Digital Banks | 15 Sep 2022

Recently, NITI Aayog has released a report titled- 'Digital Banks: A Proposal for Licensing & Regulatory Regime for India'.

What are the Recent Developments towards Financial Inclusion According to the Report?

• Nachiket Mor Committee Report:
  • The Nachiket Mor Committee Report (“Committee”), released in 2014 marks an important milestone towards promoting financial inclusion in a mission mode.
    • One of the salient recommendations of the Committee was differentiated banking policy, i.e. issuing specialized bank licenses that would harness narrow specialization along a given dimension rather than have every bank do everything and pursue every opportunity on both sides of its balance sheet.
    • Pursuant to the Committee’s recommendations, RBI issued guidelines for both Payments Banks (PBs) and Small Finance Banks (SFBs), in 2014 respectively.

• Pradhan Mantri Jan Dhan Yoja:
  • Under PMJDY, launched in 2014, 420 million bank accounts have been opened till date.
    • However, credit penetration remains a policy challenge, especially for the nation’s 63-million-odd MSME (Micro, Small and Medium Enterprises).
• India Stack:
  • India Stack refers to an ambitious project of creating a unified software platform to bring India’s population into the digital age.
• Electronically Knowing Your Customer (e-KYC):
  • The electronic Know Your Customer eKYC is the transposition of the KYC process to the digital and online plane.
  • The financial sector and its related industries are the digital pioneers.
    • The digital transformation took place much earlier in these sectors of activity than in others that are still anchored in semi-digitalized models.
• Unified Payments Interface (UPI):
  • As of today, UPI has facilitated Rs. 4 trillion worth of transactions, making it the bellwether of real-time payment systems.
  • Starting from peer-to-peer use-case, it has since leveraged third party applications - fintechs and pure-play technology incumbents - as channel partners to add commercial use-cases across varied contexts.
• Direct Benefit Transfer (DBT):
  • The Financial Inclusion also resulted in Direct Benefit Transfer (DBT) through apps such as PM-KISAN and extending microcredit facilities to street vendors through PM-SVANIDHI.

What is a Digital Bank and What is its Need?

• Digital Bank:
  • It will be defined in the Banking Regulation Act, 1949, and shall have its own balance sheet and legal existence.
  • It will be different from the 75 Digital Banking Units (DBUs) - announced in the Union Budget 2022-23 - which are being set up to push digital payments, banking and fintech innovations in underserved areas.
  • Digital banks will be subject to prudential and liquidity norms at par with existing commercial banks.

• Need:
  • Bridging the Credit Gap:
    • The success that India has witnessed on the payments front is yet to be replicated in meeting the credit needs of its micro, small and medium businesses.
    • The credit gap reveals a need for leveraging technology effectively to cater to these needs and bring the underserved further within the formal financial fold.
  • Reliance on Digital channels:
    • Banks and fintech businesses that offer digital banking services rely primarily on digital channels that organically have high-efficiency metrics relative to incumbent commercial banks.
    • This structural feature makes them a potentially effective channel through which policymakers can achieve social goals like empowering the under-banked small businesses, and enhancing trust among retail consumers.
  • Drawbacks in Neo-Bank Models:
    • The existing partnership-based neo-bank models face several challenges, such as revenue generation and viability.
      • Neobanks don’t have a bank license of their own but count on bank partners to provide bank licensed services.
    • They have limited revenue potential, high cost of capital, and offer products of only partner banks.
• Global Experience:
  • The UK has led the pack in terms of digital banks, with new entrants in the form of Monzo and Starling Bank.
  • Several jurisdictions in the South East Asian region have witnessed the rise of digital banks.
    • Hong Kong has issued a separate licenses for virtual banks. As of May 2020, the Hong Kong Monetary Authority has licensed 8 entities out of 33 applications.
    • In South Korea, Kakao Bank and K Bank operate as internet banks licensed under the country’s Banking Act. The Philippines has approved six licenses for digital banks.

