The Curious Case of Co- Lending Model

The Micro Small and Medium Enterprises (MSMEs) sector plays a crucial role in enhancing and ensuring India’s socio-economic development. The sector has gained significant importance due to its contribution to the country’s Gross Domestic Product (GDP) and exports.[1] A survey by International Labour Organisation indicates that MSMEs account for more than 70% of global employment and 50% of GDP[2].

However, one of the sectors that was most impacted by the Covid-19 pandemic and the resultant lockdowns, capital crunch, high risk perception by banks, etc., in India was the MSME sector. Further, the protracted nature of the pandemic has resulted in global slowdown and all-time high inflation rates.

Over the last two years, sectors such as ed-tech, pharmaceuticals, e-commerce witnessed exponential growth, but 67% of MSMEs in India were temporarily shut for three months or more in FY21 and over half of all MSMEs saw a decline of over 25% in revenues[3].

As the pandemic worsened, it became clear that the MSME sector would require a helping hand to survive. The Reserve Bank of India (RBI), in order to cushion the impact of the pandemic on the vulnerable sections of the society, revised and rechristened its 2018 framework for co-origination of loans[4] into a more flexible framework of co-lending model (CLM) in 2020[5]. This model facilitates collaboration between banks and registered non-banking financial companies (NBFCs), thus enabling priority sector lending at affordable cost. The idea was to improve flow of credit to the unserved and underserved sectors of the economy, benefitting from the lower cost of funds from banks and greater reach of NBFCs.

It is apparent from the co-lending circular that CLM relies heavily on the ability of NBFCs to source reliable borrowers for banks to provide funding. To that extent, the RBI also looks for NBFCs to have skin in the game. The RBI has, therefore, retained the position, under the co-origination framework, of requiring NBFCs to have a minimum of 20% share of the individual loans on their books at all times.

Similarities aside, one might wonder how the new policy of co-lending is different or better than co-origination policy. A deep dive into both these circulars spells out the nuances of the two. One of the key differences is that the co-lending model is applicable to banks and all registered NBFCs (including housing finance companies)[6], whereas the previous model was restricted to non-deposit taking, systemically important NBFCs (NBFCs-ND-SI) only. Considering the scope and reach of CLM, which covers all registered NBFCs, the RBI has restricted banks from co-lending with NBFCs belonging to promoter groups, to ensure that lending under CLM is transparent and at arm’s length.

The CLM mandates both banks and NBFCs to have a board approved policy, setting out the broad framework, basis which banks and NBFCs will enter into co-lending arrangements. The policy is required to be in line with the co-lending circular and may include provisions relating to criteria for selection of partner bank/ NBFC, products covered under the co-lending model, creation of security and enforcement thereof, etc.

The board approved policy is a precursor to banks and NBFCs entering into a master co-lending arrangement. Such arrangement will either provide for the banks to mandatorily take their share in the loans originated by the NBFCs in their books (Non-Discretionary Model) or retain the discretion to reject certain loans after their due diligence, prior to taking the loans in their books (Discretionary Model). Banks and NBFCs may also agree on the terms and conditions of such arrangement, specific product lines, areas of operations, different roles and responsibilities of banks and NBFCs, appropriation of funds between banks and NBFCs, framework for monitoring and recovery of loans, customer interface and protection issues.

The key difference between the Discretionary Model and Non-Discretionary Model is that the participation of banks under the Non-Discretionary Model is upfront (i.e. at the time of origination of the loan). However, under the Discretionary Model, even after origination of loans by the NBFC, banks have the right to reject loans after undertaking due diligence.

To avoid any inter-mingling of funds and for operational ease to the parties, the co-lending circular requires that all transactions (including disbursements/ repayments) under the CLM be routed through an escrow account maintained with the banks. Such escrow arrangement will also set out the detailed understanding between the parties in relation to operation and maintenance of such accounts. It would be relevant to note that while the co-lending circular requires routing of funds through an escrow account, both the bank and NBFC will also have to maintain each individual borrower’s account.

While the above arrangement provides the framework for origination of loans and routing of funds, aspect of recovery of such loans remains open. As NBFCs have better reach at the grassroot level, they are significantly more capable than banks in handling the recovery of loans. The RBI seems to agree with this notion as the circular requires NBFCs to remain the single point of interface for customers.

Against this backdrop, it naturally occurs that the responsibility of servicing and collection of payments be placed on NBFCs. To record such arrangement, banks will appoint NBFCs as servicer agents, responsible for collection of monies from the borrowers and depositing the same in the escrow account on or before the relevant due date. With this approach, the probability of timely servicing of debt by the borrowers may increase substantially.

The co-lending model has the potential to bring about a significant change in the priority sector. Implementation of this model in the right spirit will be key. Wider customer reach and integration of technology of NBFCs such that the end users at remote places are able to take advantage of the scheme, combined with the robust financial backing of large institutions may transform the lending and borrowing market in the priority sector. The regulator is backing the proper implementation of this scheme by banks as banks may claim priority sector status in respect of their share of credit while adhering to the specified conditions. This framework, coupled with the board approved policies and master agreements reflect the endeavour of the RBI, banks and NBFCs to drive financial inclusion, by providing tailor-made and affordable financial solutions at the grassroot level. This bodes well for accelerating the country’s overall economic development as well. If implemented in the manner envisaged by the RBI, the co-lending model may just prove to be the catalyst the industry was looking for to uplift the priority sector from its economic hardships.


[1] MSME Industry in India, India Brand Equity Foundation, Available at: https://www.ibef.org/industry/msme

[2]MSME Day 2020: the COVID -19 pandemic and its impact on small business, International Labour Organisation, Available at: https://www.ilo.org/empent/whatsnew/WCMS_749275/lang–en/index.htm

[3] Covid impact: 67% MSMEs temporarily shut in FY21, over half lost 25% revenue’, The Indian Express, February 8, 2022, Available at: https://indianexpress.com/article/business/economy/covid-impact-67-msmes-temporarily-shut-in-fy21-over-half-lost-25-revenue-7761520/

[4] Notification on Co-origination of loans by Banks and NBFCs for lending to priority sector, Reserve Bank of India, September 21, 2018, Available at: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11376&Mode=0

[5] Co-Lending by Banks and NBFCs to Priority Sector, Reserve Bank of India, November 5, 2020, Available at: https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT6300DF94088B674E7FB6FC7EEC214B0200.PDF

[6] As per the CLM, the co-lending model shall not be applicable to foreign banks (including wholly owned subsidiary) with less than 20 branches