Shruti Madhogaria & Prachi Thakur
ABSTRACT
Digital banks are the future of banking in India. However, there is a grave deficiency of regulation of these banks owing to their recent adaptation into the mainstream. The paper intends to delve into the licensing of these banks in India according to the law of the land. As of now, the majority of these banks rely on the partnership model under which they partner with other traditional banks.
The paper discusses the viability of Niti Aayog’s paper titled ‘Digital Banks – A Proposal for Licensing & Regulatory Regime for India, 2021.’ Under the proposed full-stack digital license, Niti Aayog proposes a two-stage approach of phased authorization of Digital Banks. After a thorough study of the model proposed, the paper attempts to accommodate the loopholes in the model by suggesting modifications in its implementation including relaxation of license restrictions and setting of certain defined timeline for the restriction period that would reduce the entry barriers in the digital banking industry and in effect would promote competitive and innovative digital landscape in future. The other suggestions made in the paper altogether add an open-minded approach to the model proposed in line with the prevalent international standards.
INTRODUCTION
Banks can handle all of the financial needs, including savings accounts, deposits, credit cards, and more. They provide these services through a nationwide network of branches. Neo-banks, a type of fintech company and start-up, now provides a more convenient and hassle-free solution to address these needs.
In this paper, “Digital Banks” or “DBs” refers to banks as specified in the Banking Regulation Act of 1949.[1] To put it another way, these organizations will issue deposits, make loans, and provide the complete range of services that the BR Act authorizes. However, as the name implies, DBs will mostly offer their services over the internet and other nearby channels, rather than through physical branches. In India and elsewhere, marketing terms like “challenger banks,” “neo-banks,” and “digital banks” are used interchangeably in financial / fintech discourse, regardless of whether this fintech genuinely functions as “banks” as defined by local legislation.
As indicated by the high cost to income and high cost to serve numbers, incumbent commercial banks have inefficient business models. Banks and fintech companies that provide digital banking services (known as neo-banks) rely mostly on digital channels that have high-efficiency metrics as compared to traditional commercial banks. This structural aspect makes them a potentially effective route for policymakers to achieve social goals like empowering previously underbanked small enterprises and increasing consumer trust.
When technology-based financial service companies challenged traditional banks, these banks arose. In the United Kingdom and Germany, some of the first players appeared.[2] Niyo Solutions was one of the first companies in India to enter this market. The size and customer base of the global market for such institutions have grown at an exponential rate. Over the next five years, this industry is expected to increase at a rate of between 25 and 30 percent.
In India, there are ten neo-banks, with ICICI cooperating with three of them. These banks, however, are currently not permitted to hold customer deposits and have been denied virtual licenses by the Reserve Bank of India (RBI). More customers and small businesses are likely to overcome their fears and adapt to the changing banking environment as a result of such banks becoming mainstream participants. By 2024, these new-age banks are expected to have 98 million users with 187 million accounts managing $63 billion in worldwide assets.[3]
A characteristic feature of these neo-banks is in particular built on the following lines-
- The business model of neo-banks is to provide specialist products to demographics that are underserved by traditional banks (e.g., small businesses, migrants, paycheck-to-paycheck retail consumers, gig economy workers, and millennials).
- They provide their customers with speed (and its corollary, the elimination of friction), a superior user experience (in comparison to traditional banks), and low-cost, transparent cost structures.
- Profitability has emerged as a major concern for non-regulated businesses.
STRUCTURE OF DIGITAL BANKS IN INDIA
In India, the Neo-bank business model is a result of a regulatory vacuum. Fintechs presenting the Neo-bank concept in India have adapted and embraced the “front-end neo-banks” model in the lack of a licensing regime for “full-stack” digital banks. As the name implies, this is a collaboration between traditional banks and neo-banks in which the latter provides the engagement layer and the former provides the “utility” layer, and both sides of their balance sheet are offered.
