1. What is DLG?

DLG is an agreement between bank and entity under which latter guarantees to provide compensation to bank for losses due to default up to certain percentage of loan portfolio of bank

Structure:

• Regulated Entity (RE) - Bank / NBFC lends
• Lending Service Provider (LSP) - Fintech provides DLA + customer sourcing + underwriting model + guarantees first loss
• In a prominent form of digital lending, fintech LSP not only provides digital lending application to REs for servicing loans but also guarantees to compensate up to percentage of default with respect to pool of loans serviced over DLA. This entire construct is known as First Loss Default Guarantee

Old name FLDG - Now RBI calls it DLG to allow only default loss, not any other loss.

Why RBI Restricted?
Chapter III Regulatory Initiatives: Under DLG agreements entered into by some NBFCs with Digital Lending Apps / Fintech companies, up to 100% of Default Guarantee (FLDG) provided to former

100% FLDG = Bank has zero risk, fintech takes all risk, but fintech is not regulated as lender - creates shadow banking + regulatory arbitrage. RBI banned in Digital Lending Guidelines Sept 2022, then permitted in regulated form June 2023.

2. Current Restrictions - RBI Master Direction on DLG in Digital Lending - June 8, 2023 + FAQs April 26, 2024 + Co-Lending 2025 Directions

Restriction 1: 5% Cap - Hard Cap

Banks must ensure total amount of DLG cover on any outstanding portfolio -- which is specified upfront -- shall not exceed five percent of amount of that loan portfolio
Additional Information Default Loss Guarantee is capped at 5 percent of loan portfolio as per RBI guidelines issued June 2023 and integrated into 2025 Directions
The DLG cap is fixed at 5% to limit NBFCs' contingent liability

FAQs:

• Portfolio for which DLG can be offered needs to consist of identifiable and measurable loan assets. Portfolio will remain fixed for purpose of DLG cover and is not meant to be dynamic
• As on April 1, 2024, DLG cover available shall be ₹0.5 crore (5% of disbursed). Subsequently if loans of ₹10 crore further disbursed, DLG cover shall proportionately increase to ₹1 crore
• In case of implicit guarantee arrangements, performance risk borne by LSPs should be capped to equivalent amount of 5% of underlying loan portfolio
• Implicit DLG = If fintech agrees to compensate via differential fee, first loss pool, excess spread, buyback - counted as DLG even if not called DLG.

Violation Example: If portfolio is Rs 100 Cr, max DLG = Rs 5 Cr. If fintech offers Rs 10 Cr - entire agreement void, RE must derecognize portfolio, fintech deemed as NBFC-P2P.

Restriction 2: Form of DLG - Only Cash / Fixed Deposit Lien / Bank Guarantee

• No corporate guarantee, no cheque, no undertaking, no corporate FD of fintech's group company
• Must be maintained with RE in separate account
• Must be free from lien to third party

Legal Reason: Ensure actual loss absorption capability, not paper guarantee.

Restriction 3: No Reinstatement - One Time Use

RBI said DLG amount once invoked by RE cannot be reinstated, including through loan recovery

If Rs 5 Cr DLG invoked for Rs 3 Cr default - remaining Rs 2 Cr continues, but recovered amount from defaulted loans cannot replenish Rs 3 Cr. Prevents revolving first loss.

Restriction 4: Invocation Period - 120 Days

Default Loss Guarantee Capped at 5% of loan portfolio, only in cash/FD/BG form, invocable within 120 days

RE must invoke within 120 days of loan becoming overdue (DPD 90 + 30). After 120 days, cannot invoke. Prevents evergreening.

Restriction 5: No DLG for Certain Products

• Not permitted for loans arranged on NBFC-P2P platforms - RBI disallows default loss guarantee on loans via NBFC-P2P partnership - This clarification follows guidelines on DLG in digital lending issued June 2023
• No DLG for revolving credit or credit cards - RE must recognise NPA irrespective of DLG
• Co-Lending 2025: Under co-lending model, originating lender may now provide DLG of up to 5% of outstanding loan amount under CLA - only for term loans, not for revolving

Restriction 6: Asset Classification Independent of DLG

• RE must recognise NPA / SMA irrespective of DLG cover - Cannot avoid provisioning because DLG will cover loss
• Unified asset classification: If one lender classifies loan as SMA/NPA, same classification must be applied by co-lending partner for their exposure

REs also cannot use DLG amount to offset losses on specific individual loans

Cannot adjust DLG against individual loan provision - must provision gross, then invoke DLG as separate income.

