Compelling need of the hour: Digital Banks

The structure of the banking system in India can be broadly divided into scheduled banks, non-scheduled banks and development banks, however during recent times banking evolved to new horizon and changed into multi aspect branches of banking. Payment bank, small finance bank, neo bank etc. concepts have been formalized.

First it is important to understand difference between payment bank & small finance bank (SFB) then only we will be able to formulate whether these banks could successful in filling void or have cemented their place in banking industry or not.

Payment Banks (PB) were essentially “narrow banks” that issue deposits, offer payments services and not issue credit in any form, thus having no asset side of the balance sheet. Small Finance Banks are full-fledged banks that focused principally on lending to small businesses. SFBs could leverage low-cost deposits to lend to micro, small and medium sector enterprises and enable financial deepening.

Even as these reforms took shape on the banking front, a broader Digital India revolution catalyzed by PMJDY, India Stack, e-KYC and UPI led a paradigm shift in the way India interacted with and consumed financial services. In parallel, India has also taken steps towards operationalizing its own version of “Open banking” through the Account Aggregator (“AA”) regulatory framework enacted by the RBI. Once commercially deployed, the AA framework is envisaged to catalyse credit deepening among groups that have hitherto been under-served.

However, while regulatory innovation has helped payment system to become effective and reformed, but credit delivery side still lacking these innovation and wide spread reach. Credit delivery or credit dispensing is a challenge for innovation eco system and present setup or products could not fill this void. Despite the rapid strides India has taken to further its financial inclusion agenda, the lack of financial deepening remains a challenge, partly flowing from that inertia, the country still has large segments who have not befitted from this digital revolution.

• A substantial fraction of MSME remain outside the ambit of formal finance and there is continued reliance on informal money markets like money lenders (quick disbursal without documentation) or chit funds (delayed disbursal but lower interest rates than money lenders) to finance itself, even at the cost of staying uncompetitive owing to the usurious interest burden.
  • As per RBI estimates the total addressable credit gap in the MSME segment to be ₹ 25.8 trillion and growing at a CAGR of 37% (total addressable market demand by the MSME sector is approximately ₹ 37 trillion, of which banks, other institutions and NBFCs supply about ₹ 10.9 trillion).
  • The informal debt definitionally is not visible in the credit bureaus, lenders exercise rational apathy towards funding the MSME segment. In other words, the costs of due diligence that a bank will incur towards evaluating the credit risk adjusted against the ticket-size and the yield from the loan make it unviable.
  • The other supply side stakeholder here are the NBFCs. NBFCs are regulated moderately relative to banks and have leveraged that autonomy to develop distribution, underwriting and product expertise in niche areas that are not serviced by banks. However, lacking the ability to take deposits, they rely on funding from bank loans and debt capital markets themselves. This translates into higher cost of capital for the NBFCs.

• There is significant room to grow consumption in India and promote credit usage. A data point from a recent CIBIL Report underscores the point; out of a total 220 million credit-eligible retail customers, CIBIL found that banks are servicing 33% only.
  • Internal working group of the RBI on digital lending suggests, bad actors have perverse incentives to take advantage of desperate borrowers in urgent need of funds. The RBI Report recommends several supply and demand-side measures to mitigate the potential risks flowing from digital lending. However, the fundamental drawback of the formal and regulated retail banking space, is lack of innovation, which constrains potential “thin-file” borrowers to look towards the unregulated and gray markets for their financial needs.
  • The median age of India is 28 years (proxying an aspirational middle class) and it would be ideal to provide them with multiple credit opportunities such as small ticket personal loans, credit cards, Buy-now-pay-later other substitutes to enable higher consumption and unleash economic growth.

To summarize, there is an opportunity for other banking innovations that will support and facilitate a new class of business formation on the MSME banking side and retail banking. In absence of such innovation existing digital payment product will soon loose their importance and flow to informal sector will only increase leading to fall of banking industry.There is scope for banking innovation on the credit market side, to inject competition and facilitate corollary innovation for the issues mentioned here.

Digital banks may trigger those set of innovations or may catalyse such innovations so that this credit side can be taken care of and sufficient liquidity and availability can be insured. Digital banks are sometime confused with Digital banking unit (DBU) or Neo banks, without regard to whether these fintechs actually function as “banks” as the applicable law defines them.

Digital Banks: The Promise They Hold for India

“Digital Banks” or DBs means Banks as defined in the Banking Regulation Act, 1949 (B R 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.

However, as a natural corollary to being a “Bank” in full sense of its legal definition, it is proposed that DBs will be subject to prudential and liquidity norms at par with the incumbent commercial banks. Having said that, DBs offer a differentiated proposition and as such, there is scope for differentiated treatment in adjacent areas of their operation consistent with treating them identically with incumbent commercial banks, in the critical areas of prudential and liquidity risk.