These Neo-banks have specialized deeper into consumer and small business offerings, respectively. A typical consumer-facing Neo-bank provides additional conveniences such as a digital debit card, personal money management tools such as spend analytics for improved budgeting, investment possibilities via its mobile app through B2B partnerships, and possibly a credit line. A typical neo-banking fintech for small businesses will provide spending management products (such as employee prepaid cards), payroll administration, accounts receivables management platform, and a business loan/credit line facility through a banking partner.
Savings-led neo-banks, credit-led neo-banks, and payments-led neo-banks are the three types of neo-banks now available. The majority of millennials and Gen-Zs have no idea how to manage their money. Eight out of ten millennials have no idea how much money they have.[4] Finance is not something that is taught in school like trigonometry, and there is a stigma associated with it, therefore it is not discussed much in social gatherings. The objective of these banks is to demystify finance and assist customers in maximizing their savings. A portion of clients is looking for digital bank accounts that can only be accessed online.
The percentage of the population that are able to borrow from structured financial institutions such as banks is 8% while the population that is able to borrow from anywhere (including informal sources) is 42%.[5] As a result, there is a huge gap in legitimate credit access, where one can borrow money safely and create a credit profile.
Customers, not just enterprises, require credit lines. On the credit side, having flexible access to money through the comfort of a smartphone is one of the differentiators. Traditionally, high-net-worth individuals have had access to international investing and banking.
CHALLENGES IN THE EXISTING REGULATORY FRAMEWORK
In India, the majority of neo banks currently rely on partnerships with other traditional banks. Customers may face difficulties if the agreement does not work out. One of the issues for the business has been the lack of a licensing framework for neo banking. We’ve always approached innovation with a cautious attitude. Neo banks must now conform to the specialized banking license structure. The differentiated banking license differs from the universal banking license in that it allows for exceptions.
When comparing the income potential of this diverse set of services, it’s clear that fintech has a monetization challenge. Wherever they function as channel partners (account opening and onboarding, investment opportunities credit), they earn a fee-based revenue and possibly a fraction of interchange. Other than these two buckets, no other payments are processed by cards; nevertheless, there are no other payments processed through cards. Furthermore, the interchange is regulated indirectly in India (through merchants). Unlike established countries such as the United States.
Fintechs that provide neo-banking services is limited by the product buckets that their partner bank can offer because of its business and technological infrastructure. Their full potential will never be realized unless they can use their balance sheet and technological stack to produce “ground-up” credit products and user experiences.
Furthermore, in the absence of a regulatory framework, neobanks are unable to issue low-cost deposits and are forced to rely on pricey equity capital to fund innovation and operations. Finally, for licensed firms, the licensing structure acts as a strategic moat. Entry hurdles for fintech to enter the Neo-banking industry are low in the lack of a regulatory system. The ecology suffers from two negative externalities as a result of this. First, as with any ecosystem with low barriers to entry, this environment allows players that are not fit-and-proper to enter the market, posing a consumer protection risk, particularly in the retail sector. Second, it generates a herd mentality in terms of merely duplicating market-tested business structures and products rather than actual innovation.
