Explained: Commonly Used Jargon in Co-lending
Like any financial concept, keeping up with the evolving buzzwords and jargon associated with co-lending can be challenging. Understanding these terms is crucial to successfully navigate the co-lending landscape. That's why we decided to create a handy list of the most important and frequently used co-lending words, with the support of our Subject Matter Experts, to help readers understand this financing model better.
For starters, the Co-lending Model (CLM) is a cohesive approach where two or more lenders come together to provide a loan to a borrower. The model gained popularity in recent years for its ability to provide access to credit for borrowers who may not qualify for traditional loans. We have discussed this compelling framework at ground level including features, the impact, and more in our blog.
Now, let's dive into the key terms.
- Accounting Method refers to the approach used to track and report financial transactions in a co-lending arrangement to ensure accurate financial reporting, transparency, and accountability among lenders.
- Accrual-based Co-lending is a lending arrangement where the interest generated on a loan is distributed among the lenders on an accrual basis. In this type of co-lending, each lender's interest share is recognized as earned on the due date, regardless of whether or not it has been received.
- Amortization Schedule is a detailed list of EMIs and their due dates for the loan duration. It includes the total loan amount, a fixed interest rate, and the loan term. It helps the borrower track what they owe and when payment is due and forecast the outstanding balance or interest at any point in the cycle.
- Asset Classification is the process of categorizing assets based on their credit risk to help lenders manage their credit risk exposure and determine the appropriate level of provisioning for potential losses. This helps co-lenders make informed decisions on the interest rates, collateral requirements, and loan terms for the co-lending arrangement while also monitoring the creditworthiness of the borrower.
- Cash-based Co-lending is a model in which the co-lender receives the interest share only after the borrower makes a payment. This enables shared risk and reward among lenders as they receive their percentage of earnings during the loan repayment period.
- Co-lender First (Repayment Strategy) refers to the approach in which the borrower's partial EMI payment is entirely paid to the co-lender in the first installment. The service partner receives their share only when the borrower makes the second partial payment.
- Credit Exposure is the total money a lender risks losing if the borrower defaults on a loan. In a co-lending arrangement, each lender has a particular share or portion of the loan, representing their credit exposure.
- Debt Service Coverage Ratio (DSCR) is used to evaluate a loan's risk and determine the borrower's ability to repay. It is calculated by dividing the borrower's Net Operating Income (NOI) by Total Debt Service (TDS). Higher the ratio, the greater the ability to repay the loan.
- Direct Assignment denotes the process where a lender directly assigns a portion of a loan to another lender instead of originating the loan together. This means that the originating lender transfers some of the loan's rights and obligations to the other lender.
- Downstream Co-lending is a collaboration between an NBFC and a servicing partner, where the NBFC provides its balance sheet to jointly lend funds to borrowers, with the servicing partner originating and servicing the loans.
- Escrow Management refers to managing funds provided by multiple lenders for a single loan through an escrow account. The purpose is to ensure the secure and fair distribution of funds, minimize the risk of fraud or default, and manage any disputes that may arise.
- Equity Method is an alternative accounting approach to proportional consolidation. Under this method, each lender reports their share of the loan and associated interest, fees, and expenses as a single line item on its financial statements. All lenders jointly control the loan and the borrower, and each lender has an equal share in the co-lending arrangement.
- Funding Ratio is the proportion of the loan that each lender provides in a co-lending arrangement. For example, a borrower applies for a loan of INR 1,00,000 through a co-lending agreement. Lender A agrees to fund 70% of the loan, while Lender B agrees to fund 30%. In this case, the funding ratio would be 70:30. As it determines the level of risk and responsibility of each lender, they typically negotiate and agree upon a funding ratio appropriate for their level of risk tolerance and financial resources.
- Intercreditor Agreement sets out the terms and conditions of a co-lending relationship, including the respective lenders' roles and responsibilities, rights and obligations, the allocation of risk, and the order of priority in which they will be repaid in the event of a default or bankruptcy of the borrower.
- Internal Rate of Return (IRR) is a metric used to calculate the profitability of an investment. In other words, it is the rate at which the co-lending partnership's cash inflows and outflows are equalized. The IRR can help co-lending partners evaluate the potential profitability of the collaboration and make informed decisions.
- Loan Account Numbers (LAN) are a unique string of numbers assigned to a borrower's loan account by the lending institutions in a co-lending model. It helps lenders track the borrower's loan account and manage the loan and the repayment process.
- Hurdle Rate is the interest rate an NBFC must earn on a loan to share a portion of the interest income with its lending partner. For example, if the ROI of a loan product is y%, of which x% is intended to be shared with the partner depending on the partnership agreement, the x% is referred to as the hurdle rate.
- Master Agreement is a legal document that outlines the terms and conditions under which multiple lenders will provide financing to a borrower. The master agreement typically sets out the roles and responsibilities of each lender, as well as the terms of the loan, such as interest rates, repayment schedules, and collateral requirements.
- Net Operating Income (NOI) is the borrower's income from operations, such as rent or sales revenue, minus their operating expenses.
- Priority Sectors are those sectors that the Government of India and the Reserve Bank of India (RBI) consider as crucial for the development of the basic needs of the country. It includes Agriculture, MSME, Export Credit, Education, Housing, Social Infrastructure, Renewable Energy, and others.
- Proportional Consolidation is a type of accounting method under which each lender reports their share of the loan and associated interest, fees, and expenses as a separate line item on its financial statements. In this method, each lender has direct control over its proportionate share of the loan, and the borrower is the responsibility of all lenders in proportion to their loan commitment.
- Risk/Credit Assessment means identifying the potential risks and opportunities associated with lending to a particular borrower and establishing the terms and conditions of the loan, including the interest rate, repayment schedule, and collateral requirements. The risk level will be determined after thoroughly analyzing the borrower's financial statements, credit reports, and other relevant information, as well as discussions with the borrower and other stakeholders.
- Risk Level Versioning refers to assigning different risk levels to different parts of a loan provided by multiple lenders in a co-lending model. In co-lending, lenders can have different risk appetites and underwriting standards. Risk level versioning helps to ensure that each lender is exposed to the risk level that aligns with their risk appetite and underwriting standards. This process involves dividing the loan into tranches, each with a different risk level, and assigning the tranches to the lenders accordingly.
- Split Equally (Repayment Strategy) refers to the repayment approach in which the borrower's partial EMI payment is distributed among lenders based on their capital contribution.
- Statement of Account (SOA) is a document that provides a transparent record of the financial transactions between the borrower and the co-lenders. It reflects details of the loan, such as the total amount borrowed, the interest rate, and the repayment schedule. It provides a breakdown of the payments made by the borrower, including the principal amount and interest paid to each lender.
- Total Debt Service (TDS) is the total amount of debt service that the borrower is required to pay, including the principal and interest payments on all their outstanding loans.
- Transaction Splitting refers to dividing the repayment amount between the service partner and the co-lender based on an agreed repayment strategy. This helps ensure that both parties receive their fair share of the borrower's repayment, and it provides transparency and clarity in the distribution of funds.
- Upstream Co-lending is the strategic partnership between an NBFC and a bank, where the bank provides the funding for the loans and maintains the balance sheet, and the NBFC handles the loan origination and servicing.
Now that you know the key terms needed to comprehensively understand the model, it is time to plunge into the ocean of co-lending. In a detailed blog, we have explored how the CLM works, the regulatory landscape, and how finflux's tech is solving the complexities of the model. Read now!