Potential of joint lending for unserved/underserved segments

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Co-lending is a mechanism developed by RBI to ensure that NBFCs operating in lower regions and in the MSME (Micro, Small and Medium Enterprises), EWS (Economically Weak Areas), EWS (Economically Weak Areas) , LIG ​​(Low Income Group) and MIG (Middle Income Group) categories, in which banks are somewhat reluctant to lend due to higher operating costs and credit risk.

The primary focus of co-lending is to improve the flow of credit to the unserved and underserved segments of the economy. The co-lending model allows NBFCs to cheaply source funds from banks through a tie-in agreement and requires them to raise 20 percent from their own funding sources.

This 80:20 ratio ensures that NBFC does not underwrite poor quality loans, as its 20 percent stake would also be affected by losses resulting from such underwriting.

This mechanism ensures a win-win situation for all three parties – borrower, bank and NBFC. Borrowers receive the funds at a lower cost than they would have received from NBFC on their own basis. The Bank would better allocate its funds to the unserved and underserved sectors and NBFC would have a steady flow of economical and reliable sources of funding.

If the model is so good, what’s plaguing its growth?

Complexity of the model: The model requires banks to publish their lending policies for accepting such loans. Other banks and NBFC must conclude a framework agreement on loan servicing and customer service. There is also a complex accounting methodology that needs to be set up for the three components of joint lending – 80 percent, 20 percent and 100 percent. Separate accounts must be maintained for the bank, the NBFC and the borrower.

Demand-supply mismatch in the PSL (Priority Sector Lending) segment: Banks typically lack RBI’s PSL mandate and rely on NBFCs to sell them their loans (because NBFCs have no such mandate). The supply of PSL loans by the NBFCs is far less than their demand, making the commercial negotiations between the banks and the NBFC very lopsided in favor of the NBFCs.

NBFCs also retain most other revenue in the form of processing fees, insurance commissions, additional interest rates, check-bending fees and penalties.

Curious case of mixed financing cost and borrower interest rate: NBFCs say they are unsure whether banks would approve a particular loan they originated for pooled lending during banks’ pool selection and therefore cannot pass on the benefit of mixed costs to the borrower at the time of origination.

This is a major problem as this uncertainty ultimately defeats the purpose of collective lending at lower interest rates as envisaged by the regulator.

NBFC customer segment does not overlap with bank: The credit profiles of NBFC customers are relatively riskier and therefore the possibility of higher credit losses cannot be ruled out. Banks also complain that their ability to absorb higher loan losses is very limited. Banks have very little understanding of the credit risk of NBFC borrowers.

Regulatory compliance is different for banks and NBFCs: The regulatory standards for banks and NBFCs are different, so there are issues related to know-your-customer (KYC) and collateral standards. Do these problems make the co-lending model unprofitable? Well, the usefulness of the model far outweighs the concerns on either side. Solutions will emerge from these challenges that will hopefully make this model a great success.

Some IT and fintech companies have already developed the accounting and escrow solution for NBFCs and banks. The demand-supply mismatch will resolve itself over time. If co-lending does not take off, the supply (of PSL loans) will not improve as it is very difficult for the NBFCs to raise funds to lend. Unless NBFCs grow in size and demonstrate their ability to manage credit and liquidity risk well, the NBFC size issue will not be resolved.

Co-lending offers a perfect opportunity to address initial concerns about inexpensive means of lending. As the co-lending model becomes more widespread, competition between NBFCs will ensure that the mixed costs are passed on to the end customer.

The issue of banks not understanding the creditworthiness nuances of this segment will clear up over time as banks gain experience managing these acquired portfolios and see the performance of these segments over time. There are guarantor companies in the MSME and home loan space in India that can be leveraged by the banks while defining their risk appetite for the co-lending business with NBFCs and also providing loan default guarantees until they are willing to take that risk on their own.

The terms between banks and NBFCs, as both are beginning to see the benefits, are eventually settled despite the mismatch between supply and demand in the PSL sector.

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