes the credit risk associated with the credit facility, while the Traditional Lending Entity merely holds the loan in its books of accounts. Through this mechanism, Fintech firms ultimately bear the credit risk associated with the credit facility and provide further impetus to the digital lending industry while resulting in greater financial inclusion.

The RBI in its working paper on digital lending dated 18 November 2021, had discussed the above FLDG mechanism and recommended the prohibition of Traditional Lending Entities from entering into such synthetic structures with such unregulated entities. While the Master Direction does not explicitly deal with digital lending or BNPL services, the indirect underwriting of credit risk by Fintech firms through synthetic structures such as offering of FLDG, may also get unintentionally covered within the ambit of offering of credit products, resulting in the application of each of the consequent restrictions and regulations on the Fintech firms, as prescribed by the Master Direction as well as other circulars and directions issued by RBI in relation to such lending business.

Thoughts

The Master Direction may be one of many such regulations which may come into effect in the near future to regulate the digital lending space which is currently fueled by regulatory arbitrage. Any regulations which increase the capital or compliance obligations / costs of the Fintech firms should also take into account the fact that some of the Fintech firms are hastening the process of ‘financial inclusion’ or ‘banking the unbanked’. The Fintech firms are providing access to alternative credit to many who may not have access to credit through formal financial institutions or access to credit at the cost that is being offered by the Fintech firms either directly or through NBFCs.

Accordingly, regulations in this space should be designed to incentivize the development of technology based financial products which will further extend the growth of creating credit history of identifiable Indian citizens (i.e., through the Aadhaar framework) and strengthen India’s credit platforms. It should not happen that for protecting the financial system from unscrupulous digital lenders, our regulations invade the domain of innovation and adversely impact India’s Fintech success story!

Author: Souvik Ganguly 

The information contained in this document is not legal advice or legal opinion. The contents recorded in the said document are for informational purposes only and should not be used for commercial purposes. Acuity Law LLP disclaims all liability to any person for any loss or damage caused by errors or omissions, whether arising from negligence, accident or any other cause.

[1] a product offering credit services similar to credit cards