What is the “Partnership-Based” Neo-Bank Model?

• About:
  • The prevalent Neo-bank business model in India is a function of the regulatory vacuum.
  • In the absence of a licensing regime for “full-stack” digital banks, fintechs offering the Neo-bank proposition in India have improvised and adopted the “front-end neo-banks” model.
  • As the name indicates, this is a partnership between traditional banks and neo-banks such that the latter bring in the engagement layer and the former bring in the “utility” layer and offer both sides of their balance sheet.
• Division of Neo-banks:
  • These Neo-banks have further specialized into consumer-facing and small business-facing offerings respectively.
    • Consumer Facing:
      • A typical consumer facing Neo-bank offers additional conveniences like digital debit card, Personal finance management tools like spend analytics for better budgeting, investment avenues through its mobile application through its B2B partnerships and potentially a credit line.
    • Small Business-Facing Fintech Offering:
      • A typical small business-facing fintech offering neo-banking services will offer expense management products (like employee prepaid cards), payroll management, accounts receivables management platform and a business loan / credit line facility through the banking partner.
• Challenges:
  • Limited Revenue Potential:
    • Neo-banks earn revenue from interchange fees that are levied on customers when they swipe the debit or credit cards issued by the partnered banks.
      • However, the amount of revenue generation is extremely low and not enough to allow neo-banks to keep their heads above water.
    • Moreover, interchange is indirectly regulated in India (through merchant discount rate regulation), so unlike developed markets like the United States (where fintechs can earn revenue on interchange by partnering with small and medium banks), fintechs in India are constrained along this dimension.
  • Potential Obsolescence of the Partner Bank Core Banking System:
    • Fintechs offering neo-banking services are constrained by product buckets the partner bank can offer within its business and technological infrastructure.
    • Without the ability to leverage their balance sheet and their own technological stack to create “ground-up” credit products and user experiences, their potential will never be fully unlocked.
• High Cost of Capital & No Entry Barrier:
  • Neobanks cannot issue low-cost deposits and are constrained to rely on expensive equity capital to fund innovation and operations.
    • The licensing framework also serves as a strategic moat for licensed entities.
    • In absence of a licensing framework, entry barriers for fintechs to enter Neo-banking space are low.
  • This creates two negative externalities for the ecosystem.
    • First, as with any ecosystem with low barriers to entry, this context offers opportunities for actors that are not fit-and- proper to enter the market creating a consumer protection risk especially on the retail side.
    • Secondly, it creates herd mentality in terms of simply replicating business models and products already witnessed by the markets, rather than genuine innovation.

What are the Recommendations?

• Digital Bank Licensing: The report recommends the following steps for a calibrated approach:
  • Issue of a Restricted Digital Bank License: It means the license would be restricted in terms of volume/value of customers serviced.
  • Licensee Enlistment in a regulatory sandbox framework enacted by the Reserve Bank of India.
  • Issue of a ‘full-scale’ Digital Bank License: The license should be contingent on satisfactory performance of the licensee in the regulatory sandbox, including salient, prudential and technological risk management.
• Strong Technological Basis: It is also imperative to lay out a strong technology foundation built on that is cyber-proof along with building of capacities to deal with and mitigate technological risks.
  • Given the fast-paced changing landscape of the regulatory templates, it will be necessary for digital banks to use emerging technologies for seamless integration with RegTech solutions (technology to meet regulatory requirements) of banks and regulators, along with regulators themselves developing emerging SupTech solutions (to enable them automate their supervisory requirements).
• Financial Literacy as Ecosystem Enabler: In terms of ecosystem enablers, financial literacy will be the key enabler in the context of a regulatory framework for digital bank licence.
  • A National Centre for Financial Education (NCFE) survey (2019) found that only 27 % of adult Indians are financially literate.
    • This is an area that will require key focus to ensure the success of digital banks in India.