Not an unusual development for a nation with Unified Payments Interface (UPI) which witnessed extraordinary adoption and recorded over 4.2 billion transactions worth over ₹ 7.7 trillion in just October 2021, NITI Aayog now has produced a discussion paper (paper) for my/your and others’ observations/comments on ‘A Proposal for Digital Banks in India: Licensing & Regulatory Regime’, which runs 50 pages with 7 sections and a concluding part.
Let us learn the architecture of the report. (extensively quoted from main paper for easy reference and for discussion purposes)
- “This Discussion paper makes a case and offers a template and roadmap for a Digital bank licensing and regulatory framework in India.
- Section II gives a summary of recent developments in financial inclusion and the rapid strides India.
- Section III caveats these achievements by identifying significant credit gap that persists among various segments, like the MSMEs, underlining the need for alternative mechanism.
- Section IV explains its potential and gives an overview of the prevalent business models, while defining the concept of “Digital bank”.
- Section V explains the scenario that has evolved in India following the regulatory vacuum and absence of a Digital bank license regime.
- Section VI describes the elements of a “Digital Global Regulatory Index”, created for the purposes of this Discussion paper and maps out the regulatory practices of certain identified benchmark jurisdictions against the Index.
- Finally, Section VII serves as the capstone and recommends a template for a Digital bank licensing regime/ regulatory framework and a pathway for sequencing the ensuing reforms.
- Section VIII gives the recommendations.”
Now, let me analyze the discussion paper in our view.
Why a digital bank/banks for India when every street virtually corners a brick-and-mortar bank? If fact, some of the nationalized or private bank branches do face an uncertain future
This must be understood in the context of global situation, and also from Indian perspectives.
Global scene
From China
Researchers at the IMF used the pandemic opportunity to test the correlation between digital lending and firm performance, as we understand from the paper. These researchers found that lending to a random sample of 40,000 MSEs by a Digital bank (MyBank) was positively associated with sales growth at borrowers.
So, we understand thar remote areas without physical presence of digital banks emphatically served its neglected clients.
United Kingdom (page 27 of paper)
Starling Bank: Starling bank acquired a restricted license from the PRA Prudential Regulatory Authority in 2016. In the past 5 years, it has come of age with offerings both on the small business side and retail side.
Equally exciting to note is that with NIM (net interest margin) growth, Starling turned monthly profitable from October 2020.
About other countries
Singapore, Hong Kong, and Malaysia have issued special DB regulatory regimes. Elsewhere, as in the United Kingdom, regulators have recognized the DB business model by issuing banking licenses to banks offering “digital-first” / “digital-only” propositions within already existing regulations without creating specialist regimes.
So, the above narrative clears our cobwebs on the need for digital banking. A necessity than a novelty.
The following 4 factors are claimed as the privileges of the digital banks.
- Entry barriers: This factor will score a regime contingent on whether the entry barriers for fintechs and adjacent entities in securing the DB licenses are high or low. Countries mentioned above encouraged digital banks to venture in and face the competition.
- Competition: This factor scores a regime in terms of how pro-competitive it is. In the context of the banking services market, competition arises between incumbent predominantly “brick-and-mortar” commercial banks and digital banks.
- Let us compare the cost of operation of a normal commercial bank and a DB. Page 27 nails the fact that DBs march over the normal commercial banks.
- “Estimates indicate that DBs have high-cost efficiency. Webank (China) for instance incurs a per account operation cost of $0.5. Compare that to traditional banks and (depending where we are), it may come up to 10-20 times higher.
- In the Indian context, a FIBAC 2019 Annual Insights Report estimated the banking industry cost to income ratio at about 50 %. Very painful to learn but a truthful statement.
Now let us venture into Indian scene.
How does one define a digital bank in Indian contact of applicable laws?
“Digital Banks” or DBs referred in this Paper means Banks as defined in the Banking Regulation Act, 1949 (BR Act). In other words, these entities will issue deposits, make loans, and offer the full suite of services that the B R Act empowers them to.
As the name suggests however, DBs will principally rely on the internet and other proximate channels to offer their services and not physical branches.”
In simple terms, one can operate an account with a DB with just an internet connection and after fulfilling KYC requirements. DBs would encourage opening of accounts by rural or urban people without much of paper work.
Page 39 of the paper leads us as under. Three step sequence is shown and recommended:
“Step 1:
Introduce a restricted Digital Business bank license (the dimensions along which the license will be restricted has been detailed below in sub-section-B and the legal mechanics involved in sub-section- C below).
Step 2: The applicant acquiring this restricted license (“Licensee”) enlists in the regulatory sandbox and commences operations as a Digital Business bank in the sandbox.