ANALYSIS OF THE PROPOSED REGULATORY FRAMEWORK FOR DIGITAL BANKS:
Niti Aayog in its discussion paper titled ‘Digital Banks – A Proposal for Licensing & Regulatory Regime for India, 2021 has proposed a full-stack digital bank license by following a phased authorization approach or a two-stage approach.[6] As per this licensing/regulatory framework, firstly, a restricted digital business bank license would be granted to the new applicant banks which would restrict them in terms of their assets, deposit size, and customers serviced). [Step 1] Following this, the applicant (i.e., the licensee) would get themselves enlisted in the RBI’s regulatory sandbox, where they are not subjected to the full set of regulatory requirements/compliance as are normally applicable to traditional banks and can conduct only a limited range of activities. [Step 2] Regulatory sandbox usually refers to live testing of new products or services in a controlled/test regulatory environment for which regulators may (or may not) permit certain regulatory relaxations for the limited purpose of the testing.[7] These relaxations are granted to the new entrants enlisted in the sandbox to facilitate experimentation and innovation during the monitoring period.[8] [3] Within this sandbox, the start-ups are progressively monitored against a certain set of success metrics selected by the RBI to evaluate the performance of the licensees. Contingent upon the licensee’s satisfactory performance within the sandbox, it is extended a full-stack Digital Business Bank Licence which would transform it into a fully functioning digital bank. [Step 3]
I. The restriction phase can be made optional for some banks:
Such a mode of phased authorization has already been implemented in many countries across the world such as Australia, Singapore, Malaysia, and the UK. Among these, Malaysia and Singapore require all-digital bank applicants to go through a restricted phase before becoming fully functioning digital banks. In the UK and Australia, all banks can go through a restricted phase, regardless of whether they are traditional banks or digital banks. Going through the restricted phase is not a requirement, but is optional based on the choice of the applicant.[9] The rationale behind making this restricted phase optional is to provide an opportunity to such applicants, who possess the resources and capability to apply directly for a business bank license. Furthermore, some of the fintech/companies applying for a digital bank license may not need the relaxation in terms of the net worth criteria (minimum paid-up capital), provided to the new banks during the restricted phase, as they might already be well-funded start-ups or well-established corporations who want to enter the digital banking space quickly. Therefore, such minimum capital requirements and mandatory restricted phase might delay the progress of such applicants and the entry of some well-established players in the digital banking sphere.
II. Certain defined timelines for the restriction period may be set:
The Paper has suggested that the duration of the licensee’s progression, i.e., the duration for which the Licensee will operate in a regulatory sandbox will vary from case to case. Such case-by-case ascertainment of the restricted phase for different entities, following the Singaporean approach,[10] though quite practical but suffers from certain disadvantages. The non-stipulation of a definite timeline makes the licensing process arbitrary and vague. It gives RBI the unilateral power to determine the restriction period for each bank which would leave no room for such new entrants to speak up in case of any illegality or irregularity. Thus, there is a need to set a certain minimum and maximum limit to the restricted period after which the licensee would be provided with a full-stack DB license, with the RBI retaining the capacity to extend the time frame by a further period depending upon the circumstances. A predefined length for the restriction period would bring in a sense of certainty, and transparency in the licensing process. which would protect it from uncertain delays and extensions. Moreover, it would be beneficial for the firms who aren’t able to meet the metrics over a defined period to plan out their exit from the sandbox at a correct time thereby minimizing their potential losses.
III. Licence Restrictions must be on a differential basis:
The Discussion Paper set out a range of license restrictions on the new entrants to manage risks during the restricted phase, including a limit on deposit-taking, ongoing capital adequacy, customer size, and liquidity requirements[11]. However, a uniform set of restrictions on all the new banks might be detrimental to their growth potential during the restricted phase.[12] For example, setting a very low aggregate deposit limit restriction on all the banks would limit potential customer numbers such as being too few to adequately test commercial viability (which may lead to incorrect assumptions given a small data set). An alternative approach for the regulators might be to identify restrictions depending on the profile of the individual applicant, its business model, and financial projection, among others instead of putting prescriptive limitations on business.[13]
IV. Parameters in the regulatory sandbox must also be determined on a case-by-case basis:
The Paper provides for the RBI to identify a set of metrics against which an applicant’s progression will be evaluated in Step 2 of the Sandbox. In assessing the bank’s readiness to graduate to become a fully functional bank, RBI will consider parameters such as cost to acquire a customer (CAC), volume/value of credit disbursed to MSMEs, and technological preparedness. However, there is a requirement for certain other qualitative as well quantitative parameters while evaluating a licensee’s performance such as metrics to assess the sandbox’s impact on the market and market players. An example for this would be case studies demonstrating the response of incumbents to new entrants in the market which would be useful in gauging the market sentiments.[14] Along with this, the licensees should be evaluated based on their business model value proposition and “innovative use” of technology to serve customers, ability to manage a sustainable digital banking business, their growth prospects, and contributions to India’s financial industry.
