India's largest banks sit on trillions of rupees in low-cost deposits. They can lend at 9-10% and still earn a healthy spread. But their branch networks thin out dramatically beyond district headquarters. A farmer in rural Odisha, a micro-entrepreneur in a Rajasthan village, a self-help group in Jharkhand — these borrowers are invisible to the banking system. They exist in the records of microfinance institutions, small NBFCs, and local money lenders who know their cash flows, their harvest cycles, and their repayment patterns.
India's NBFCs and microfinance institutions have the reach. But their cost of funds — 12-14%, because they borrow from the same banks they compete with — makes their loans expensive. A farmer paying 18% on an NBFC loan is paying 8 percentage points more than what the same loan would cost from a bank.
The co-lending model exists to bridge this gap: combine the bank's cheap money with the NBFC's last-mile presence, and the borrower gets a loan that neither institution could offer alone.
How did co-lending begin?
The RBI first tried this idea in September 2018 under a different name — "co-origination." The Co-origination of loans by Banks and NBFCs for lending to priority sector RBI/2018-19/49 laid out the concept:
"All scheduled commercial banks may engage with NBFC-ND-SIs to co-originate loans for the creation of priority sector assets. The arrangement should entail joint contribution of credit at the facility level, by both lenders. It should also involve sharing of risks and rewards between the bank and the NBFC for ensuring appropriate alignment of respective business objectives."
The co-origination model required both the bank and the NBFC to be present at the point of origination. Both institutions had to jointly appraise the borrower, jointly contribute funds, and jointly own the credit risk from day one. A single blended interest rate was offered to the borrower.
The idea was sound, but the execution was cumbersome. Banks were reluctant to station their officers alongside NBFC field agents in remote locations. The requirement for joint origination meant the bank had to be involved in every individual loan from the start — defeating the purpose of leveraging the NBFC's distribution advantage.
Why did the RBI rebrand it as co-lending?
Two years of feedback made clear that co-origination was too rigid. The November 2020 Co-Lending by Banks and NBFCs to Priority Sector circular RBI/2020-21/63 replaced the framework with a more flexible model:
"Based on the feedback received from the stakeholders and to better leverage the respective comparative advantages of the banks and NBFCs in a collaborative effort, it has been decided to provide greater operational flexibility to the lending institutions... The primary focus of the revised scheme, rechristened as 'Co-Lending Model' (CLM), is to improve the flow of credit to the unserved and underserved sector of the economy and make available funds to the ultimate beneficiary at an affordable cost, considering the lower cost of funds from banks and greater reach of the NBFCs."
The critical change was that the NBFC could now originate the loan first and bring the bank in later. The NBFC identifies the borrower, appraises creditworthiness, disburses the loan, and then offers the bank's share to the partner bank on a back-to-back basis. The bank takes its portion onto its own books after conducting its own due diligence — but it does not need to be present at the point of origination.
This two-step process preserved the bank's independent credit judgment while eliminating the operational bottleneck that had killed co-origination. The NBFC could originate hundreds of small loans in a week; the bank could review and accept them in bulk.
How does the risk-sharing work?
Under the November 2020 framework, the NBFC was required to retain a minimum of 20 per cent share of the individual loans on its books. The bank took the remaining 80% or less. This 80:20 split was not arbitrary — it ensured the NBFC had skin in the game. If the NBFC could originate loans and transfer 100% of the risk to the bank, it would have no incentive to screen borrowers carefully.
The 20% retention requirement also meant the NBFC's capital was at risk. If the loan defaulted, the NBFC lost 20% of the outstanding principal before recovery proceedings. This alignment of incentives — the originator retains a meaningful share of the credit risk — is the same principle that underpins securitisation regulation globally.
The Master Agreement between the bank and NBFC specified the terms: pricing (a blended interest rate that reflects both the bank's lower cost of funds and the NBFC's origination expenses), customer interface (typically the NBFC manages the customer relationship), default management (who initiates recovery, how costs are shared), and reporting (both institutions report the loan to credit information companies).
The Governor's October 2020 statement signalled the shift:
"Review of the Co-origination Model"
— Governor's Statement – October 9, 2020 (Governor’s Statement – October 9, 2020)
Why does co-lending matter for priority sector targets?
Every scheduled commercial bank must lend 40 per cent of its Adjusted Net Bank Credit to priority sectors — agriculture, MSMEs, education, housing, and other specified categories. Banks that fall short must deposit the shortfall with NABARD or SIDBI at below-market rates. Meeting PSL targets is therefore a direct financial imperative, not just a regulatory obligation.
The co-lending model offered banks a new channel. The bank's share of a co-lent loan counts toward its PSL target if the underlying borrower qualifies. A bank that co-lends with an NBFC specialising in agricultural credit can claim PSL classification for its 80% share — without building a single rural branch or training a single agricultural field officer.
