What is Co-Lending and
How will NBFCs Benefit From It?

With more than 1.4 billion in India, nearly 63% of the population still live in rural areas, with a significant part remaining unaware of formal financial services. Even today the LIG (Low-Income Group), the EWS (Economically Weaker Sections) categories, the priority sector (including agriculture, the micro, small, and medium enterprise (MSME) segment), and other critical sectors are finding it difficult to access the liquidity required for their daily working capital needs. 

The people in these segments contribute majorly to India’s economic growth so making financial services available to these categories is crucial. For instance, the MSME sector alone contributes about one-third of the economic growth of India, which is also expected to contribute $1 trillion to India’s exports by 2028. 

The Reserve Bank of India identified this gap faced by the MSMEs and other priority sectors and introduced a policy change of which Co-Lending is a major component. While the adoption of formal financial services has been slow in these segments, the co-lending model is preferred by these people for the ease of cash transactions.

Co-Lending: What is it? 

Co-lending is a lending arrangement where a traditional lender such as a bank, partners with a non-banking financial company (NBFC) to provide loans so that both lenders in conjunction can improve the credit flow to the underserved sectors at affordable rates. While the NBFCs (Non-Banking Financial Companies) would do the grunt work of loan origination and paperwork, banks would offer their liquidity strength to finance a majority of the loan. This partnership creates a symbiotic relationship where both parties benefit and share the risks and rewards throughout the loan lifecycle. 

NBFCs have always benefited from their ability to pierce smaller, harder-to-reach geographical areas through the use of modern loan origination software and banking practices. Banks, on the other hand, have bigger wads of cash, and bigger fee structures. But the problem is banks were not able to reach the underserved population and the NBFCs don’t have enough cash to serve these segments. Co-lending is a give-and-take model by which NBFCs can improve their liquidity, profitability, and client base. At the same time, banks can take advantage of the market outreach, loan origination, and servicing acumen of NBFCs.

The co-lending book of NBFCs is expected to reach Rs 1 trillion by June 2024, after more than 5 years since the model came into being. This indicates significant growth in the adoption of co-lending arrangements.

How can a Co-lending Model drive financial inclusion and economic growth?

The priority sector has ever since played a crucial role in advancing financial inclusion and the overall growth of the economy. However, the traditional lending approach followed by the banks makes it a challenge for the priority sectors to access liquidity. While NBFCs that are in close connection with this segment lack the liquidity to bridge this gap. As per statistics, bank credit growth in India will be in the range of 14-14.5% for the financial year 2024-25. These numbers highlight the potential for growth in India’s banking sector, underscoring the importance of including banks in the meaningful expansion of credit. The co-lending model acknowledges that banks dominate vast liquidity reserves and presents an opportunity to leverage this untapped potential.

On one hand, co-lending gives credit access to a higher number of individuals and business entities served by NBFCs. On the other hand, banks can utilize technology in back-end operations, KYC processes, and documentation. This enables seamless credit flow to the underserved. This means banks can extend credit to borrowers, whose loan applications would otherwise be rejected. This leads to greater financial inclusion.

Terms of a Co-Lending Arrangement

On 5th Nov 2020, RBI released a notification titled ‘Co-Lending by Banks and NBFCs to Priority Sector‘ that served as a revision to the 2018 loan co-origination scheme, amended to include Housing Finance Companies (HFCs) under the umbrella term of Non-Banking Financial Companies (NBFCs). The following are some of the typical terms of the agreement between the parties,

1. 80-20 split: Banks and NBFCs will usually take on an 80:20 capital deployment ratio, with NBFCs mandated to maintain at least 20% of the funding throughout the loan term. Both parties’ funds must be collected and allocated in their agreed ratio at the time of funding and at the time of repayment collections, in such a way that neither party uses the funds that belong to the other.
2. Joint underwriting: As both entities are equally involved in the lending arrangement, the underwriting is also done jointly, allowing for double checks.
3. Risk-return split: The 80:20 split for capital deployment also trickles down to the amount of risk and return that is split between the two entities.
4. Final interest rate: Both parties can charge their own interest rates and the final interest rate charged to the customers is generally a blended interest rate, which lies between the interest rate charged individually by the bank and NBFC.
5. Defined roles: Generally, the NBFC is responsible for sourcing, customer experience and management, product innovations, quick documentation, and fast turnaround time, whereas the banks are responsible for bringing in funds and establishing credibility. Risk assessment is done by both NBFC and the partner bank and the loan origination will be done by the NBFC to the customers.

How does a Co-Lending Agreement Work?

Here are the 4 steps on how Co-Lending works,

1. First, the NBFC performs loan origination activities through co-lending software and checks on the prospective client, after which it recommends him/her to the partner bank with the relevant documentation. 
2. The bank independently does requirement analysis and risk assessment of the client and vets him/her if found creditworthy.
3. NBFCs and banks enter a tripartite agreement with customers if they meet all requirements, between lenders and borrowers.
4. The bank and NBFC pool their funds into a common escrow account from which the loan shall be disbursed. Each lender allocates funds as per the pre-decided ratio in the agreement. Although both lenders will maintain the client’s accounts, they must share information and collaborate to generate a unified statement of accounts for the borrower for easier repayments.