Adapting India’s Regulatory Framework to Digital-only Banks: A Case for Reform

Fintech’s reach has been steadily expanding India, with a proliferation of intermediaries, particularly in the payments and lending spheres. While not wholly devoid of activity, the digital banking space is considerably less busy. In our latest report, summarised below, we analyse this market and argue that India’s regulatory framework may be adapted to allow for the growth of digital-only banks (or ‘challenger banks’).

The Status of Digital-only Banks in India

The Reserve Bank of India (RBI) (India’s central bank and banking regulator) has, over the years, introduced small but significant reforms to facilitate the greater use of technology in banking processes. An example is the case of differentiated banks in the form of Payments Banks and Small Finance Banks. Introduced in 2014, they are intended to foster financial inclusion by providing payment services, deposit products, and credit supply (only by Small Finance Banks) to small businesses and low-income households. Importantly, Payments Banks are required to have technology-driven and fully networked operations to offer low cost banking solutions, and the operational costs of Small Finance Banks are sought to be reduced through high-technology operations.

Regardless of these developments, extant regulation in India continues to place emphasis on the physical delivery of banking services, through branches or agent networks. For instance, banks must open at least 25% of their ‘banking outlets’ in a financial year in ‘unbanked rural centres’. This effectively rules out the possibility of delivering banking services primarily through a digital medium. This is not a new development—the maintenance of physical branches has been a policy consideration from as early as 1969 and continues till date, with the RBI underscoring the importance of physical outreach measures in the form of agent networks and brick and mortar branches to deepen the quality and access to financial services across the country.

Existing banking regulations do not permit digital-only banks, which are ‘licensed deposit-taking institutions that are members of a deposit insurance scheme and deliver banking services primarily through electronic channels instead of physical branches’. Examples elsewhere include Monzo in the UK and the German bank N26. Nevertheless, India has seen iterations of this format, notably through digital-only units of existing licensed banks and bank-fintech partnerships.

Currently, some licensed banks deliver certain financial services exclusively through digital media. While these services are primarily an extension of their mobile and internet banking operations, they are often marketed under a different brand name and seek to tap into a tech-savvy customer base. For instance, the State Bank of India, India’s largest public sector bank, has launched ‘YONO’, a web-based platform marketed as a ‘Mobile Banking and Lifestyle App’. In parallel, banks have also begun to partner with fintechs (commonly referred to as neobanking platforms in India) that target a specific customer segment, such as small businesses and entrepreneurs (‘Partnership Model’). This symbiotic partnership is often structured as an outsourcing arrangement by banks and allows them to access a specialised customer segment without altering their core banking infrastructure, which is built for scale rather than customisation.

The Road Ahead

The introduction of digital-only banks in several jurisdictions, including the UK, Singapore and Hong Kong, is primarily driven by objectives of competition and innovation. Certain jurisdictions such as Malaysia and Taiwan also seek to leverage these models to promote financial inclusion.

Given India’s emphasis on physical infrastructure for banking and the nascent stage of the Indian neobanking market, our report attempts to design a phased policy roadmap for India with two broad objectives. First, in the short-term, regulatory interventions need to be designed to tap into the benefits of the Partnership Model to enhance consumer welfare and address immediate consumer protection shortfalls (identified in the report). Second, India’s move towards the adoption of a licensing framework for digital-only banks should be facilitated to bolster competition and innovation, without undermining financial inclusion initiatives that rely on physical delivery channels.

On these issues, our findings and policy recommendations are threefold.

First, we identify certain consumer protection risks based on an analysis of 17 neobanking platforms in India. Several fintech companies market themselves as banks or as providing banking services, which risks violating the law, under which only licensed banks are permitted to employ these terms. Further, many fintech companies fail to disclose the consumer grievance redressal mechanisms that apply to them. Therefore, in the short term, we recommend that these issues be immediately addressed by the RBI by clarifying the regulatory framework applicable to these partnerships and issuing directions to address these risks.

Second, the report finds that several digital banks and neobanking platforms often target underserved customer segments such as micro, small, and medium businesses. While the Partnership Model may be suitable for a nascent digital banking market, this model will be challenging to balance the objectives of prudential regulation and promotion of innovation. The absence of effective supervision of the fintech partner by the regulator (which regulates only the banking partner under an outsourcing arrangement) may lead to regulatory arbitrage and enforcement issues, ultimately impacting financial stability. For fintechs, such contractual relationships may not be conducive to scale them up, as such partnerships may become pervasive. This often leads fintechs to apply for regulatory licenses to expand their service offerings. Therefore, as a medium-term strategy, the report recommends leveraging the RBI’s regulatory sandbox, which will allow the regulator to closely study the risks from the Partnership Model and assess India’s readiness for digital-only banks.

Third, in the long term, India should consider allowing the participation of more players in its banking sector to increase competition, innovation, and support of small businesses, by issuing licenses to digital-only banks. Given emerging evidence that the Coronavirus crisis is changing consumer preferences and has increased the demand for digital services, enhancing the incentives to adopt competitive user-focused technological solutions in banking processes may address this demand and improve consumer welfare. Digital-only banks may be subjected to prudential requirements and licensing pre-conditions that are in line with existing commercial bank requirements, with modifications where necessary, to address data protection, operational, and technology risks that emanate from the digital nature of these entities.

A move to introduce digital-only banks should not be viewed as an attempt to underestimate the significance of a financial inclusion strategy that focuses on the delivery of financial services through physical points of presence. Digital-only banks will supplement India’s ongoing efforts to create differentiated banks to meet the needs of the vast Indian population with a varied socio-demographic profile.

Shehnaz Ahmed is a Senior Resident Fellow and Lead in Fintech at the Vidhi Centre for Legal Policy, India.

Krittika Chavaly is a Research Fellow in Fintech at the Vidhi Centre for Legal Policy, India.