Hi everyone,  

Welcome to the 156th edition of The Pattern, a weekly where we dive into the latest from the world of economy, technology and finance. Let’s get started!  

"You cannot escape the responsibility of tomorrow by evading it today." – Abraham Lincoln. 

In a gold rush, people often forget to carry safety gear. Something similar happened in the world of digital lending recently as an entire business model seems to have come crashing down. 

For years now, banks and NBFCs have partnered with digital platforms to improve their distribution. This arrangement not only helps them expand their loan books but also find quality borrower pools at a fraction of the cost. Except, sometimes, people default on repayments.  

Every risk model worth its salt accounts for a certain level of defaults. The problem starts when observed defaults are more than what anyone predicted. For this, lenders had “arrangements” with these FinTechs—a default loss guarantee—sometimes about 5% of the portfolio.  

The Reserve Bank of India, in its latest move, has pulled the rug off one’s feet. Now, the regulator wants lenders to ensure their provisioning for bad loans is in the quantum of predicted losses, not predicted losses adjusted with DLG money they’re supposed to get back.  

It’s like the insurance policy is no longer valid, or rather, much less effective if you must keep your safety net intact anyway.  

As a result, the digital lending game has changed—once again. What happens next? Let’s dive in. 

But just as with all shortcuts, the risk was always lurking beneath the surface. 

It all started with a large FinTech defaulting on their DLG obligation. The amount? A whopping Rs 172 crore! The default payment not only hurt the lenders’ books but also called into question the systemic fragility of such partnerships where one bad quarter can make everything come crashing down.  

The dominoes started falling.  

New rules of engagement  

Now, according to the new rule, NBFCs must exclude DLGs from their expected credit loss calculations. They can only write it back after the loan matures, and once the fintech pays. The modified arrangements must be implemented by September 30.  

The aim is to limit damage in the lending ecosystem and realign incentives for all participants.  

As our CEO, Rajat Deshpande , said in a recent interview, "Regulated entities must maintain full ownership of their underwriting decisions and risk assessment processes." 

Our Co-founder Srijan Nagar added that "The RBI's decision represents a fundamental shift away from what I call the 'balance sheet rental' model that has dominated digital lending partnerships.   

While this will undoubtedly increase provisioning costs for NBFCs in the near term and reduce the attractiveness of FinTech partnerships, it's forcing a much-needed evolution in the sector. The winners will be those who pivot quickly from risk-transfer models to genuine value-creation partnerships based on data analytics, customer acquisition technology, and superior servicing capabilities.” 

Fintechs, without the ability to offer DLGs, will have to work hard to woo lenders. They will need to rebuild trust based on data, technology, and servicing capabilities—not just guarantees. 

Ultimately, the borrowers belong solely also feel the tremors from the shakeup. Lenders might grow cautious and reduce approval rates or increase interest rates until they develop comfort with new risk frameworks.  

Who will emerge stronger from this storm? Those who shift gears and adapt to this change—fast. From leaning on default guarantees to building a solid foundation rooted in data-driven underwriting, participants must invest in sharper risk intelligence models, customer acquisition technology and superior servicing capabilities to maintain growth. 

Rebuilding the tower of trust   

To re-establish a trusting relationship, here are a few critical shifts they will need to embrace: 

1. Improving innovation: FinTechs should find smarter ways to assess borrowers using platform and alternative signals to reduce lender risk.  

2. Investing in better risk management: Lenders must advanced modelling, scorecards and AI analytics to identify high-risk borrowers early and actively monitor loan portfolios. 

3. Building better Early Warning Systems (EWS): If a borrower is likely to default, lenders need to be aware of it before it happens. EWS tools can flag distress signals in real time, allowing lenders to intervene at the right time. 

4. Revamping partnership management and compliance:  Fintechs must work closely with NBFCs to ensure all rules are followed, and risks are shared more transparently, thereby ensuring full compliance with RBI guidelines. 

The balancing act  

The recent regulatory guidelines will surely push the market toward tech-forward, sustainable lending. It's setting the stage for healthier, more transparent collaborations between lenders and fintechs. This shift eliminates regulatory arbitrage and reinforces the RBI's broader goal: ensuring that regulated entities retain full ownership of their credit decisions, regardless of the partnership's structure. 

It also arrives at a time when digital personal loans are showing stress. According to CRIF High Mark, personal loans under ₹10,000 saw a  44% rise in delinquency rates between Dec 2023 and June 2024. Among fintech NBFCs,  14% of borrowers fall into the highest risk bracket. 

Perhaps the RBI acted because of this trend or to keep worse things from happening, but now that the new regime is in place—it’s necessary to embrace it.  

Lending has always been a serious business. The regulator is just trying to ensure that everyone involved knows that it is.  

This is all from me this week. As always, leaving some reading recommendations below.

Reading List:  

1. Frauds: A sum of many parts  

2. Public sector banks drive record profits in India for FY25 amidst asset quality improvements  

3. RBI makes it easier to claim dormant funds  

4. Rules planned to curb mis-selling of products by banks and NBFCs  

5. NBFCs can’t rely on fintech cushions anymore as RBI cracks down on default loss guarantees  

Thank you for reading. If you liked this edition, forward it to your friends, peers, and colleagues. You can also connect with me on X here and follow FinBox on LinkedIn to always get all updates. 

Cheers, 

Mayank