Investment Theme of the Month: Digital Banking

Digital Bank – NITI AAYOG paper

“A Proposal for Digital Banks in India: Licensing & Regulatory Regime”


  1. Nachiket Mor Report in 2014 – Payment Banks, SFBs, differentiated banking policy, harnessing narrow specialisation instead of doing everything.
  2. Payment banks – 11 licences granted only 6 are functional
    1. issue deposits, no credit but earn income from HQLAs and fees from distribution, aimed at furthering financial inclusion.
    2. envisaged as distribution points for other socially relevant financial instruments (e.g. insurance).
  3. SFBs – 11 licensed and still operational
    1. Have to maintain at least 50 % of the loan portfolio in ticket size of ₹ 2.5 million and below.
    2. 75% of the credit to sectors identified as priority sector
    3. Are envisaged to leverage technology to increase coverage and financial deepening
  4. Other developments:
    1. Under PMJDY, launched in 2014, 420 million bank accounts have been opened till date.
    2. UPI, launched in 2016 was the bellwether of enabling real-time payments system, clocking ₹ 4 trillion (in value) transactions till date
    3. India’s own version of “Open banking” through the Account Aggregator (“AA”) regulatory framework enacted by the RBI. – Likely to deepen credit amongst underserved.

What is left?

While regulatory innovation has catalysed payments sector reforms, upended the user experience, i.e., the engagement layer of payments but making little improvement in the core utility banking layer – large segments not benefitted by the digital revolution.

A substantial fraction of 63.88 million MSMEs remain outside the ambit of formal finance -with reliance on informal money markets like money lenders (quick disbursal without documentation) or chit funds – no credit history – unviable with extensive due diligence required. Documentation by banks is large and takes long time to complete.

Credit gap to MSMEs is still ₹25 trillion – Supply side factors

  1. Limited underwriting ability
  2. High transaction costs
  3. Lack of innovation in products
  4. Low risk appetite

Thus, there is both demand side and supply-side friction that results in what economists refer to as “market failure” in the formal MSME debt markets.

NBFCs by digitising value chain has higher market share in MSME lending. TReDS also suffer from (a) procedure restrictive (b) reverse factoring by corporates (c) limited pool (d) limited to MSMEs and corporates don’t want multiple platforms.

  1. New Business Models – public policy intervention on banking license innovation required-
    1. Digital native -MSMEs- using SaaS vendors – requiring WC tailored to its billing and payment cycle. Traditional banks cannot customise credit codes on CBS on the fly for these clients.
    2. Researchers found that lending to a random sample of 40,000 MSEs by a Digital bank (My Bank in China) was positively associated with sales growth at borrowers. They further established a possible causal relationship between lending by a Digital bank and the MSE’s higher sales growth during the pandemic, due to absence of high touch due diligence.

 What is Digital Bank?

  1. 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
  2. Same prudential norms as with other commercial banks
  3. New regulations for DBs as regulatory innovation and not arbitrage.
  4. Relying on digital channels have high efficiency metrics and Govt can empower unbanked small businesses with ease.
  5. Three models in use:
    1. Neo banks: These neo-banks partner with licensed banks to offer “over-the-top” services to the consumers “renting” the balance sheet of a bank (properly so called) to lend and issue deposits from. (Open Technologies, RazorPayX, Dave). Neo banks bring in the engagement layer and the licensed banks bring in the “utility” layer and offer both sides of their balance sheet
    2. Digital Banks: These entities are fully functional banks, regulated by the banking regulator and issue deposits and make loans on their own balance sheet. (Starling, Webank, Kakao, Monzo, N26)
    3. (Autonomous) unit of traditional banks: These are essentially neobanking operations of traditional banks that function autonomously and compete with stand-alone neo-banks. (Marcus,25 (Goldman Sachs) 811 (Kotak Mahindra Bank), and Yono (State Bank of India)
  6. DBs are better than front end neo banks as
    1. They combine niche products to under catered to segments
    2. They offer speed
    3. Superior user experience
    4. Recording profits through on balance sheet lending – like Starling
  7. DBs are better than commercial banks
    1. Low-cost income ratio compared to PSBs and Pvt sector banks
    2. Lower CAC
    3. Can offer BaaS solutions – for example to a RRB or Coop Bank (need not spend on technology and offer niche offerings to existing clients) B-a-a-S makes it possible for the existing banking ecosystem to “do more with less” (in other words, to enhance unit economics) thus making it more competitive and efficient.
    4. Fintech NBFCs can partner with a Digital Business bank and leverage their credit card issuance infrastructure to issue and manage its own credit card clientele. The cloud-native architecture of the Digital Business Bank can potentially cut down the time-to-market for the NBFC by an order of magnitude, as opposed to traditional banks that can take up to 6 weeks to integrate and run such a program
  8. Augmented Credit Under-writing: Account Aggregators (AA) can on-board Digital Business banks on the AA ecosystem. Business consumers can then use the consent architecture to share their data with these banks with “financial information users” to enable better credit underwriting. On the same lines, can augment their own credit models and underwriting by relying on historical data provided by incumbent “financial information providers” to offer business banking and lending products to their customers.
  9. Limitations of neo banks:
    1. Limited revenue potential – only fee sharing on channel partnerships (account opening, investment support, credit etc.,) and inter payment charge on cards (challenge on MDR persists)
    2. Restricts 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 – obsolete CBS with banks does not permit
    3. High cost of capital (no access to low-cost deposits) and low entry barrier (Me Too Risk – herd mentality of so many coming up

