RBI Consultation Paper on P2P Lending: Summary
1. Introduction
2. Crowdfunding and P2P Lending
3. Observations Made Regarding Current Practice of P2P Lending Companies
4. Types of Regulatory Regimes for P2P Lending Companies across the World
5. Arguments against Regulation
7. Proposed Regulatory Framework
7.1. Permitted Activity
7.4. Business Continuity Plan (BCP)
7.5. Customer Interface
9. Endnotes
10. Author Profile
1. Introduction
The Reserve Bank of India published a Consultation Paper on Peer-to-Peer Lending on April 28, 2016 [1]. The Paper notes that:
Although nascent in India and not significant in value yet, the potential benefits that P2P lending promises to various stakeholders (to the borrowers, lenders, agencies etc.) and its associated risks to the financial system are too important to be ignored. The Reserve Bank (the Bank) has therefore found it necessary to put out this discussion paper to elicit public opinion and views of the various stakeholders on the future course of action having regard to the current legal and regulatory framework in place to regulate the business of financial intermediation.
Here I present a summary of the Consultation Paper. The next post in this series will discuss in detail the different types of obligations that the Peer-to-Peer (henceforth, P2P) Lending Companies will have to satisfy if classified as Non-Bank Financial Companies, and other related issues.
2. Crowdfunding and P2P Lending
The Paper starts with discussing (and distinguishing) SEBI’s Consultation Paper on Crowdfunding in India, published on June 17, 2014, to avoid overlap of jurisdiction [2]. SEBI's paper classified crowdfunding initiatives in to:
- Community Crowdfunding: 1) Social Lending, and 2) Reward Crowdfunding; and
- Financial Return Crowdfunding: 1) Peer-to-Peer Lending, and 2) Equity Crowdfunding.
Traditionally, Start-ups are funded through private equity, angel investor or loan arrangements with a financial institution. Any offering of public equity takes place only after the product or business becomes commercially viable. However, in Equity based Crowdfunding solicitation is done at an earlier stage. It refers to fund raising by a business, particularly early-stage funding, through offering equity interests in the business to investors online through a crowdfunding platform website acting as the intermediary.
Though, P2P lending did not appear to involve securities, loan/notes/contracts can be traded on a P2P platform or a secondary market. Thus, these loans may become securities, with the contract between the lender and the borrower being the security note.
In summary, SEBI’s paper suggested that under Security Based Crowd funding, the possible routes that could be explored are the following:
- Equity based Crowd Funding (EbC): Raising equity through a crowd funding platform.
- Debt Based Crowd Funding (DbC) Raising of funds by issuing debentures or debt securities through a crowd funding platform.
- Fund Based Crowd Funding (FbC): Raising of funds for pooling under an Alternative Investment Fund (AIF) through a crowd funding platform.
3. Observations Made Regarding Current Practice of P2P Lending Companies
- P2P lending is in relation to unsecured loans.
- The borrowers and the lenders can be both natural and juristic persons.
- The interest rate can range from a flat interest rate fixed by the platform to dynamic interest rates as agreed upon by the borrowers and the lenders to cost plus model (operational costs plus margin for platform and returns for lender).
- The companies often follow a reverse auction model in which the lenders bid for a borrower’s loan proposal and the borrower has the freedom to either accept or reject the offer.
- Borrowers are able to avail lower rates than those offered by money lenders/unorganized sector. Lenders can obtain higher returns than what conventional investment opportunities offer.
- Some of these are involved in the business targeted at micro finance activities with the stated primary goal being social impact and providing easier access of credit to small entrepreneurs.
- The borrowers pay an origination fee (either a flat rate fee or as a percentage of the loan amount raised) according to their risk category.
- The lenders, depending on the terms of the platform, have to pay an administration fee and an additional fee if they choose to use any additional service (e.g. legal advice etc.), which the platform may provide.
- The platform provides the service of collecting loan repayments and doing preliminary assessment on the borrower’s creditworthiness.
- The regulatory concerns in such cases would relate to KYC and recovery practices. Since all payments are through bank accounts, the KYC exercise can be deemed to have been carried out by the banks concerned. The platform facilitates collection of post-dated cheques from the borrower in the name of the lender as a proxy for repayment of the loan.
- The platform does NOT profit from the difference in the deposit and the loan rates, as is the case with Banking Financial Institutions.
- In summary, while crowd funding - equity, debt based and fund based- would fall under the purview of capital markets regulator (SEBI), P2P lending would fall within the domain of the RBI.
4. Types of Regulatory Regimes for P2P Lending Companies across the World
- Complete Exemption / Non-regulation due to Lack of Definition: Regulations already in place to be applicable which protect the borrowers from unfair interest rates, unfair credit provision, and false advertising. Hence no further, or specific, regulation is undertaken.
- Intermediary Regulation: Registration required as an intermediary to enable it to access the market. Other rules and requirements determine how the platform should conduct its business (for example, the licensing needed to provide credit and/or financial services).
- Banking Regulation: To be applicable due to their credit intermediation functions. As such, the platforms must obtain a banking licence; fulfil disclosure requirements and other such regulations.
- US Model: Involves two levels of regulation, involving a central agency (SEC in this case) and state legislations.
5. Arguments against Regulation
The presence of regulation would lend credibility to P2P lending, attracting lenders with low awareness to these platforms who may not understand the risks involved specially in the context of susceptibility of these platforms to attract high risk borrowers. Regulation may stifle the growth of an innovative, efficient and accessible avenue for borrowers who either do not have access to formal financial channels or are denied loans by them. The market for P2P lending, currently in a nascent stage does not pose an immediate systemic risk nor any significant impact on monetary policy transmission mechanism.