This is why co-lending grew rapidly after 2020. Banks could meet PSL targets through partnerships rather than infrastructure. NBFCs gained access to cheaper funds, which they could pass on to borrowers. Borrowers received loans at rates they could not get from either institution individually.
The Master Directions – Priority Sector Lending (PSL) – Targets and Classification RBI/2016-17/81 defines the categories and sub-targets that co-lent loans can satisfy, including the sub-targets for small and marginal farmers, micro-enterprises, and weaker sections.
What changed with the August 2025 Directions?
The April 2025 developmental policies statement previewed a major expansion:
"The extant guidelines on co-lending are presently applicable only to arrangements between banks and NBFCs. Moreover, they are restricted to priority sector loans. To exploit the huge potential of such lending arrangements, it is proposed to extend them to all regulated entities and to all loans — priority sector or otherwise."
— Governor's Statement: April 9, 2025 (Governor’s Statement: April 9, 2025)
This promise was delivered through the Reserve Bank of India (Co-Lending Arrangements) Directions, 2025 (Reserve Bank of India (Co-Lending Arrangements) Di) (since withdrawn), issued on August 6, 2025. The new directions represented a fundamental expansion of the co-lending framework:
"In view of this and to broaden the scope of co-lending, comprehensive revised Directions on co-lending arrangements (CLA) are now being issued with the objective of providing specific regulatory clarity on the permissibility of such arrangements, while addressing some of the prudential as well as conduct related aspects."
Key changes included:
Broader applicability: Co-lending was no longer restricted to bank-NBFC pairs for priority sector. Commercial banks, All-India Financial Institutions, and NBFCs (including HFCs) could enter co-lending arrangements with each other for any type of loan.
Lower minimum retention: The minimum retention was reduced from 20% to 10 per cent per regulated entity (since withdrawn) — meaning both the originating and partner RE must retain at least 10% of each loan.
Default Loss Guarantee: The 2025 Directions included specific provisions allowing originating REs to provide default loss guarantee up to five per cent of loans outstanding (since withdrawn) under a CLA, addressing a grey area that had complicated earlier transactions.
Digital lending integration: The Directions clarified that digital lending arrangements involving co-lending must comply with both the Digital Lending Directions RBI/2025-26/36 (since withdrawn) and the co-lending Directions simultaneously.
The 2025 Directions came into force from January 1, 2026 (since withdrawn), with existing co-lending arrangements grandfathered under the prior framework.
What does co-lending look like in practice?
A typical co-lending transaction works like this: A microfinance institution operating in rural Tamil Nadu originates a Rs 50,000 crop loan to a small farmer. The MFI has pre-assessed the borrower, verified the landholding, and determined the crop cycle. Under its co-lending agreement with a large public sector bank, the MFI offers the bank 80% (later 90% under the 2025 Directions) of the loan. The bank's system reviews the borrower profile against pre-agreed eligibility criteria and accepts or rejects the loan within 24 hours.
If accepted, the bank funds its share directly to the borrower's account. The MFI funds its share separately. The borrower receives the full Rs 50,000 at a blended interest rate — say 10%, compared to the 16% the MFI would have charged on its own or the 9% the bank would have charged if it could reach the borrower directly. The bank books its share as a priority sector agricultural loan. The MFI earns a servicing fee for managing the customer relationship.
The MSME lending Regulatory Sandbox exit (Regulatory Sandbox: Third Cohort on ‘MSME Lending’) highlighted one successful model: a product enabling "a completely digital cash flow-based credit underwriting process" that "provides credit line through co-lending to MSMEs to purchase inventory from large corporates via a smooth digital process."
What are the risks?
Co-lending is not without pitfalls. The originating NBFC controls the customer relationship, the underwriting process, and the early warning signals. The partner bank relies on the NBFC's systems and judgment. If the NBFC's underwriting standards deteriorate — because its incentive is to originate volume, not quality — the bank absorbs the majority of the credit loss.
The 2025 Directions address this by requiring that each RE under a CLA maintain independent credit assessment capabilities and that the Master Agreement specify segregation of responsibilities for customer interface, collection, and recovery. But the structural tension remains: the entity that knows the borrower best retains the smallest share of the risk.
The other risk is regulatory arbitrage. Co-lending allows banks to book loans that they could never originate through their own branch network. If the bank treats co-lent loans as equivalent to self-originated loans for provisioning and capital adequacy purposes, it may underestimate the additional risk that comes from delegated origination.
Also in this series:
- Priority Sector Lending: The Complete Timeline
- NBFC Regulation: The Complete Timeline
- Why Banks Must Lend to Farmers — and What Happens When They Don't
Last updated: April 2026