Moreover, no one “blanket approach” exists for enabling and regulating fintech, as appropriate regulation depends on the jurisdictional context, including legal and regulatory frameworks, the complexity of the fintech market, and the availability of resources.[15] Therefore the metrics chosen for the Indian digital banks should be in line with the problems which are to be solved by granting such licenses i.e., to provide financial support to the MSME sector, to push the envelope on financial inclusion,[16] increase competition in the digital financial services space and force banks to accelerate the adoption of a technological solution. Also, the weightage given to different metrics must be decided carefully as there cannot be one “hero” metric. As Goodhart’s law suggests, “When a measure becomes a target, it ceases to be a good measure.” If one metric is made primary, it might be easy to gain this single metric at the cost of other factors.[17]
CONCLUSION:
Digital Banks are undoubtedly the future of banking in India and the proposed licensing framework by the RBI has, therefore, accordingly addressed the loopholes in the existing framework by allowing such Digital Banks to offer innovative and efficient products and services with unique user experience.[18] It is certain that this framework would correctly enhance regulatory oversight over Digital Banks, prevent uncontrolled replication of business models and protect the interest of the consumers as was prevalent in the previous model. However, this framework also entails some operational hurdles and challenges for the Digital Banks which need to be addressed before-handedly. The proposals made by the author, in this article, for the modification of the proposed framework such as relaxation of license restrictions and setting of certain defined timeline for the restriction period would reduce the entry barriers in the digital banking industry and in effect would promote competitive and innovative digital landscape in future. Also, the recommendations for the differential treatment of banks which are currently at different stages of their banking journey would help such well-established and experienced players to quickly venture into the digital banking space and the same would aid in the progress of digital banking in the country.
An open-minded approach to these recommendations by the RBI would substantially solve some major issues which might crop up after the implementation of the licensing model. To address the same, the RBI would have to propose detailed and comprehensive licensing and operational guidelines.
LIST OF REFERENCES:
1. A Proposal for Digital Banks in India: Licensing & Regulatory Regime”, NITI AAYOG Jun. 7, 2022, 11:52 AM), https://www.niti.gov.in/sites/default/files/2021-11/Digital-Bank-A-Proposal-for-Licensing-and-Regulatory-Regime-for-India.24.11_0.pdf.
2. R. JOSHI, A Study on Customers’ Perception on Adoption of Digital Banking in Indian Banking Sector, SSRN, Jun. 7, 2022, 11:52 AM), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3363623.
3. India: Niti Aayog’s Discussion Paper On Digital Banks, MONDAQ (Jun. 7, 2022, 11:52 AM), https://www.mondaq.com/india/financial-services/1190510/niti-aayog39s-discussion-paper-on-digital-banks.
4. Raphael Bick, Denis Bugrov, Hernán Gerson, Alexander McFaull, and Alexander Pariyskiy, Joining the next generation of digital banks in Asia, McKINSEY & COMPANY, (Jun. 7, 2022, 11:52 AM), https://www.mckinsey.com/industries/financial-services/our-insights/joining-the-next-generation-of-digital-banks-in-asia.
5. Shehnaz Ahmed, Deconstructing Digital-Only Banking Models| A Proposed Policy Roadmap for India, VIDHI | CENTRE FOR LEGAL POLICY, (Jun. 7, 2022, 11:52 AM), https://vidhilegalpolicy.in/research/deconstructing-digital-only-banking-models-a-proposed-policy-roadmap-for-india/.
6. Brad Rustin, Craig Nazzaro, and Mark Miller, In the Trenches: The Shift to Digital Banking Trends and Risks Post COVID-19, NELSON MULLINS, (Jun. 7, 2022, 11:52 AM), https://www.nelsonmullins.com/idea_exchange/events/in-the-trenches-the-shift-to-digital-banking-trends-and-risks-post-covid-19.
7. Vivek Belgavi, Challenger Banks And The Future Of Digital Banking, PWC, (Jun. 7, 2022, 11:52AM),https://www.pwc.in/assets/pdfs/consulting/financial-services/fintech/publications/challenger-banks-and-the-future-of-digital-banking.pdf.
8. Dr. Daniel Kobler, Dr. Stefan Bucherer, Johannes Schlotmann, Banking Business Models of the Future, DELOITTE, (Jun. 7, 2022, 11:52AM), https://www2.deloitte.com/content/dam/Deloitte/tw/Documents/financial-services/tw-banking-business-models-of-the-future-2016.pdf.