6. Arguments for Regulation
- Considering the significance of the online industry and the impact which it can have on the traditional banking channels/NBFC sector, it would be prudent to regulate this emerging industry. Regulation would reduce its potential to disrupt the financial sector and throw surprises. As P2P lending promotes alternative forms of finance, where formal finance is unable to reach and also has the potential to soften the lending rates as a result of lower operational costs. Therefore, the importance of these methods of financing needs to be acknowledged. If the sector is left unregulated altogether, there is the risk of unhealthy practices being adopted by one or more players, which may have deleterious consequences.
- Section 45S of RBI Act prohibits an individual or a firm or an unincorporated association of individuals from accepting deposits, if his or its business wholly or partly includes any of the activities specified in clause (c) of section 45-I (i.e. activities of a financial institution); or if his or its principal business is that of receiving of deposits under any scheme or arrangement or in any other manner, or lending in any manner. Contravention of Section 45S is an offence punishable under section 58B (5A) of RBI Act. As per the Act, ‘‘deposit’’ includes and shall be deemed always to have included any receipt of money by way of deposit or loan or in any other form, but does not include any amount received from an individual or a firm or an association of individuals not being a body corporate, registered under any enactment relating to money lending which is for the time being in force in any State. Since the borrowers and lenders brought together by a P2P platform could fall within these prohibitions, absence of regulation may lead to perpetrating an illegality.
7. Proposed Regulatory Framework
RBI concludes that a regulatory mechanism would facilitate the creation of an alternative avenue of credit. It proposes to bring the P2P lending platforms under the purview of RBI's regulation by defining P2P platforms as NBFCs under section 45I(f)(iii) of the RBI Act by issuing a notification in consultation with the Government of India. After the notification, RBI can issue directions under sections 45JA and 45L of RBI Act to such platforms regarding registration requirements and prudential norms. Below are the features of the proposed regulation.
7.1. Permitted Activity
Considering the present stage of development, the platform could be registered only as an intermediary. i.e. the borrowing and the lending activity could not be reflected on the Balance Sheet. The platform will be required to ensure that section 45S of the RBI Act is not attracted by its activities. The platforms will be prohibited from giving any assured return either directly or indirectly. The platforms will be allowed to opine on the suitability of a lender and creditworthiness of a borrower. Adequate regulations on advertisements will also be put in place. It will also be mandated that funds will have to necessarily move directly from the lender’s bank account to the borrower’s bank account to obviate the threat of money laundering. The guidelines would also prohibit the platforms being used for any cross-border transaction in view of FEMA provisions relating to transactions between residents and non-residents.
7.2. Prudential Requirements
The prudential requirements will include a minimum capital of Rs 2 crore. With a view to ensure that there is enough skin in the game at a later date, leverage ratio may be prescribed so that the platforms do not expand with indiscriminate leverage. Given that the lenders may include uninformed individuals, prudential limits on maximum contribution by a lender to a borrower/segment of activity could also be specified.
7.3. Governance Requirements
The guidelines in this regard will include fit and proper criteria for promoters, directors and CEO. A reasonable proportion of board members having financial sector background could be suggested. The guidelines may also require the P2P lender to have a brick and mortar place of business in India. The management and operational personnel of the platform would need to be stationed within the country.
7.4. Business Continuity Plan (BCP)
The platforms need to put in place adequate risk management systems for its smooth operations. BCP and back up for the data needs to be put in place since the platform also acts as a custodian of the agreements/cheques etc. In case of failure of the platform to continue its operations, it should have a ‘living will’ or alternative arrangement in the form of an agreement for continuation of its operations.
7.5. Customer Interface
Most of the platforms operating in India provide a credit score for the borrowers using their customized algorithms. Confidentiality of the customer data and data security would be the responsibility of the Platform. Transparency in operations, adequate measures for data confidentiality and minimum disclosures to borrowers and lenders would also be mandated through a fair practices code. The current regulations applicable to other NBFCs will be made applicable to the P2P platforms in regard to recovery practice. The operators would also be mandated to have a proper grievance redress mechanism to deal with complaints from both lenders and borrowers and require reporting to the Board.
7.6. Reporting Requirements
In order to assist monitoring, the platforms will need to submit regular reports on their financial position, loans arranged each quarter, complaints etc. to the Reserve Bank. The Bank may come out with a detailed reporting requirement.
8. Scope of RBI's Regulation
It may be noted here that RBI has powers to regulate entities which are in the form of companies or cooperative societies. However, if the P2P platforms are run by individuals, proprietorship, partnership or Limited Liability Partnerships, it would not fall under the purview of RBI. Hence, it is essential that P2P platforms adopt company structure. The notification can therefore specify that no entity other than a company can undertake this activity. This will render such services provided under any other organisational structure illegal. Alternatively, the other forms of structure may be regulated by the State Governments.
Comments are sought on following aspects of this discussion paper:
- Whether there is a felt need for regulating P2P lending platforms?
- Is the assessment of P2P lending and risks associated with it adequate?
- Are there any other risks which ought to be addressed?
- Is the proposed approach to regulating these platforms adequate?
- Any other relevant issues pertaining to P2P lending.
9. Endnotes
[1] See: https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=3164.
[2] See: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf.
10. Author Profile
Pavishka Mittal is a law student at West Bengal National University of Juridical Sciences, Kolkata and has completed her second year. She takes contemporary dance very seriously and hopes to contribute to the dance community in India. Other than dancing, she indulges in binge-watching in her spare time.
