Digital Lending and Shadow Banking within Indian Legal Frameworks: Systemic Risk and Financial Stability Implications

Abstract

The structure of credit intermediation is changing due to technological innovation and growing reliance on non-bank intermediaries, which presents a major challenge to financial law and regulation. These developments have been taking place in an institution-based legal framework in India which balances the prudential regulation to deposit-taking banks although functional convergence is increasingly becoming prevalent with the financial intermediaries. Therefore, a significant portion of credit creation has been to be carried out by non-bank and technology-based institutions that carry out bank-like activities but are not under fragmented or indirect regulatory oversight, creating systemic stability vulnerabilities. This article is a doctrinal review of the legal frameworks that govern digital lending and shadow banking in India and their historical development, legislative basis and current modification. It makes three main contributions. First, it conceptualizes financial stability as a legal outcome, shaped by statutory design, regulatory philosophy, and supervisory coherence rather than solely by macroeconomic conditions. Second, it shows that regulatory arbitrage in digital lending is a legal failure, which is the result of institution-based regulation where similar economic credit operation can undergo different legal treatment. Third, it demonstrates how digital lending increases systemic risk by hastening credit cycles, further increasing interconnectedness between regulated and unregulated intermediaries, and procyclical behaviour by driving technology-based decision-making. The study argues that the issue of systemic risk being internalized, and ensuring financial stability in India is achieved by having one, activity-based, macroprudential regulation that encompasses all forms of loan intermediation.