1. How to make payments banks work

How to make payments banks work

The need is to test and refine existing models before a final one is adopted

By: | Published: July 28, 2016 6:10 AM
Money This is the liabilities side of the balance-sheet, with the licence permitting a payments bank to only take deposits, and mandating that investment be made only in certain securities.

Payments banks are a global phenomenon; many countries have adopted and evolved this approach. The fintech revolution is accelerating this model. But a number of academic reports hold that one cannot drive revenues by just managing one side of the balance-sheet in a bank. Hence, payments banks are ill-conceived and non-viable, thanks to issues such as the requirement of minimum regulatory capital, cost of establishing the business, restrictive rules, the underlying economics, etc.

This is the liabilities side of the balance-sheet, with the licence permitting a payments bank to only take deposits, and mandating that investment be made only in certain securities. The spreads are inadequate to drive RoE. Let us forget, for the time being, efficiency ratios.

This is before any loan-loss provisions. Let’s assume the NPAs are zero, efficiency ratio is 20% and spreads are inadequate to generate RoE. For the stakeholder, the question would be: What is the gap between revenue and expense and how to address it?

Is the banking model in a standstill? Will the rules framed today hold for next two decades? Will models and regulation be calibrated with time? With the implicit model of financial inclusion and some financial literacy, is there not scope for adding other categories of products, driven by segment needs? Since RoI is perceived as an issue, a feedback loop would have proved vital.

Clearly, wallets are not the answer. The way wallets have been touted in India smells and feels like they are the last-mile to be traversed before universal banking and universal commerce is achieved. Far from it. Starbucks is about selling coffee, Amazon is about e-commerce, Apple Pay is about selling content via its store. So, payments banking is about banking and making payments, not selling wallets.

This is where I will deviate from the conventional mindset on managing P&L. When RBI launched this initiative under Raghuram Rajan’s leadership, it knew it had to launch a bank to take India forward and address the maladies of the system, namely universal reach, to bring cash in circulation into the system and to migrate from cash to digital economy. This would empower all with access to the banking system and financial services, and improve access to pensions, welfare payouts, e-commerce, etc, bringing about wider participation for all in the economic system.

Small countries in Africa and the rest of the world have addressed these needs. What about India?

RBI should have launched a pilot phase with 10-15 self-contained tests across a few districts in the country. The central bank could have suggested incumbents to complete the tests with samples of 5,000 registered customers, conducting transactions that could be monitored. The model could have been fine-tuned and evolved from that point.

Let us shift our attention to M-Pesa, the much-touted ‘use-case’ adopted by Kenya for its under-banked population. M-Pesa is a fully-managed and monitored service with funds deposited in several commercial banks, under the governance of the Central Bank of Kenya. The money held and supplied is accounted for as part of M1—savings and deposits. All transactions are monitored for money laundering and other regulatory needs. They are also fully stress-tested for compliance. But this was an evolutionary journey The system was not perfect from day-1.

Consumer literacy is one of the key themes for this segment, especially for credit. So, credit has remained outside the spectrum. Even for established institutions in western markets, unsecured credit lending, for sub-prime candidates, has been a difficult proposition.

Fintech, along with crowd-sourcing and P2P lending, may lead to the emergence of new categories of lending.

A three-factor identity management and authentication model was put in place in Africa to address fraud and other issues in 2007-08. We are now in 2016. Even by banking standards, the model was more than adequate.

Financial inclusion, while directly not achievable under this platform, enabled the ‘reach’ factor and, in the process, inclusion was indirectly accomplished. This is evident from the adoption numbers.

M-Pesa, though, met its limitation in South Africa. A study reveals that the needs of the market were different. When one carefully looks at the Indian construct, there are many similarities to this model, but it is not identical.

The key takeaway from the use-case is that the system was tested and refined, and it subsequently evolved to allow participants to contribute and learn from their journey. The transaction fees for remittances and other payments also provided adequate revenue. The spreads were razor-thin. Even systemic risks were assessed—due to deposits being held in commercial banks. The Central Bank of Kenya has tailored the licensing and regulation aspects, meeting the needs of the local model.

India should have developed its own version—and then tested, refined and assessed revenue models from transactions. It should have modelled for profitability and regulatory capital requirements and then scaled it. The first phase could have been just deposits, remittances, bill payments, benefit transfers, etc.

A billion Aadhaar numbers, Unified Payment Interface (UPI), world-class IT capabilities are all added incentives. A business model could perhaps evolve using UPI. There is still time to get back on the track. The government is launching the Post Bank. Few licensed players are also launching similar services. This is a good first set of actions.

Let us look at the second example, the just announced fintech bank, N26. The Berlin-based start-up said on July 21 that it has received a German banking licence which allows it to offer a fuller range of products across Europe. Its mobile app lets European consumers maintain an account, transfer money and pay by MasterCard from their smartphones. Now licensed as a bank by the European Central Bank and Germany’s BaFin financial supervisory authority, the start-up—formerly called Number26—can offer savings, investment, credit and insurance products from partners.

The operative part here is ‘from partners’—and in the Indian context, this is perhaps where RBI would have headed once the model had been established and stress-tested.

The approval for the three-year-old German company provides another template of regulatory approval for fintech start-ups that seek to outmanoeuvre bigger banks by offering financial services via smartphones and tablets.

Though the model is targeted at young, geeky customers who use smart devices, the Indian approach is primarily targeted at the under-banked—who are all very adept at using mobile phones.

The final example is the launch of the First Direct (a bank running on telephone lines). The banking industry has launched digital products on one side of the balance-sheet and managed them successfully with viable profit margins. The revenue side of the business was always addressed through fee-based services. Are bank balance-sheets not made up of net interest income and non-interest income in P&L?

What would that mean for the unbanked segment? The thinking should be backed by a defined testing framework—the ability to refine revenue models based on demographics and unmet needs—with price-testing and choice-testing, and scaled to assess the feasibility.

An India-centric micro-bank or payments bank model will soon dawn, with a product-set that includes deposit accounts, savings accounts, retirement accounts, remittances, bill payments and perhaps even fee-based products.

Spreads will no longer be the subject of debate, akin to the wallet story in India. They can be almost equal to efficiency ratios. The journey should not end here. This should be scaled to small business, microfinance and should integrate P2P lending and B2B commerce platforms for small business.

Wishful thinking? Perhaps not. Let the tests demonstrate that.

The author is chairman, EIP Fund, Vedas Group

  1. Rajeev Lal
    Jul 28, 2016 at 5:10 pm
    Good article, very thoughtful. Please also see
    Reply

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