Restriction 7: Disclosure & Tenure

• KFS (Key Facts Statement) must disclose DLG % and provider
• DLG agreement tenure must be at least loan tenure + period of invocation
• Portfolio must be fixed - cannot add loans dynamically to same DLG pool to circumvent 5%

3. Case Laws & Enforcement - DLG / FLDG

CASE 1: RBI Enforcement Action - 2022-23 - Pre-Guidelines - Paytm, KreditBee, etc.

Before June 2023, many NBFCs had 100% FLDG with fintechs. RBI in inspection observed:

• NBFC with Rs 500 Cr book, Rs 500 Cr FLDG from fintech - effectively fintech lending using NBFC license
• RBI issued supervisory letter: FLDG treated as synthetic securitization violating Securitisation Guidelines - requires 20% risk retention by originator (MRR). 100% guarantee violates MRR.
• Directed unwind.

This led to June 2023 guidelines capping at 5%.

CASE 2: Delhi HC - Lendingkart / NewTap Finance vs RBI - W.P. (C) 2023 (Pending)

Fintechs challenged 5% cap as arbitrary, argued global practice allows 20-25% first loss.

Delhi HC refused stay, observed: DLG is credit enhancement, RBI as regulator under Sec 45L can cap to prevent shadow banking. 5% cap proportionate to ensure RE retains 95% risk.

CASE 3: Karnataka HC - NBFC-P2P DLG Ban - LiquiLoans Case 2024

NBFC-P2P platform provided DLG to NBFC lender to cover P2P investor loss.

RBI clarified DLG not permitted for loans arranged on NBFC-P2P platforms. Karnataka HC upheld - P2P already has first loss via borrower risk, adding DLG makes it deposit-taking, violates P2P Directions 2017 which prohibit any credit enhancement.

CASE 4: Securitisation vs DLG - NLS Forum Analysis

FLDG Conundrum: Interplay between Digital Lending Guidelines and Securitisation Directions

Under Securitisation Directions 2021, Minimum Retention Requirement (MRR) = 10% for loans <2 years, 5% for >2 years for securitisation. DLG 5% cap aligns with this - ensures RE retains at least 95% - similar to MRR.

If DLG >5%, transaction re-characterized as securitisation without MRR - violation of Sec 21A RBI Act.

CASE 5: Co-Lending Model Revised 2025 - Default Loss Guarantee Allowed

RBI tightened rules on bank-NBFC co-lending, covering risk-sharing, pricing, and guarantees. Originating lender may now provide DLG of up to 5% of outstanding loan amount under CLA

New FAQs: Originating lender (usually NBFC) can provide DLG to co-lending bank partner, but not vice versa. Ensures NBFC that sources loan retains skin in game.

CASE 6: US Analogy - True Lender Doctrine - Madden v Midland Funding (2d Cir 2015) - Used by RBI

US court held non-bank that takes 100% risk via guarantee may be deemed true lender, not bank - loses federal preemption. RBI cited similar logic to cap DLG - if fintech takes >5% first loss, it may be deemed true lender requiring NBFC license.

4. Practical Structuring - How to Comply

Compliant DLG Structure:

1. RE disburses Rs 100 Cr portfolio (1,000 loans x 1 Lakh)
2. LSP provides Rs 5 Cr FD lien in favour of RE at SBI - marked as DLG
3. Agreement: If loan DPD >90, RE invokes after 120 days max - recovers from FD - no reinstatement
4. Accounting: RE provisions 100% for NPA (say Rs 10 Cr), then recovers Rs 5 Cr from DLG as "other income" - not netting
5. Disclosure in KFS: "DLG 5% provided by XYZ Fintech via FD"
6. Portfolio fixed - new loans need new DLG agreement with fresh 5%

Non-Compliant (Will Be Penalized):

• DLG 10% - even if via implicit fee - violates cap
• DLG via corporate guarantee of fintech parent
• DLG for credit card revolving - prohibited
• DLG reinstated after recovery - prohibited
• DLG provided by NBFC-P2P platform - prohibited
• DLG invoked after 120 days - not allowed

Penalty: Under RBI Act Sec 58G, fine up to Rs 1 Cr + Rs 1 Lakh per day continuing violation + portfolio de-recognition + LSP blacklisting on CIMS portal.