9. Basu Chandola, Digital banks: A Proposal For A Licensing & Regulatory Regime For India, OBSERVER RESEARCH FOUNDATION, https://www.orfonline.org/research/digital-banks-a-proposal-for-a-licensing-regulatory-regime-for-india/#_ednref16.
Notes:
[1] The Banking Regulation Act, 1949, No. 10, Acts of Parliament, 1949 (India).
[2] Karen Kornbluh & Ellen P. Goodman, Safeguarding Digital Democracy: Digital Innovation and Democracy Initiative Roadmap, German Marshall Fund of the United States (Jun. 13, 2022, 10:26 AM), https://www.jstor.org/stable/resrep24545.
[3]. Global Financial Development Report 2014: Financial Inclusion. Washington, DC, WORLD BANK, <https://openknowledge.worldbank.org/handle/10986/16238> License.
[4] The Deloitte Global 2022 Gen Z and Millennial Survey, DELOITTE, (Jun. 11, 2022, 10:36 PM), https://www2.deloitte.com/global/en/pages/about-deloitte/articles/genzmillennialsurvey.html.
[5] Dan Schawbel, 10 New Findings About The Millennial Consumer, FORBES (Jun. 12, 2022, 11:40 AM), https://www.forbes.com/sites/danschawbel/2015/01/20/10-new-findings-about-the-millennial-consumer/?sh=20b6083d6c8f.
[6] NITI Aayog, “A Proposal for Digital Banks in India: Licensing & Regulatory Regime”, https://www.niti.gov.in/sites/default/files/2021-11/Digital-Bank-A-Proposal-for-Licensing-and-Regulatory-Regime-for-India.24.11_0.pdf.
[7]Reserve Bank of India, Enabling Framework for Regulatory Sandbox, https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/ENABLING79D8EBD31FED47A0BE21158C337123BF.PDF.
[8] Id.
[9] Mehmet Kerse, Stefan Staschen, Digital Banks: How can they be regulated to deepen financial inclusion, CGAP, https://www.cgap.org/sites/default/files/publications/slidedeck/2021_12_Slide_Deck_Digital_Banks_Regulation_for_Financial_Inclusion.pdf.
[10] This is on identical lines as Singapore. MAS retains the discretion to make the determination about the licensee’s progress based on disclosed objective factors but does not prescribe any time period. See https://www.mas.gov.sg/-/ media/Annex-A-Digital-Full-Bank-Framework.pdf.
[11] Responses to the Bank of England’s Discussion Paper on new forms of https://www.bankofengland.co.uk/paper/2022/responses-to-the-bank-of-englands-discussion-paper-on-new-forms-of-digital-money.
[14] World Bank Group, “Global Experiences from Regulatory Sandboxes” FINANCE, COMPETITIVENESS & INNOVATION GLOBAL PRACTICE Fintech Note | No. 8 https://documents1.worldbank.org/curated/en/912001605241080935/pdf/Global-Experiences-from-Regulatory-Sandboxes.pdf.
[15] Appaya, Jenik, How Regulators Respond to Fintech: Evaluating Different Approaches — Sandboxes and Beyond, WORLD BANK (Jun. 7, 2022, 11:52 AM), https://documents1.worldbank.org/curated/en/912001605241080935/pdf/Global-Experiences-from-Regulatory-Sandboxes.pdf.
[16] Supra note 9.
[17] Basu Chandola, Digital banks: A Proposal For A Licensing & Regulatory Regime For India, OBSERVER RESEARCH FOUNDATION, https://www.orfonline.org/research/digital-banks-a-proposal-for-a-licensing-regulatory-regime-for-india/#_ednref16.
[18] Avisha Gupta and Sourav Padhi, Digital Banks: The Future of Banking In India – MONDAQ (Jun. 6, 2022, 5:53 PM), https://www.mondaq.com/india/financial-services/1173720/digital-banks-the-future-of-banking-in-india.
Author Bio
