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‘Co-lending’: A partnership model to solve India’s $1 trillion credit gap

‘Co-lending’: A partnership model to solve India’s $1 trillion credit gap

‘Co-lending’: A partnership model to solve India’s $1 trillion credit gap
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By Sashank Rishyasringa  Feb 24, 2021 4:25 PM IST (Published)

Learnings from recent years of co-lending make it clear that technology is essential for the model’s inherent scalability.

India’s retail credit market has always represented a massively underserved and extremely exciting opportunity in financial services. In recent years, there has been a surge of innovation in this space, driven by entrepreneurship, risk capital, and enabling infrastructure. Technology has played a pivotal role in bridging some of the credit gaps, by lowering costs of distribution, improving risk management, and enabling more customer-friendly products. However, liquidity has remained a perpetual constraint in this endeavour, partly due to the structure of Indian debt capital markets and exacerbated by the recurring shocks to the financial sector over the past two years.

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Co-lending, or co-origination to retail borrowers, emerged around 2014 at a unique moment in India’s financial services landscape. Specifically, the thought process around co-lending drew from learnings in three critical areas —the sub-optimal outcomes of both extremes of capital markets regulation in both India and the West, Indian experience with banking sector reform and liberalisation over the previous decade, and the explosion of financial technology, or “fin-tech” models in the Indian credit markets starting in 2012. While debates raged globally on competition between banks and fintech, or how alternative lenders should be regulated, India’s financial sector neatly sidestepped these by opting for a partnership model between banks and non-bank lenders.
At its core, co-lending is a collaborative model of financing between NBFCs and banks. NBFCs bring niche expertise in terms of customer knowledge, product, distribution and underwriting, but are often growth constrained due to limited access to low-cost capital. Banks, on the other hand, have liquidity but may be constrained by a lack of expertise in specific frontier segments or high operating cost structures. In co-lending, the NBFC sources loans, which are then jointly underwritten by both entities and disbursed in a 20:80 ratio, with the bank holding the higher share. Risk is shared, and the NBFC is responsible for the end-to-end lifecycle management of the customer.
Liquidity and systemic stability
What co-lending does so effectively is to solve two related issues of utmost importance—liquidity and systemic stability. On the liquidity front, it acknowledges that any meaningful expansion of credit has to come from the banking system at the back end. Our debt capital markets are still nascent, with conservative regulations and a dearth of market makers or participants.
Meanwhile, 60 percent of the country’s liquidity reserves reside within the public sector banks (PSB) system alone. New-age lenders must tap into this liquidity to scale, and an off-balance sheet model obviates many of the growing pains of accessing wholesale debt capital, such as ratings, vintage, and profitability. In addition to legitimising such partnerships, co-lending also offers a framework for implementing them, which could over time evolve into a set of standards that eliminate the typical friction in lender-bank partnerships.
Systemic stability is where co-lending truly scores as a model. As a partnership between two—albeit differently—regulated entities, i.e. a bank and an NBFC, it ensures a high degree of standardisation, compliance, fiduciary care, and customer protection. Borrowers are underwritten not once, but twice and by two different entities, and risk governance is a mutually reinforced exercise with adequate checks and balances. Co-lending also functions as a superior form of market-making for debt asset generation, with mandatory skin-in-the-game for the originator and risk-sharing through the 80:20 mechanism enshrined in the RBI’s guidelines. Additionally, a co-lent loan portfolio is one where asset and liability durations are perfectly matched, avoiding many of the ALM pitfalls that wrecked several non-bank lenders during the 2018 IL&FS crisis.
Role of technology
Learnings from recent years of co-lending make it clear that technology is essential for the model’s inherent scalability. In a world of instant digital credit, real-time digital back-end operations are an equal necessity. API-based underwriting, the digital exchange of data, e-documentation, and automated reporting and flow of funds are crucial building blocks for co-lending to work successfully. Much like a securities exchange or online marketplace, bilateral and larger co-lending platforms must be built from the grounds up as “tech first”. Once accomplished, these can prove to be highly extensible, supporting everything from a 24-hour Rs 5 lakh MSME loan to a two-minute consumer checkout purchase.
Risk sharing
Once the technology is in place, successful co-lending partnerships come down to shared risk DNA. Digital credit products, in particular, often include large datasets at the time of application, automated credit policies, and iterative risk management models. Achieving alignment on these is important for every partnership. But even more critical is having a shared set of principles around risk management that can form a common basis for navigating changes in the macro-environment as they happen. Major discontinuities such as the impact of COVID last year can be challenging for any lender to manage individually; managing through these as a partnership is even more important.
Overall, there are many reasons to be bullish on co-lending as the model of the future for credit deployment in India. A recent BCG-Google report projects the mass market digital lending opportunity to reach Rs 1 trillion over the next five years. COVID will have accelerated that journey, fast-tracking consumer digital adoption over and above the pre-existing tailwinds of mobile phone penetration, cheap data, digital identity and payment rails. Given this backdrop, liquidity is the multi-trillion-rupee problem to solve over the coming years. While other solutions may nibble at the fringes of this, co-lending tackles the biggest prize of all—the massive liquidity inherent in India’s banking system today, and the strong structural incentives for players to work together to deploy this.
—Sashank Rishyasringa is Co-founder, Capital Float. The views expressed are personal
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