Co-lending model: Can changes in the co-lending model facilitate the availability of credit for the priority sector?
Now, based on feedback received from stakeholders, to better leverage the respective comparative advantages of banks and NBFCs in a collaborative effort, RBI had, in November 2020, published a revised scheme renamed the “Co-Lending Model” ( CLM) which aimed to give greater operational flexibility to lenders while requiring them to comply with regulatory guidelines on outsourcing, KYC, etc. In accordance with the revised model, lenders have a choice of two options to structure their co-loan products from the bank, either as a pre-disbursement contribution to a loan under an ex ante due diligence mechanism. , or as a recovery after disbursement by the bank in the loan on a back-to-back basis.
The conceptualization is fully in line with the regulator’s intention to improve the flow of credit to the unserved and underserved sector of the economy, given the static culture and strict hierarchy of credit institutions, by especially in PSUs. However, these options present critical operational challenges.
The first option above is similar to the previous co-origin model, where banks are expected to approve the case initiated by NBFCs before disbursement and involves a joint contribution. In this option, in accordance with RBI guidelines, banks are categorically required to undertake due diligence prior to disbursement and ensure compliance with outsourcing guidelines and KYC instructions. Now, although on a literal interpretation, banks can rely on NBFCs (being a regulated entity) on various lending processes and KYC aspects, banks generally tend to adopt a more stringent version of the instructions, thus limiting the scope of the instructions. NBFC to take over the agreement which destroys the effectiveness of the marriage and again delays the process.
In the second option which was specifically designed to give operational flexibility to the process, NBFCs are expected to disburse the loans and the banks must, after disbursement, perform due diligence and acquire its share in the loans on a selective basis similar to a mission. This appears to be a much simpler option since the industry is already familiar with the procedures and requirements of these direct assignment transactions. However, direct assignment in a co-loan model typically with a bank calls for various critical challenges, as below.
Compliance with Direct Assignment Guidelines: The co-loan model requires the acquiring bank to ensure that all the requirements of the direct transfer guidelines are met, except for the minimum holding period (MHP). Now in a traditional direct assignment transaction, direct assignment occurs for a pool of assets by performing a deed of assignment, paying stamp duty on the deed, seeking legal advice. on genuine sale, among others. To reproduce the same thing in co-loan would mean the execution of deeds of assignment for each client, the payment of stamp duty on a case-by-case basis, etc. This will not only increase the documentation / procedures but also increase the cost of the loan for the end borrower.
Security creation and restoration: The co-loan model very conveniently mentions that co-lenders should arrange for the creation of security and fees on mutually acceptable terms and the same for monitoring and collection. In practice, the bank which usually has to hold a larger share of the exposure would like the security to be created in its name. However, the loan is disbursed by the NBFC and the guarantee is provided even before knowing the bank’s decision on its participation. It is practically not possible to create security on behalf of a bank. So, to solve this problem, four options could be explored. First, by transferring the title to the bank’s name with the assignment, but that would double the cost of creating the title. Second, the creation of the security can be done after the disbursement after the bank’s decision, but it is practically not viable to sue the customer after the disbursement. And thirdly, the security must be created in the name of NBFC and it will continue to hold the same title as the agent of the bank, but banks usually do not agree to buy this option as it then implies that the banks must s ‘relying on NBFCs for recovery and other operations while there is also apprehension about the risk of bankruptcy, usually when it comes to young NBFCs. The fourth option which seems practically viable is to bring a third partner into the structure, i.e. a security trustee and create a security interest in its favor which will hold the security in favor of the NBFC. And whenever a bank agrees to take over the loan, the bank must be included in the fiduciary arrangement by a deed of adhesion. This certainly involves a lot of costs and procedural delays. Likewise for recovery also, the security trustee will be in charge and take the necessary measures on behalf of the lender (s).
Loan repossession and credit enhancement: The transaction under the co-loan agreement involving the post-disbursement assumption of the bank’s share in the loan is akin to a direct assignment and records will be sought in accordance with parameters agreed upon in advance. However, banks still want to exercise 360 degrees of due diligence in their internal policies while selecting loans and tend to follow an ideal co-origin approach. This consists of a KYC verification, a title verification by an independent lawyer, a public advertisement for the creation of a mortgage, among others. This defeats the purpose and flexibility offered by the model. Banks, for some reason, especially PSUs, have historically been unconvinced of the processes and practices of NBFCs. Perhaps a credit enhancement offer built into the transaction / arrangement in the form of an FLDG or collateral would reassure or help banks rely on the due diligence performed by NBFCs, such as the also provides for the regulator. Although the direct assignment guidelines restrict credit enhancement by the NBFC seller, the co-lending system allows banks to ask for statements and guarantees for which the originating NBFC will be responsible with respect to the share of the loans taken. in its books by the bank.
Despite its multiple operational challenges, the method of direct transfer of the co-loan was justified by attracting a lot of confidence among the banks. The assigning factor being the familiarity of its structure and practicalities. Riding the same, combined with the more ambitious goal of effectively leveraging collaborative efforts towards financial inclusion, would certainly yield positive results in the times to come.
The author is Chief Legal & Compliance Officer, U GRO Capital)