In December 2020, the Hyderabad police arrested seven people involved in digital lending business after a spate of suicides in Telangana’s capital in a grim reminder of last decade’s social chaos caused by a similar web of elaborate deception.

Nearly 75 bank accounts with Rs 423 crore in deposits were frozen. These people were running a digital money lending business through multiple mobile applications, giving out small-ticket loans without regulatory approvals.

The suicides were a result of harassment and humiliation by these modern day Shylocks after borrowers failed to pay back their dues that were amplified because of compounding of interest rates, which were anyway astronomical by normal lending standards.

The Reserve Bank of India (RBI) sprang into action and constituted a working group (WG) to study all aspects of digital lending, so that appropriate regulations can be put in place.

“We are a country of 1.25 billion with only about 35 to 40 million credit cards. Digital lenders can expand the credit base just like NBFCs did at one point in time. Unfortunately, a few bad apples have spoiled the party. But it has also brought a sector into the regulatory spotlight,” said Anuj Kacker, cofounder at digital lender MoneyTap, which has now transitioned to neo bank Freo. It is a credit platform that helps

and HDB Financial among others to acquire customers.

The six-member working group also had to identify risks posed to financial stability, regulated entities and consumers, and suggest regulatory changes, a fair practice code and also measures for robust data governance.

In November 2021, the committee recommended regulatory, technology and consumerrelated changes.

Key recommendations that can be implemented in the near term include restricting lending activities only to entities regulated by the RBI. A self-regulatory organisation (SRO) to frame standards and good practices among digital lending companies is another crucial suggestion.

It was also for a Digital Trust of India Agency (DIGITA) to detail minimum technical standards and verify compliance.

Small loans, big growth

The digital lending ecosystem has evolved into two broad categories of firms — balance sheet lenders (BSLs), or companies which lend on their own books online, and lending service providers (LSPs), which provide their platform to source loans for banks or NBFCs for a fee. To be sure, these lenders form a miniscule part of the lending ecosystem in India. Moreover, even among banks, lending through digital means forms a tiny part of the loan portfolio.

The WG analysed a representative sample of banks and NBFCs and observed that lending through digital mode relative to physical mode is still at a nascent stage in case of banks (Rs 1.12 lakh crore via digital mode vis-à-vis Rs 53.08 lakh crore via physical mode) whereas for NBFCs, the comparative figures are Rs 0.23 lakh crore vis-à-vis Rs 1.93 lakh crore.

However, the overall volume of disbursement through digital mode for the sampled entities has exhibited a growth of more than twelve-fold between 2017 and 2020 (from Rs 11,671 crore to Rs 1.41 lakh crore).

Industry leaders say the strong growth in digital lending indicates the huge untapped credit potential in India which can be bridged efficiently through the use of technology. Kacker, who is also an executive committee member of the 80-member Digital Lenders Association of India (DLAI), says bringing digital lenders under RBI regulation will help weed out the bad apples and ensure only serious players survive as cost compliance may be too high for the mischief makers.

Deep-pocketed villains

Digital lending has taken off over the last couple of years, also helped by the distress in the salaried class segment after Covid — and led by shady deep pocketed mobile applications.

The typical modus operandi of these companies is to lure customers by small-size loans of Rs 5,000, which can be paid back in a couple of weeks with some interest — typically of Rs 500 per month.

However, if the borrower fails to re pay this amount, it gets compounded at 120% per annum (10% per month), making it difficult for the borrower to repay.

This loan is sometimes masked as a service called Buy Now, Pay Later (BNPL), which allows shoppers to buy something but pay for it later within a stipulated interest-free period in three or more instalments. These loans mostly target young, new-to-credit, cash-strapped millennials.

However, if a buyer fails to pay the amount within the defined repayment window, the lender will charge interest on the unpaid amount along with a hefty late payment fee.

Until the RBI crackdown earlier this year, many applications used to offer loans without any credit checks or loan agreements for small ticket sizes.

These loans would be booked by little known NBFCs and backed by deep pocketed investors — sometimes originating from China or registered in other developed markets.

Madhusudan Ekambaram, cofounder and CEO, KreditBee, a digital lender with an NBFC licence, says these foreign investors either took over an NBFC by installing dummy directors or offered huge incentives for small NBFCs to use their loan books for lending.

“Typically, these investors offered a first-loss default guarantee (FLDG) of 80% when the industry trend was 10%. Such a high guarantee for defaults, lucrative fees and a growing market meant that many small NBFCs joined the bandwagon and lending practices went out of hand,” Ekambaram said.

In banking parlance, FLDG is offered to a small partner or a co-lender to cover initial defaults. For example, in a business correspondent model, banks used to provide a 6% to 7% FLDG to insulate partners against any defaults. However, an 80% guarantee means that a small NBFC may never make a loss, making them compromise on underwriting standards.

Global experience

Ekambaram says India is not the first market where these deep pocketed investors have made a dent.

“About a year earlier, the story was similar in Indonesia. When the regulatory heat increased there, they came to India. It was China before Indonesia. So, in a sense, we are just a couple of years behind. If you ask people as to where these investors are now, some say they have moved on to Bangladesh and Mexico,” he said.

Industry leaders say the WG’s recommendations are much needed when the industry is seeking directions. Groups like DLAI and individual companies like MoneyTap, Kreditbee will also give their own suggestions to the RBI by the December 31 deadline.

Anurag Jain, co-founder of KredX, a platform for invoice discounting for micro and small enterprises, says recommendations include ensuring there is easy availability of credit at the right price while complying with all the regulations set out by RBI.

“One thing is clear, you cannot be a lending institution if you do not comply with regulations, have no risk management systems in place or do not have adequate capital. But yes there is a need to deepen the credit base and digital lending companies can do the same thing that micro finance companies did but just like them, we will have to follow regulations,” said Jain, who is also a member of DLAI.

The report of the working group could form the crux of digital lending regulations by the central bank in the future. As neo banks and digital platforms flourish, these entities can only expect more regulatory attention which could mean less than desired growth rate, but a stable long term smooth runway.