Co-lending is now popular! Bank of Baroda established its own co-lending platform with a target loan book of 10,000 crores. Co-lending arrangements between banks and NBFCs are becoming more common. Third-party lenders appear to be eager to join the co-lending bandwagon as well. Some believe it has the ability to close India’s credit gap, which is estimated to be several trillion rupees.
What Exactly Is Co-lending?
Simply described, it is the union of banks and NBFCs facilitated by the RBI. Why should they join forces? Because there is so much they can accomplish together.
Because of local expertise, specialised knowledge, and efficient credit distribution mechanisms, NBFCs have shown their capacity to reach the last mile. However, they incur a massively high cost of capital, which is a huge hindrance to their profitability.
Then there are the banks, which are sitting on a mound of cash. The majority of it is then passed on to financial intermediaries like NBFCs, MFIs, and home finance businesses for further lending.
This essentially implies that NBFCs undertake all of the legwork of originating, underwriting, processing, disbursing, and monitoring loans to the bottom of the pyramid, while banks profit handsomely by facilitating access to funds.
This is a terrible strategy. As a result, in the spirit of Ricardian economics, the RBI designed a strategy to incentivize both banks and NBFCs to capitalise on each other’s comparative advantages.
When banks’ access to cheap funding meets NBFCs’ flawless credit distribution mechanism, the result is what the RBI refers to as the co-lending model (CLM).
What Is The Process Of Co-lending?
You would believe that two lenders working together to give credit – the bank funds 80% of the loan, while the NBFC funds 20% — is nothing out of the ordinary. Furthermore, banks can expand their loan book, NBFCs’ liquidity issues are resolved, and credit reaches the ultimate beneficiaries at a reasonable cost. Even better, CLM loans are deemed priority sector lending (PSL), therefore co-lending will relieve banks of the burden of reaching PSL requirements.
It does appear to be a package deal. The devil, however, is in the details. Banks and NBFCs are quite distinct institutions; getting them to agree on anything is easier said than done. Let’s look at why.
Banks have two alternatives for loan approval under the CLM.
- The non-discretionary arrangement, which is an irrevocable commitment by the bank to book its portion of individual loans originating from NBFCs.
- The bank’s discretionary arrangement is to take a percentage of the loans created by NBFCs.
Option A necessitates high-level cooperation between the bank and the NBFC, in which the two companies originate, underwrite, and sanction loans together. This is not an easy task. Consider that banks and NBFCs must agree on 10,000 factors in order to grant a loan of $1,000,000. The collaboration problem is enormous, and it may appear insurmountable.
Option B appears to be less difficult operationally, as NBFCs can originate, sanction, and distribute loans on their own and then sell them to banks. After reviewing for compliance, the bank might accept or reject the loan portfolio.
In theory, it is simple; in actuality, it is complicated. The merger of banks and NBFCs is akin to an arranged marriage. While both sides willingly entered the union, they quickly recognise that it is a balancing act.
“Co-lending, like marriage, is a daily challenge.” Banks and NBFCs use separate systems, have different underwriting processes, and use various factors. For the collaboration to succeed, banks and NBFCs must be willing to reconcile their various personalities, attributes, and dispositions on a regular basis.”
Integrating the two systems to reach common ground is a difficult task, as the complexities create a complex web.
As an example of how complicated things may get, suppose a bank and an NBFC engage in non-discretionary CLM (Option A). You’d think that once the two parties had agreed on a lending policy, no matter how complicated the process was, things will go smoothly from there. Except, it doesn’t. Because the RBI does not allow banks to totally outsource essential services such as loan sanctioning, the bank will still be involved in the daily lending activities of its partner NBFC.
As you dive further, things become significantly more difficult. Here’s another one. Each loan application needs the NBFC and the bank to agree on whether a floating or fixed interest rate will be charged. After clearing this obstacle, the bank decides on one interest rate and the NBFC on another, based on their different risk appetites for their respective shares of the loan exposure. If they choose a floating interest rate, they must determine a weighted average of the benchmark interest rates in proportion to the loan contribution. If they choose a fixed interest rate, a final blended rate is calculated. The complexities are mind-boggling.
The final consumer is just concerned with how much money he or she will have to pay at the end of the day. However, this approach requires a lot of meandering to arrive at a final interest rate. There are several aspects to reconcile, align, and integrate, ranging from broad lending policy to minutiae like KYC rules and security creation to reporting, documentation, and internal audits. Such compatibility is difficult to accomplish.
RBI has clearly blessed this union, expecting it to be one soul in two bodies. This begs the question, is this marriage doomed from the start?
FinTech Is A Marriage Counsellor
Banks and NBFCs are increasingly realising that significant progress necessitates collaboration. However, information silos and integration issues make collaboration between banks and NBFCs difficult at the moment. Nonetheless, every marital therapist will tell you that efficient communication is the key to a happy marriage.
Banks and NBFCs should be able to communicate and cooperate in real-time. This is where FinTechs come into play. They come in and set up a well-designed network of APIs that centralises stakeholder communication in a single user-friendly platform.
Lenders should be able to post their individual exposures in their books with a handful of API pull requests. A centralised dashboard can provide all stakeholders with a comprehensive view of the escrow account into which loans will be directed. As a result, each side has access to a single source of truth.
FinTechs can also completely code and automate the performance of jointly originated loans. However, the amount to which this is possible is determined by the facility agreement and the software. A brief, low-value facility agreement with few options is simpler to develop and automate. A long, high-value co-lending facility agreement with hundreds of pages of intricate provisions and many negotiated (i.e. non-standard) terms, on the other hand, will be far more difficult.
Smart contracts underpin the digital future of co-created loans. Because of their capacity to automate data and payment flows, lenders can deliver more efficient loan servicing and a better customer experience. Clearly, there is plenty of room for a well-designed end-to-end technological solution to dominate the market. However, a global market worth $4.6 trillion each year is available for the taking.
Technology may overcome the numerous barriers raised by CLM using established workflows, in-app communication capabilities, and process automation. The future we want is a single platform that navigates the maze to finally provide a single loan arrangement.
After all, is said and done, no matter how much technology simplifies things, the co-lending space should be built on trust. Banks and NBFCs must come together to make co-lending a reality. Every day, it becomes evident that co-lending cannot operate unless it is based on relationships. This is expected to be true even if data aggregation technology advances to supercomputing levels.
We at Ignosis have developed a new-age tech stack for the digital lending ecosystem. Our mission is to democratise digital lending and make it efficient and accessible across the entire digital ecosystem. If you want to enable co-lending, reach out to ignosis for Tech solutions.