Introduction
Co-lending, the practice by which a bank and an NBFC jointly originate and fund loans to priority sector borrowers, was formalised by the RBI through its Co-Lending Model (CLM) guidelines in November 2020. The policy rationale was straightforward and compelling: banks have access to low-cost deposits and priority sector lending (PSL) obligations they often struggle to fulfil through their own branch networks; NBFCs and fintech lenders have distribution reach, credit assessment technology, and customer relationships in segments — small businesses, microenterprises, agricultural borrowers — that banks find costly to serve directly. Co-lending was designed to combine these complementary strengths, channelling credit to underserved borrowers at lower cost.
Four years into the framework, co-lending has achieved significant scale. Total co-lending disbursements have reached hundreds of thousands of crores of rupees across the MSME, agriculture, and housing sectors. Major NBFCs and fintech lenders are co-lending partners to multiple large banks simultaneously. But the framework’s rapid growth has also revealed structural tensions that the original guidelines did not fully anticipate — principally the problem of regulatory arbitrage, where the co-lending structure is used to achieve outcomes that neither partner could accomplish individually within their respective regulatory constraints.
Legal Framework
The Co-Lending Model Guidelines 2020 established the basic architecture: the bank and NBFC enter a master agreement for co-lending under which they jointly contribute to each loan (the bank at 80% and the NBFC at 20% as a default ratio, though variations are permitted), with the NBFC originating and servicing the loan. The NBFC retains the customer relationship, conducts credit assessment, and handles collections. The bank provides the majority of the loan funding at lower cost, earning PSL credit for its contribution.
The legal structure of each co-lent loan involves a bilateral lending arrangement: the borrower has separate loan agreements with both the bank and the NBFC for their respective portions. The NBFC retains the servicing role but is not the sole lender. Both lenders have pro-rata claims against the borrower.
The RBI’s master direction on PSL establishes the eligible categories — agriculture, MSMEs, affordable housing, education, social infrastructure, and renewable energy — and the targets applicable to different bank categories. Co-lending loans qualify as PSL for the bank’s portion, provided the loan meets the eligibility criteria for the relevant PSL category.
Contemporary Issues and Analysis
The regulatory arbitrage problem manifests in several forms.
The NBFC-as-regulatory-pass-through structure: In some co-lending arrangements, the NBFC effectively functions as a distribution and origination agent for the bank, with the bank providing nearly all the funding and bearing most of the credit risk, while the NBFC retains the customer relationship and earns processing fees. This arrangement is, in economic substance, bank lending with NBFC origination — but in regulatory form, it generates PSL credit for the bank without the bank having built the underwriting capability or customer relationship management infrastructure that PSL targets are designed to incentivise. The RBI has noted this concern informally but has not yet issued guidance that directly addresses the economic-substance-versus-regulatory-form problem.
The risk allocation opacity problem: Under the co-lending guidelines, the NBFC is required to retain a minimum 20% of the loan in its own books. However, the NBFC may have obtained a first-loss default guarantee (FLDG) from a fintech partner or a credit enhancement from another entity that effectively transfers this 20% risk back off-balance sheet. If this layered risk transfer is not disclosed to the bank or to the RBI, the bank is co-lending under a false assumption about the NBFC’s risk exposure. The bank believes the NBFC has 20% skin in the game; in practice, the NBFC has insured away that exposure. This opacity creates systemic risk.
The accountability gap on mis-selling: Who is accountable to the borrower when a co-lent loan is mis-sold — when the interest rate is misrepresented, loan terms are not clearly explained, or the product is inappropriate for the borrower’s needs? The NBFC is the customer-facing entity, but the bank is also a lender of record. Under the Consumer Protection Act and RBI’s fair practices guidelines, both entities bear obligations. In practice, when complaints arise, banks have sometimes deflected responsibility to the NBFC, arguing that the NBFC conducted origination and servicing. This deflection is legally incorrect — the bank has direct obligations to borrowers in co-lent arrangements — but the accountability gap in the customer-complaint process is real.
Comparative and International Perspective
The United States’ Community Reinvestment Act (CRA) framework, which requires banks to meet the credit needs of communities in their assessment areas including low-and-moderate-income neighbourhoods, has developed extensive jurisprudence on bank-NBFC partnership structures. The Office of the Comptroller of the Currency’s guidance clarifies that banks cannot use fintech partnerships simply to generate CRA credit without genuine community engagement — the substance-over-form principle is actively enforced.
The UK’s partnership lending model, particularly the Funding for Lending Scheme that was operated through the Bank of England, similarly required participating lenders to demonstrate genuine incremental lending to real economy borrowers rather than using subsidised funding to replace existing lending at lower cost.
Practical and Policy Implications
For banks, the key compliance risk is maintaining adequate oversight of NBFC partners’ origination standards, credit assessment methodologies, and servicing practices. The co-lending guidelines make the bank responsible for the quality of PSL credit claimed, which requires the bank to conduct genuine due diligence on each co-lent loan — not merely rely on the NBFC’s credit assessment output.
For NBFCs, the strategic appeal of co-lending is real: access to lower-cost bank funding, PSL-linked business volumes, and the bank relationship. But the compliance obligations — maintaining the minimum 20% retention genuinely, not obscuring risk through undisclosed credit enhancements, providing accurate borrower disclosure — are binding, and enforcement actions against NBFCs for co-lending violations are an increasing regulatory risk.
Suggestions and Reforms
The RBI should require co-lending partners to file a joint regulatory return disclosing the structure of risk allocation, including any credit enhancements or FLDGs that affect the effective retention of the NBFC’s 20% portion. This return should be filed with the Department of Regulation and should trigger supervisory review if risk retention falls below the mandated threshold on an effective basis.
The guidelines should be amended to specify the customer-complaint escalation pathway in co-lending arrangements — confirming that both the bank and the NBFC are jointly responsible for regulatory compliance with fair practices guidelines and that the borrower has the right to escalate to either lender’s grievance redressal mechanism.
Conclusion
Co-lending is a genuinely valuable policy instrument that has expanded credit access for underserved borrowers at meaningful scale. The regulatory arbitrage problems that have emerged are not inherent to the model but are consequences of regulatory gaps that the RBI has the authority and capacity to close. The choice is between allowing the framework to evolve through undirected market practice — with the accountability gaps that entails — or intervening with targeted rule refinements that preserve the model’s benefits while closing its most significant vulnerabilities.
