Co-lending is a mechanism designed by the RBI to ensure that low-cost funds from banks are made available to NBFCs that operate in deeper geographies and work in MSMEs (Micro, Small and Medium Enterprises), SAPs (economically weaker sections), LIG (low income group) and MIG (middle income group) categories, where banks are slightly reluctant to lend due to higher operating costs and credit risks.
The main purpose of co-lending is to improve the flow of credit to unserved and underserved segments of the economy. The co-lending model allows NBFCs to seek low-cost funding from banks through a participation agreement, and requires them to provide the remaining 20% from their own funding sources.
This 80:20 ratio ensures that the NBFC does not create bad quality loans, as its 20% stake would also be affected by the losses that would arise from such creation.
This mechanism ensures a win-win situation for all three parties – borrower, bank and NBFC. Borrowers obtain the funds at a lower cost than they would have obtained on a stand-alone basis from NBFC. The bank would get a better deployment of its funds to the unserved and underserved sector, and NBFC would have a steady stream of economical and reliable sources of funding.
If the model is so good, what is hindering its growth?
Model complexity: The model requires banks to publish their credit policy to accept such loans. In addition, banks and NBFC must enter into a framework agreement regarding loan servicing and customer service. There is also a complex accounting methodology that must be in place for the three components of the co-loan – 80%, 20% and 100%. Separate accounts should be maintained for the bank, NBFC and the borrower.
Supply-demand mismatch in the PSL segment (loans to priority sectors): Banks are normally short of RBI’s PSL mandate, and they depend on NBFCs to sell their loans to them (since NBFCs have no such mandate). The supply of PSL loans by NBFCs is much lower than their demand, which makes the commercial negotiation between banks and NBFC very unbalanced in favor of NBFCs.
NBFCs also retain most other income in the form of processing fees, insurance commissions, additional interest rates, NSF check fees, penalty interest.
Curious case of the combined cost of the fund and the borrower’s interest rate: NBFCs say they do not know whether banks would approve a particular loan issued by them for a co-loan when banks select the pool and therefore cannot pass on the benefit of the blended cost to the borrower at the time of granting.
This is a big concern because this uncertainty ends up defeating the purpose of the co-loan at a lower interest rate as envisioned by the regulator.
The NBFC customer segment does not overlap with the bank: The credit profiles of NBFC customers are relatively riskier and therefore the likelihood of higher credit loss cannot be ruled out. Banks also complain that their ability to absorb higher credit losses is very limited. Banks have very little understanding of the credit risk of NBFC borrowers.
Regulatory compliances are different for banks and NBFCs: The regulatory standards for banks and NBFCs are different, so there are issues around know-your-customer (KYC) standards, collateral standards. Do these issues make the co-lending model unviable? Well, the benefits of the model far outweigh the concerns on both sides. There are solutions that will emerge from these challenges that will hopefully make this model a great success.
Some IT and fintech companies have already come up with the accounting and escrow solution for NBFCs and banks. The mismatch between supply and demand will resolve itself over time. Unless co-lending takes off, the supply (of PSL loans) will not improve as NBFCs find it very difficult to raise funds for loans. Unless NBFCs grow in scale and prove their ability to manage credit and liquidity risk well, the NBFC scale problem will not be solved.
Co-lending offers a perfect opportunity to take care of the initial concerns of low cost funds for loans. As the co-lending model develops, competition between NBFCs will ensure that the mixed cost is passed on to the end customer.
As for banks not understanding the credit nuance of this segment, this will be resolved over time as banks gain experience in managing these acquired portfolios and are able to see the performance of these segments over time. There are guarantee companies in the area of MSMEs and home loans in India which can be operated by banks while defining their risk appetite for co-lending activities with NBFCs, and also taking a guarantee of credit default until they are ready to take that risk on their own.
The terms between the banks and the NBFCs, as both begin to see the benefits, will eventually be settled despite the supply and demand mismatch in the PSL sector.