Digital Banking Units and Digital Banks

Since DBUs and Digital Banks are similar constructs, for the sake of abundant clarity and to distinguish from DBUs, we will underline the key differences between the two.

Neo Banks and Digital Banks

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. These Neo-banks have further specialized into consumer-facing and small business-facing offerings respectively. However, these Neo banks are different than Digital banks and have limited area of operations with some inherent challenges;

• Limited Revenue Potential
• Potential Obsolescence of the Partner Bank Core Banking System
• High Cost of Capital & No Entry Barrier

India has the opportunity to leverage present enablers (digital innovations) to enact an industry leading regime for establishing Digital banks.  India has the technology stack to fully facilitate Digital Banks. Creating a blueprint for digital banking regulatory framework & policy offers India the opportunity to cement its position as the global leader in Fintech at the same time as solving the several public policy challenges.Consistent with best practices the following 3 step sequence is recommended for development of Digital bank eco system

• Introduce a restricted Digital Business bank licence and a restricted Digital Consumer Bank license
• The applicant acquiring this restricted license (“Licensee”) enlists in the regulatory sandbox and commences operations as a Digital Business bank/ Digital Consumer bank as the case may be, in the sandbox.
• Contingent on satisfactory performance of the Licensee in the sandbox, the restrictions can be relaxed when the Licensee graduates from the sandbox and becomes a full-scale Digital bank.

The duration of this progression, i.e. the duration for which the Licensee will operate in a regulatory sandbox will vary from case to case. So, the regulation could leave for the RBI to make that determination. Given the significance of this regulatory innovation, RBI is expected to leverage this built-in flexibility to decide the duration on a case-to-case basis in consultation with the licensee and give itself and the Licensee sufficient and fair time to observe the Licensee’s execution as a Digital Business bank in the sandbox before graduating it to full-scale Licensee.

On the other hand, if the metrics agreed on ex ante are not met over a defined period, the licensee may be given a window to unwind the liabilities created including any term deposits, assign assets created to an identified buyer and exit the sandbox, per the process laid down in RBI’s regulatory sandbox framework.

What can make best in class Digital Banks

Track record & Potential Applicant Pool: Here the small finance banks, neo banks with existing setup may be considered for establishment of digital banks. To become successful in this venture it is important that controlling persons of the applicant entity to have an established track record in adjacent industries such as e-commerce, payments, technology (e.g. cloud computing). Existing neo-banks seeking to upgrade or small finance banks / other regulated entities are also potential eligible candidates for application, fintechs should also be included in the potential applicant pool.

Equal Access to the Infrastructure Enablers: In order that business proposition of a Digital Business bank / Digital Consumer bank remain viable and to promote competition, it should have access to all the key infrastructure enablers in the Indian financial ecosystem, as traditional banks are.

Phased relaxation of Business Restrictions: Minimum paid up capital requirement and other reserves & investment related restriction may be loosened during sandbox testing and should be increased or enforced in phased manner to observe their effect and flexibility of those requirements in digital arena. Regulatory touch points like capital adequacy, risk weights, liquidity coverage ratio will be required to be fully compliant Digital banks will start working out of sandbox regulations.

Technological Risk regulation: Technology risks assume greater importance for Digital Business Banks / Digital Consumer banks relative to the traditional banks because they leverage their APIs to have relationships to numerous counter-parties that risks can originate from. It should neither express a preference for nor bar a Digital Business bank from using/ not using any technology.

Business Continuity Planning: Since after the global financial crisis, regulators including the Federal Reserve have required banks under their supervision to submit “business continuity plans” (BCPs) in order to game out “an exit strategy” for depositors and other creditors to the bank, in the event of bank failure or winding down of business for other reasons.

Products and services: Subject to asset and deposit limits and other restrictions (including for eg, number of customers), a Digital Business bank may potentially offer all banking services in the restricted phase.

Conclusion

India’s public digital infrastructure, especially UPI has successfully demonstrated how to challenge established incumbents. 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. These indices demonstrate India has the technology stack to fully facilitate DBs. Creating a blue-print for digital banking regulatory framework & policy offers India the opportunity to cement its position as the global leader in Fintech.

Recently, the National Institution for Transforming India (“NITI Aayog“) has released a discussion paper titled Digital Banks A Proposal for Licensing & Regulatory Regime for India (“Licensing Framework“). The Discussion Paper has tried to resolve some of the above issues by the introduction of a full-stack digital bank license proposal, that would mitigate the gaps in the existing Neo Bank Model. The Licensing Framework offers a road map and template for digital bank licensing i.e. that would help in reinventing the banking ecosystem and mitigating the deepening challenges of financial inclusion. However, certain practical and regulatory issues and issues of the stakeholders would need to be addressed, for which the RBI would have to propose detailed and comprehensive licensing and operational guidelines.