Technology and digital innovation have improved productivity, efficiency, and competitiveness in the delivery of financial products and services. Digital Banks or Neo Banks as they are popularly called in regulatory parlance ("Digital Banks") have transformed banking services in India, by offering instant account opening facilities and other value-added services through digital platforms. Digital Banks have used technology to plug gaps and shortcomings depicted by the incumbent banking system and offer a bouquet of innovative and customized products.
Existing Regulatory Framework
Digital Banks operate by entering into a commercial arrangement with traditional banks ("Banks") as an outsourcing agent or business correspondent, for providing licensed/regular banking services to their customers. The outsourcing guidelines recognize applications processing (loan origination, credit card), document processing, marketing, and research as outsourcing activities. Similarly, the business correspondent guidelines also detail an inclusive list of activities, that can be undertaken by business correspondents at places other than the bank premises/ATMs. The existing operating model of Neo Banks is constrained in a number of ways, as they are not authorized to create 'ground up' credit products and user experiences and are forced to offer products as per partner Banks product bucket. Neo Banks also have limited revenue generation potential as its sources are limited to fee-based revenue from customer on-boarding/account opening, and potentially earn a fraction of interchange on payments processed through co-branded cards.
Proposed Regulatory Framework
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 proposed Licensing Framework creates an enabling environment for Digital Banks to overcome the limitations by allowing them to offer a full suite of banking services including issuing deposits and making loans. This would enable Digital Banks to offer innovative and efficient products and services with unique user experiences. The framework also would enhance regulatory oversight over Digital Banks, prevent uncontrolled replication of business models and protect the interest of the consumers.
Challenges with the proposed Licensing Framework and suggestions for addressing them
No doubt, the proposed licensing framework has addressed challenges and key risks associated with the prevailing partnership-based neo-bank model. However, this framework also entails some operational hurdles and challenges for the Digital Banks.
Currently, the framework mandates Digital Banks are mandated to comply with RBI prudential guidelines on capital adequacy and liquidity standards (including capital adequacy, risk weights, liquidity coverage ratio), at par with commercial banks. The applicability of prudential guidelines and liquidity standards would be an overburden the Digital Banks and adversely impact the profitability. A light touch or risk-based or an activity-based approach pertaining to prudential guidelines and liquidity standards would support the Digital Banks operations and governance. Any such light-touch regulatory approach needs to of course be balanced with the objective of ensuring that there remains a level-playing field between the Digital Banks and traditional banks. Hence, the same must be backed by justifiable reasons such as differential financial and systemic risks.
Entry restriction on Digital Bank applicants
The Licensing Framework requires the promoters of the Digital Bank, to have an established track record in adjacent industries such as e-commerce and payment technology, before applying for the license. The proposed precondition for a "promoter to have an established track record in adjacent industries such as e-commerce and payment technology" would be an entry barrier and adversely impact the innovation and competitive landscape of the Digital Bank segment in the future. Instead, a generic approach such as that prescribed in RBI Guidelines for 'on tap' Licensing of Universal Banks in the Private Sector for the promoter's "fit and proper" criteria, should be taken by RBI. The Universal Bank Guidelines require individuals/promoting entity/promoter group (i) to have a minimum of 10 (ten) years of experience in running its / their businesses; (ii) must have a record of sound credentials and integrity; and (iii) should be financially sound and have a successful track record for at least 10 (ten) years.
The Regulatory Sandbox enabling framework would be inadequate for testing Digital Bank models
The Licensing Framework recommends a two-stage approach a Digital business Bank/ or restricted license, to begin with, followed by a Digital (Universal) Bank license after policymakers and regulators have gained experience from the former. The Digital Banks in the first stage will be required to test their product in the regulatory sandbox of RBI. Such framework offers regulatory relaxations, for live testing of new products or services in a controlled/test regulatory environment. The sandbox testing method would assist the RBI and the licensee, in progressively monitoring the technological preparedness and compliance levels of the licensee across prudential aspects. However, the regulatory sandbox enabling framework is not adequate for assessing and evaluating a full-stack Digital Bank. The current sandbox framework is designed for testing new products and services, i.e. to be completed within a period of six months, based on the theme of the cohort. Whereas entities with restricted Digital Bank license would commence operation as a Digital Business bank within the sandbox and would have to test all the products and services permitted under Section 6 of the Banking Regulation Act, 1949. The testing period of six months would be inadequate for evaluating the wide range of products and services offered by Digital Bank. Therefore evaluating a full-stack Digital Bank, would require a more comprehensive or dedicated regulatory sandbox with detailed evaluation criteria, more oversight, and additional testing timelines, that can vary from case to case basis.
Lack of physical presence of Digital Banks can adversely impact the customer grievance redressal mechanism
Further, Digital Banks will be principally relying on the internet and other proximate channels for the delivery of services. This makes banking more convenient and efficient for both banks and their customers. However, not all people have equal access to the internet or the smartphones or skills to use and access such services. The digital divide between the banked and unbanked can be narrowed through a hybrid model with a limited physical presence, exclusively for the purpose of onboarding customers to the digital platform, and for handling customer complaints and grievances in compliance with the RBI's Banking Ombudsman Scheme, 2006. Similar approaches have been recognized by other jurisdictions like Hong Kong, which requires virtual banks to maintain a physical presence (through one or more offices), exclusively to deal with customer inquiries or complaints. The requirement for physical branches is influenced by other demographic factors like internet and smartphone penetration and financial literacy. The physical branches must be limited to one branch per region and zone and would not be offering any banking services. This would also help in building trust among new customers, aid in creating awareness and educating customers about its innovative products and services, help in driving feature phone customers to online mode.
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. It creates a regulatory structure for monitoring the Neo Banks, also enabling them to create more innovative and efficient products and services. However, certain practical and regulatory issues as discussed above, and other relevant issues of the stakeholders would need to be addressed, for which the RBI would have to propose detailed and comprehensive licensing and operational guidelines.
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