In November, the NITI Aayog released a discussion paper on ““Digital Banks – A Proposal for Licensing and Regulatory Regime for India” (Discussion Paper). It describes the need for, and components of, a proposed regulatory regime for a new concept of “digital banks” (DB). In this post, we provide an overview of the Discussion Paper and raise a few concerns on which more thinking is required.
What is a digital bank?
A DB will be able to offer the full set of services that any bank can offer as per the Banking Regulation Act of 1949, including issuing deposits and making loans. The key difference from a traditional bank, however, is that a DB “will principally rely on the internet and other proximate channels to offer their services and not physical branches.”
Why has the NITI Aayog proposed this idea?
The Discussion Paper offers this solution as a response to two problems: the overarching issue of financial inclusion and the insufficiency of the existing licensing regime to address that issue.
- The financial inclusion challenge. The Internet is seen as a powerful tool to leverage in addressing the challenge of financial inclusion. As the Discussion Paper notes, so far, the attention has been on leveraging the Internet in implementing reforms for payments (such as the account aggregator framework) or for improving the customer experience in banking. While these are necessary, the Internet is yet to be leveraged in the core utility banking layer to address gaps at that layer (for e.g., the gap of inadequate access to formal credit currently faced by medium, small, and micro-enterprises).
- The insufficiency of the existing licensing regime. Currently, entities can only leverage the Internet in banking by picking one of three routes: by offering internet banking; by setting up a neo-bank or by setting up a payments bank. The Discussion Paper makes it clear that these are all insufficient for various reasons:
- Internet banking is a non-starter, since the current guidelines require an entity interested in internet banking to have a physical presence in India (see here). This defeats the point.
- Neo-banks are not covered by any formal licensing or regulatory regime. They must partner with existing licensed banks or non-banking financial service companies and can only offer over-the-top consumer-facing and small business-facing offerings like digital debit card, personal finance management tools, amongst others. This is not an effectively model, since neo-banks (i) have limited revenue potential (ii) are constrained to operate within the product buckets of their partners (iii) cannot get a license and, therefore, cannot issue low-cost deposits.
- Payments banks are constrained by the limitations of their license. These are effectively extensions of payment service providers. While they can hold deposits, they cannot issue credit, limiting the extent of their operations. Though the RBI does permit them to upgrade to a small finance business license, this does not seem to serve as a sufficient incentive for entities to participate.
The Discussion Paper presents the “digital bank” concept as the solution to the above.
To set out design principles, the Discussion Paper lays down a “digital bank global regulatory index” which assess global regulatory responses to digital banking. It relies on United Kingdom, Malaysia, South Korea, Singapore, Hong Kong, and Australia. It looks at four parameters:
- What are the entry barriers? (proportionality in minimum capital mandates, track record eligibility, etc.)
- How pro-competitive is a regime? (e.g., do they have equal access to deposit insurance systems, payment systems schemes, revenue sources, etc. at par with incumbents)
- How much autonomy is given to a digital bank in day-to-day operations? (e.g., are there minimum presence mandates not justified by prudence; asset/deposit caps; and physical presence mandate, etc.)
- How technology-neutral is the regime? (e.g. are there restrictions on /preferences for using a particular technology)
Based on the above, the Discussion Paper derives three themes found in all jurisdictions to focus on for India: technology neutrality, calibrating regulations, and entry requirements, and exit plans or living wills. Building on this, it then recommends a two-phased regulatory and licensing model:
- A restricted digital business bank license: First, the RBI should introduce a restricted license. Applicants for this license would mandatorily be part of a regulatory sandbox. Subject to their performance, they may or may not be granted a full-stack license. Their performance could be measured on the basis of various metrics that the RBI may identify (e.g. customer acquisition cost, technological preparedness, volume of credit disbursed to MSMEs etc.,). If not granted such a full-stack license, then an exit plan should be in place for them to use. Some of the conditions applicants would have to adhere to include:
- A minimum paid-up capital for INR 20 crores.
- A need for controlling persons to have a track record in adjacent industries, like e-commerce, payments, technology, etc.
- Technology risk regulation, such as ex-ante technological preparedness including compliance with industry grade certifications, board-level policies, upskilling technology risk supervision amongst others.
- A full-stack digital universal bank license: Applicants deemed eligible for a full-stack license would be upgraded and have their restrictions relaxed. For instance, their minimum paid-up capital may be expanded to INR 200 crores. Some restrictions may also be relaxed in a phased manner. For e.g., increasing the number of serviceable customers, etc.
To ensure competitiveness, and viability of Digital Business bank, the Discussion Paper suggests that there be equal access to key infrastructure enablers – Aadhaar e-KYC, UPI, ATM Schemes, AA ecosystem etc.
Some immediate concerns
- Why do we need a separate licensing regime just to shift away from the requirement for physical branches? There is a need to discuss current challenges with the extant framework for physical branches and how digital banks would address them.
- How would competition concerns vis-à-vis traditional banks be addressed? Traditional banks need to upkeep physical branches, meet a higher minimum paid-up capital limit, and still offer digital infrastructure/applications. Future full stack digital banks will not need to worry about the first two limitations. This creates grounds for traditional banks to raise competition concerns; a non-trivial problem considering some of them are already fiscally struggling.
If you have any recommendations or suggestions on the Discussion Paper, kindly write to firstname.lastname@example.org by November 14th, 2021.