With the advancement of technology, features such as escrow accounts are becoming increasingly relevant. Escrow accounts are used in a variety of settings, from real estate to cryptocurrency trading.
As the demand for escrow services grows, so do the number of service providers. In such a case, it is critical to conduct extensive research before using the services, as escrow account fraud is on the rise.
Escrow is a legal term that refers to a financial agreement in which a third party holds an asset or money on behalf of two other parties who are in the process of completing a transaction.
The escrow agent is in charge of escrow accounts. Only after predetermined contractual obligations are met does the agent release the assets or funds (or upon receiving appropriate instructions). Escrow can be used to hold money, securities, funds, and other assets.
NBFCs, Fintechs, and Escrow
According to the digital lending guidelines by RBI, all loan repayment and disbursement must be done directly between the bank account of the lender and the borrower. This means that no third-party pass-through account can be used by banks, NBFCs, or lending service providers (LSPs).
However, co-lending use cases are an exception to this rule.
In other terms, co-lending players (like banks and NBFCs) can use escrow accounts to pool funds before disbursing to borrowers.
Since the IL&FS crisis, there have been strict RBI restrictions in place, and the large NBFCs have been experiencing a credit shortage since 2019. However, small and midsize NBFCs have been doing well and are prepared to attract a sizable amount of FDI for retail lending. Nearly 954 of India's approximately 9000+ active NBFCs have a book size of over 40 crores. The remaining 8046+ NBFCs have reached the regulatory threshold of having a loan book with a 20 million rupee loan book. This statistic alone is sufficient to demonstrate that most NBFCs require some form of outside stimulus in order to expand.
One such strategy is NBFC Collaboration, whereby current NBFC License holders collaborate with banks and fintech firms to improve their funding and seek new leads. By definition, collaboration refers to working together to achieve a common objective. The percentage of NPA risk shared by the two parties may or may not be the same. Numerous NBFCs are collaborating with banks and Fintech firms to investigate cost-effective ways to increase funding and attract clients.
The remaining portion of the loan book amount in NBFC Collaborations will be covered by the Bank or Fintech Company at the agreed-upon rate of interest for NBFCs having exposure to at least 20% of loan books. NBFC Collaboration has successfully utilized creative loan products and prompt loan disbursement through cutting-edge financial and technological instruments.
Models of Partnership between NBFCs and Other Entities
To determine a Fintech company's financial standing and the backgrounds of its promoters, NBFC should look into them. Before signing partnership agreements, the need for appropriate due diligence must be assessed, which is even more important when working with a foreign fintech company. Here are some examples of the collaboration models that NBFCs use:
Co-Lending Approach through Escrow
In this arrangement, the NBFC receives information and decision-making tools from the Fintech company in order to execute loans quickly. When participating in this collaboration, fintech companies follow the FLDG model ( First Loan Default Guarantee). It is a way of protecting the lender's interest in the NBFC. Collateral is requested by lenders in order to protect the advances made through Fintech companies. The Escrow Account underlies the model's operation. The FLDG may be as high as 70%, with the NBFC using its fund to finance the remaining 30% of the loan book. With NBFCs, fintech companies share an ROI of 24% to 36%. Additionally, Fintech firms pay 100% of NPA & expenses.
To know more about escrow, read - What is an escrow account?
Aside from the similarities, one might wonder how the new co-lending policy differs or improves on the co-origination policy. A deep dive into both of these circulars reveals the differences between the two. The co-lending model is applicable to banks and all registered NBFCs (including housing finance companies), whereas the previous model was limited to non-deposit taking, systemically important NBFCs (NBFCs-ND-SI). Given the scope and reach of CLM, which applies to all registered NBFCs, the RBI has prohibited banks from co-lending with NBFCs affiliated with promoter groups in order to ensure that CLM lending is transparent and at arm's length.
The co-lending circular requires that all transactions (including disbursements/ repayments) under the CLM be routed through an escrow account maintained with the banks to avoid any intermingling of funds and for operational ease for the parties. Such an escrow agreement will also detail the parties' detailed understanding of the operation and maintenance of such accounts. While the co-lending circular requires funds to be routed through an Escrow account, both the bank and NBFC will be required to maintain each individual borrower's account.
While the above arrangement provides a framework for loan origination and funding routing, the issue of loan recovery remains open. Because NBFCs have a greater reach at the grassroots level, they are far more capable than banks of handling loan recovery. The RBI appears to agree, as the circular requires NBFCs to remain the single point of contact for customers.
If you are a co-lender (NBFC or fintech), you can directly integrate with digital lending service providers such as Vouch Payments.
This allows you to integrate and go live in weeks.
Furthermore, Vouch's low-code APIs and dashboard access can aid in loan disbursement and collection.
The Fintech company sources lead in this model and offer sophisticated tech-driven underwriting along with risk assessment tools. NBFC typically pays Fintech a fee for leads and tool upkeep in the range of 1–3% of the loan amount.
Which Organizations Are Included?
The Co-Lending concept serves as a legally binding contract between the NBFCs and other contract parties. Prior to signing the contract, the details of the agreement must be discussed and agreed upon.
The following institutions are covered by the co-lending model:
- Companies that finance housing (HFCs)
- All Scheduled Commercial Banks and Non-Banking Financial Companies (NBFCs).
The NBFC's collaboration with Fintechs and other financial entities such as large banks may bring more stability to the existing NBFC market. Many NBFCs have experienced low growth since 2019, and they could be revitalised with the technological assistance provided by Fintechs. Existing legal firms can also assist NBFCs and Fintechs with fund management and collaboration. The future of the NBFC collaboration appears promising, and we can only hope that it will revive the sinking NBFCs.