Step 3: Contingent on satisfactory performance of the Licensee in the sandbox, the initial set of restrictions can be progressively relaxed to advance the Licensee to a Full Stack Digital Business bank license.”
Let us proceed with other requirements as prescribed by the paper.
Minimum paid-up capital
Digital Business bank may be required to bring in ₹ 20 crore of minimum paid-up capital.
Upon progression from the sandbox into the final stage, a Full-stack Digital Business bank will be required to bring in ₹ 200 Crores (equivalent to that required of the Small Finance bank)
So, progression indicates from mere Rs. 20 crores to Rs. 200 crores if its business goes up.
The applicants for these DB to have an experience and an established track record in adjacent industries such as e-commerce, payments, technology (cloud computing).
What is the access to infrastructure enablers?
Like traditional banks, DBs will have access to the following infrastructure enablers:
- Aadhaar e-KYC / Credit Information Companies
- UPI (NPCI) / Central Payment Systems (NEFT/ RTGS).
- ATM schemes
- Deposit Insurance & Credit Guarantee Corporation (DICGC) (against levy of appropriate premium as determined by the DICGC).
- AA ecosystem.
The licensee of the DB will be ready to exit the sandbox and operate as a “Full Stack Digital Business bank.” depending upon the progress shown by its existence and the expectations of the regulatory authority.
Time to learn other finer aspects of the functioning of DB.
Prudential / Liquidity risk regulation: This aspect will be identical for both Digital Business banks that have progressed to full license, and the incumbent commercial banks. Obviously, during sand-box existence the requirements under this category will be watered down by RBI.
Let us now deal with one of the most important requirements for a DB.
Technological Risk Regulation:
The license shall require conditions for ex ante technological preparedness and ex post business continuity planning (detailed in the following segment). Ex ante technological preparedness will entail:
- Continuing compliance with industry-grade certifications like PCI-DSS and the attendant audits of the Digital Business Banks.
- Board-level policies and expertise in assessing evolving cybersecurity risks (including saliently that of ransomware illustratively), by mandating a defined fraction of executive directors to have relevant experience and necessary upgradation of knowledge.
- Additionally, installing, and upskilling technology risk supervision personnel of the RBI commensurately to offer intelligent oversight. So far, RBI has been trying to match up to the latest technical excellence, but the latest landscape offers vast areas for upgradation.
- Finally, due to their “digital-native” avatar, new technologies such as machine learning and blockchain need frequent upgradation to offer world class services.
What can be other regulatory requirements?
Like other commercial banks, RBI regulations are equally applicable. DBs can use any technology without any bias.
I am interested to know what types of business; any DB would have?
Loans / Current Account /business banking Services / fixed deposits to MSME businesses, factoring / Distribution (Channel Partner), and others specified in Section 6 of the BR Act may be the reference points but strictly speaking, any restriction by RBI will disincentivize DBs to grow.
Value Added Services:
I am happy to learn about other value- added services that would be offered by DBs by APIs enabling them to integrate services like payroll, accounts receivables/ accounts payables management, tax compliance and other S-A-A-S based services in the business flows of their customers directly.
These services offer both an engagement avenue and revenue source for the proposed Digital Business Bank.
Public sector banks previously offered even payroll services reluctantly and after much persuasion until private sector banks grabbed all lucrative business from private sector companies. It is possible that DB can offer all types of services to any medium size company which need not worry about any income tax/gst/secretarial services at a mutually acceptable cost.
Legal mechanics to issue the license
Page 45 of paper explains the above topic in simple terms.
“While RBI’s authority to issue a license to a banking company under Section 22 of the Banking Regulation Act (BR Act) is straightforward54, an additional step is necessary for creating a licensing regime for Digital Business banks that permits them to offer value-added-services (and generally NFBs) that are complementary to their core financial business, on the same balance sheet as the banking services.”
Conclusion
Nothing succeeds like success and India with its technical acumen has mastered the required talents in all fields to serve high tech services to the world.
As pointed out in the opening section; UPI transactions measured have surpassed ₹ 4 trillion in value. Aadhaar authentications have passed 55 trillion. Finally, India is at the cusp of operationalizing its own Open banking framework.
Digital banking will open the rural areas and brick and mortar buildings may not be necessary and with the use of cellular phones or exclusive service providers from rural areas, they will reduce the cost of operations. This new development may look a far sighted one.
Highly technical future awaits Digital banks to serve the billion Indian population.
NITI Aayog contains the discussion paper in its website and one can refer the detailed paper for deeper understanding.
Comments on the Discussion Paper may be provided on or before 31st December 2021 preferably on email at annaroy@nic.in.
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