Regulation of digital lending to help space grow, protect consumer interest

Further, the requirement that the rationale for algorithmic features used in digital lending be documented to render it explainable will enable more transparency and audit trails, thereby minimising unfair practices resorted to by some DLAs.

By Sanjay Doshi & Vinay Narkar

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The RBI-constituted working group on digital lending recommends, in its recently submitted report, the setting up of an independent body styled as Digital India Trust Agency (DIGITA) to verify digital lending applications (DLAs) and ensure continuous surveillance of verified DLA along with setting up of a self-regulatory organisation (SRO) covering the participants in the digital lending ecosystem to identify fake/unauthorised lending apps or websites by using the whitelist created.

Setting up an SRO is a step forward and publishing a list of lending service providers (LSPs) engaged by regulated entities (REs) on their website through an SRO code of conduct will bring in better transparency from the customer’s point of view. But expectations on the effectiveness of regulating institutions by the SRO may be in the moderate territory. While the public register of ‘verified’ apps maintained by DIGITA is a welcome idea, the need of the hour is a framework that outlines the triggers when approvals are needed after DLAs achieve a certain level of threshold so that entry is not restricted and, at the same time, scaling up is closely monitored.

The recommendations restricting balance sheet lending through DLAs to REs and the prohibitions on synthetic structures are aimed at discontinuing the practice of ‘rent-an-NBFC’ model. Discontinuance of first loss default guarantee (FLDG) model may slow down digital-lending growth, especially in the small and medium ticket-size segments as traditional banks/NBFCs may not take the required risks in absence of FLDG. This would impact the pure lending fintechs or LSPs, as they will need NBFC licence if the FLDG model is discontinued.

Treatment of ‘buy now pay later’ (BNPL) as part of lending (excluded so far), except those offered by sellers as merchant credit, will lead to better reporting to credit bureaus. The BNPL segment, especially the ultra-low-ticket BNPL, will get impacted given the higher operational costs of KYC, CKYC and bureau reporting involved, especially for REs who onboard new customers through BNPL. Further clarity is required on ‘definition of credit’ for companies that are not regulated by RBI but offer BNPL as deferred payments through their balance sheet.

Development of certain baseline technology standards for offering digital lending solutions, along with requirement of all data to be stored in servers located in India and a proper consent mechanism for data collection and usage, is a welcome step. This would further some of the cloud platform providers who don’t currently have data centres in India to set these up here in order to serve clients.

Further, the requirement that the rationale for algorithmic features used in digital lending be documented to render it explainable will enable more transparency and audit trails, thereby minimising unfair practices resorted to by some DLAs.

To protect consumer interest, the working group recommendation on standardisation of the fact statement will facilitate transparency and enable comparability for the borrower. But disclosing upfront the annual percentage rate may not work for all products, especially payday loans or short-term loans.

Other recommendations, such as governing unsolicited commercial communications for digital loans under a code of conduct put in place by the proposed SRO, will prevent coercion and mis-selling; this will prevent customers from purchasing schemes with misguided communication strategies.

Maintaining a ‘negative list’ of LSPs will enable both REs and customers to identify fraudulent DLAs. But to ensure successful execution and usage of such a list, it must be data-rich and match dubious companies that sprout later with information from the existing list.

The working group has suggested many more measures on reporting, payments and settlement systems, storage of biometric data, simplification of digital products, governance, etc, to ensure financial stability, market integrity and consumer protection take precedence in the objectives of financial regulation in comparison to creating a level-playing field.

In the short term, some of the measures may be restrictive and impact or even slow down the growth of digital lending, especially in the small/medium ticket-size segment. It will also have an impact on set-up, technology, compliance and operational costs for digital lending players. Companies using alternate channels or pseudo-financing products like BNPL will need to relook product design.

Further, laws on data privacy and protection, clarity on outsourcing guidelines, transparency in product design, ability to conduct audit-trails on AI/ML based underwriting algorithm, will bring much-required monitoring and governance to the segment.

Overall, the recommendations will certainly bring in required regulatory oversight, help build trust in digital lending and provide more transparency.

Doshi is partner & head, Financial Services Advisory, KPMG in India; Narkar is partner, KPMG in India