By Shehnaz Ahmed
Even as Covid-19 takes a toll on the economy, it is catalysing the digital transformation of businesses. The financial sector is no exception, with policymakers emphasising on the digital delivery of financial services. This will have far-reaching implications for the future of the financial sector, including banking. It also provides a unique opportunity for reaching out to traditionally underserved segments such as MSMEs.
Even prior to the pandemic, several countries had witnessed the rise of exclusively digital and branchless banking models, operating either as licensed digital banks or as partnerships between licensed banks and non-banks. The UK has witnessed relative success with digital banks, with their customer base tripling from 2018 to 2019. Popular UK digital banks such as Revolut, Monzo and Starling Bank together claim to have attracted more than 17 million retail customers. Several Asian countries like Hong Kong, South Korea and Singapore have introduced separate licences for digital banks. India does not permit digital-only banks.
The digital banking model operates as partnerships between licensed banks and non-banks, popularly referred to as ‘neobanks’. In its report ‘Deconstructing Digital-only Banking Models’, the Vidhi Centre for Legal Policy finds that there around 17 neobanking platforms in India, some of which are yet to launch their products, but have secured advanced funding. Popular platforms include Open, Niyo, Jupiter and Hylobiz. They rely on partner banks to provide access to regulated services such as opening bank accounts and providing access to loan offers.
Interestingly, MSMEs have emerged as a popular customer segment for such models. Almost half of neobanking platforms surveyed for Vidhi’s report focus on MSMEs and start-ups. Traditional banks have long struggled to serve this segment due to the high cost to serve. While policy initiatives tend to focus on MSME financing, such businesses often struggle with other financial and business needs throughout their lifecycle for which they have to depend on different players.
Recognising this as an opportunity, digital banking models provide an integrated platform, which couple banking services with value-added services such as invoice generation, accounting, GST compliance, payroll management and enterprise resource planning.
Despite its value propositions, existing practices of these consumer-facing platforms give rise to consumer protection risks. Many platforms use terms like ‘bank’ or ‘banking’ to describe their services. This risks the violation of the Banking Regulation Act, 1949, which permits only licensed banks to use these terms. This coupled with the failure of many platforms to disclose their partner banks may misled consumers into thinking that these ‘neobanks’ are authorised and are regulated as licensed banks, when, in fact, their operations are carried out only through partnership with licensed banks.
To address these issues, without unduly slowing down the growth of an emerging sector, Vidhi’s report suggests light-touch regulation in the short term. This may be structured as directions from RBI clarifying the application of outsourcing guidelines to such partnerships along with specific directions to banks to address the risks above.
While an outsourcing arrangement may be relevant for a nascent industry, going forward as bank-fintech partnerships evolve, it will be a challenge for regulators to strike a balance between prudential risk management and promotion of innovation. This calls for a framework that can account for the complexities of bank-fintech partnerships and facilitate the evolution of such models into full licensing framework for digital banks. As a long-term measure, India should consider leveraging the regulatory sandbox testing model for the launch of digital-only banks.
Recognising that a well-functioning financial system requires a mix of institutions that can serve the diverse needs of the Indian population, RBI had introduced ‘differentiated banks’ in the form of small finance banks and payment banks that were envisaged to be technology-driven. Taking this to the next level, India must consider the introduction of digital-only bank licences.
The author is a senior resident fellow and lead (Fintech) at the Vidhi Centre for Legal Policy