Recommendations on framework:

  1. Start with sandbox environment with Restricted Digital Bank licence (with lower capital requirement of ₹ 20 cr. etc.,) graduating to Full stack Digital Business Bank licence, contingent on satisfactory performance. For full stack Digital Bank recommended capital is ₹ 200 cr.
  2. one or more 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 may also apply.
  3. Access to all public infrastructure – including ATMs, UPIs, AA eco system and Deposit insurance cover from DICGC.
  4. All the statutory prescriptions like CRR and SLR would also be applicable.
  5. The applicant should comply ex ante technological preparedness and ex post business continuity planning.
    1. Ex ante technological preparedness will entail:
      1. Continuing compliance with industry-grade certifications like PCI-DSS and the attendant audits of the Digital Business Banks.
      2. Board-level policies and expertise in assessing evolving cybersecurity risks, by mandating a defined fraction of executive directors to have relevant skill sets.
  • Additionally, installing and upskilling technology risk supervision personnel of the RBI commensurately to offer intelligent oversight of the first line of defence.
  1. Finally, due to their “digital-native” avatar, new technologies such as machine learning and blockchain can be more easily and seamlessly integrated into the overall operations of Digital Business banks (as also DBs generally). These technologies can provide an extra layer of security.
  2. Business Continuity Planning: Digital Business banks will be required to submit BCPs to provide for exit strategy for all potential creditors for all financial, operational, and saliently, technology risks. Regulatory oversight over BCPs is especially important in the context of DBs given that they can leverage their APIs to have relationships to numerous counterparties that risks can originate from.
  3. Technological neutrality: Consistent with the best practices the Digital Business bank license and the ambient regulation should be technologically agnostic. It should neither express a preference for nor bar a Digital Business bank from using/ not using any technology.
  1. Products and services: Subject to asset and deposit limits and other restrictions (including for eg, number of customers), a Digital Business bank should be able to offer standard banking services: Loans / Current Account /business banking Services / fixed deposits to MSME businesses / Factoring / Distribution (Channel Partner) and Others specified in Section 6 of the BR Act.
  2. Progressive interpretation of branch mandates: Consistent with the best practices the license may stipulate that the Digital bank may have one place of business. Furthermore, consistent with the RBI’s continuing progressive re-interpretation of branch mandates, to account for technology as a factor in delivery channel, the license may lay down the objective of delivering banking services to defined unbanked areas leaving the channels of delivery to be determined based on the bank’s policies.
  3. Value Added Services: APIs enable digital banks to integrate services like payroll, accounts receivables/ accounts payables management, tax compliance and other S-A-A-S based services in the business flows of their customers directly. These services offer both an engagement avenue and revenue source for the proposed Digital Business Bank. VAS offers a robust revenue model and thus digital bank have the permission to engage in non-financial business complementary to their core financial business, under this license subject to there being no prudential risk in the same.
  4. RBI will have the authority to issue licence under BR Act, vesting banks to undertake NFB services, RBI may require approval from Central Govt.
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