Default Loss Guarantee (DLG) in Digital Lending: Cap, Structure and Key Compliance Considerations

The regulatory landscape for digital lending in India has undergone a marked evolution in recent years. One of the most crucial focal points has been the use of a Default Loss Guarantee (DLG) arrangement between regulated lenders (REs) and lending service providers (LSPs). These arrangements were traditionally used by fintech-originators and NBFC-fintech partners to share credit risks. However, the Reserve Bank of India (RBI) has now placed careful guardrails around this risk-sharing model. The framework is best understood by examining three key phases: the June 2023 guidelines, the consolidated 2025 Directions, and the operational compliance issues for market participants.

1. Regulatory Background

June 8, 2023 – DLG Guidelines

In a circular titled Guidelines on Default Loss Guarantee (DLG) in Digital Lending, the RBI laid down a new regime for loss-sharing arrangements in digital lending. One of the core requirements states that the DLG cover on any outstanding portfolio shall not exceed five percent of the loan portfolio specified upfront.

Further, the DLG arrangement must be in a form permitted by the RBI such as a cash deposit, fixed deposit with lien, or bank guarantee, and must not be treated as synthetic securitisation or loan participation.

May 8, 2025 – Digital Lending Directions

The RBI subsequently issued the Reserve Bank of India (Digital Lending) Directions, 2025, consolidating earlier frameworks including the 2022 Digital Lending Guidelines and the 2023 DLG Guidelines.

These Directions reaffirmed the DLG cap of 5 percent and introduced enhanced eligibility, reporting, and monitoring requirements around DLG. Only LSPs incorporated under the Companies Act may act as DLG providers. Portfolios covered under DLG cannot include revolving credit or credit-card type exposures. Invocation must happen within 120 days of default, and NPA recognition cannot be delayed because of DLG cover.

2. The 5 Percent Cap and Its Practical Implications

The five percent cap means that for any identified “DLG Set” (the loan portfolio identified upfront for the guarantee arrangement), the maximum loss cover provided by the DLG provider is 5 percent of that portfolio.

Example: If the RE identifies a loan pool of ₹100 crore for DLG cover, the maximum DLG cover is ₹5 crore (5 percent of ₹100 crore). The DLG provider cannot promise to cover more than that amount.

Because the amount is tied to the “loan portfolio specified upfront,” the DLG cap must be documented in the contract between the RE and the LSP or another RE acting as DLG provider. The 2025 Directions reaffirm the cap and expand on operational rules, clarifying that the DLG cannot be used to delay a loan being classified as a non-performing asset and that the RE must comply with provisioning norms irrespective of DLG cover.

3. Key Compliance Obligations for REs and LSPs

a) Eligibility of DLG Provider

Only an LSP or another RE incorporated under the Companies Act may provide DLG. The contract must clearly define the extent of cover, tenor, invocation mechanics, and must be approved by the RE’s board.

b) Scope Limitations

DLG arrangements cannot be used for revolving credit facilities including credit cards or for loans already covered by other guarantee schemes.

c) Contractual and Documentation Requirements

The DLG contract must specify:

• The portfolio (DLG Set)

• The cover limit (≤ 5 percent)

• The form of guarantee (cash, FD, or bank guarantee)

• The invocation timeline (typically within 120 days of the account becoming overdue)

NPA recognition by the RE cannot be postponed because of DLG cover, and the invoked amount cannot be set off against the underlying loans.

d) Reporting and Disclosure

Under the 2025 Directions, REs must report all digital lending apps (DLAs), lending service providers, and lending portfolios to the RBI’s Centralised Information Management System (CIMS) by June 15, 2025. While the DLG cap itself is not new, the intensified reporting obligation introduces greater scrutiny of DLG arrangements.

e) Provisioning and Capital Treatment

The RBI has clarified that the five percent cap does not relieve the RE from provisioning responsibility. REs must still comply with provisioning norms even when DLG cover exists.

4. Practical Risk Considerations and Implementation Challenges

Risk of Misclassification:
If the DLG cover is not properly documented or the portfolio is not “specified upfront,” the arrangement may be treated as loan participation or synthetic securitisation, attracting regulatory penalties.

Operational Readiness:
REs and LSPs must update contracts, risk policies, board approvals, and system workflows to reflect the DLG cap and invocation timeline.

Impact on Fintech Business Models:
Many fintechs built their origination models around large risk absorption through “first-loss” structures. The 5 percent cap limits this leverage, prompting a re-evaluation of commercial incentives and underwriting practices.

Disclosure and Audit Implications:
REs remain accountable and must ensure periodic board review and audit of all DLG arrangements. LSPs may also face scrutiny by enforcement agencies if irregularities arise.

Capital and Provisioning:
Since external cover cannot be used to defer asset classification or recognition of NPA, REs must ensure provisioning is done accurately and on time.

5. Strategic Takeaways for Legal and Compliance Teams

For legal counsel and compliance teams advising digital lenders, NBFC-fintech partnerships, or banks offering digital credit through LSPs, the following steps are critical:

1. Map existing arrangements: Identify all DLG or FLDG contracts and ensure each adheres to the 5 percent rule, with the loan portfolio defined upfront.

2. Update contracts: Ensure each agreement includes defined portfolios, cover limits, invocation terms, and form of guarantee, aligned with RBI’s framework.

3. Board oversight: Implement a board-approved DLG policy, internal audit process, and periodic review of LSP performance.

4. System alignment: Integrate DLG terms into origination systems, key fact statements, and reporting structures.

5. Revisit business structures: Adjust commercial models, underwriting standards, and incentive mechanisms to align with risk-sharing limitations.

Conclusion

The RBI’s framework on Default Loss Guarantees marks a transition from permissive innovation to structured risk governance. The five percent cap on DLG cover establishes a clear compliance threshold for all regulated entities.

For lenders, fintechs, and legal advisors, the objective is not just regulatory compliance but long-term sustainability built on transparency, disciplined risk sharing, and sound governance. Aligning systems, policies, and partnerships with these standards is essential for responsible digital lending growth in India

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