New bank licences: Why digital banks aren’t a good idea just yet

By Srinath Sridharan

NITI Aayog, in a recent discussion paper titled Digital Banks: A Proposal for Licensing & Regulatory Regime for India, floated the idea of setting up full-stack ‘digital banks’, for which, primarily, the internet would be the consumer channel, instead of physical branches.The hypothesis is that such a licensing framework could help overcome financial inclusion challenges in the country and reduce cost of transactions. It makes valid arguments on access to technology and the  utilisation of the JAM trinity reducing banking-inequality.

The paper also suggests a two-stage approach : granting of a digital business bank license, followed by granting of a digital (universal) bank licence after gaining experience as the former. The size of the assets/liabilities of the Indian banking industry is expected to clock nearly Rs 195 lakh crore by March-end 2022. For achieving higher credit growth, the sector needs not just a larger number of banks, but also newer banks—of course, with healthy balance-sheets, long-term capital availability and the business interest to offer credit.

Over the past few decades, banking-licence categories have grown in number, without necessarily solving the issues faced by the targeted consumer-segment, as was originally intended. Today, the banking sector includes public sector banks, private sector banks (21), small finance banks (12), payments banks (6), regional rural banks (43), foreign banks (44), local area banks (3), financial institutions (4), urban cooperative banks (1,531), multi-state cooperative societies & banks (1,130).This landscape has resulted in a worse headache for the regulator—issues of poor governance, capital constraints, weak management, unaddressed consumer grievances, etc, being some of the problems.

Some of these problems are also because of the slow-paced regulatory reaction or the zen-like approach of ‘don’t-change-unless-its-systemic’.The Reserve Bank of India (RBI) wears multiple hats—it is the country’s central banker, the regulator of lending activities, the upholder of fiscal stability, the inflation controller, and the manager of foreign exchange reserves. As the first-among-equals amongst all the financial-service regulators, RBI has always had a larger role and responsibility as the upholder of fiscal stability.

A role it has played well, and is expected to continue playing more proactively with increased efficiency, is that of the ‘banking sector supervisor’. That is where the digital-bank idea could throw at it quite a few short-term challenges.That fintechs have the ability to raise large sums of equity capital is not in question. Neither is their ability to attract talent, a board of (eager and experienced) directors. Also, that fintechs morphing into a full-fledged digital bank could solve for financial inclusion is not in doubt. However, how and by when the homework needed is to be done, and carefully so, is the question.

Who will solve the following 10 posers?RBI’s experience with private-sector-banks licensing over the past three decades won’t make it rush to give out newer licences. They had to step in to contain damage in the case of private sector banks like Lord Krishna Bank, Centurion Bank, Global Trust Bank, Yes Bank, and LVB. Add to this the many NBFCs and other non-banking as well as banking entities where it had to intervene.While RBI has a “bank under repair” sign-board in its PCA framework, in keeping with its usual silent way of functioning, it has not said anything about the efficacy of the various other banking categories such as payments banks or SFBs.

Some of these banking categories as well as the older licence categories seem to have no visibility of viability and/or have not been able to showcase their significance in terms of the intended objective. Until such time that RBI finds materiality from its own estimation, it won’t decide or announce.A senior RBI official made, at a fintech seminar in September last year, the following critical observation about RBI’s intent being stronger on consumer protection: “… is virtually impossible for legislation to keep in step with the fast-mutating fintech landscape.

Until legislation catches up, regulation has to adapt to ensure that the financial system absorbs digital innovation in a non-disruptive manner… Slowing down the process of change, which attracts the criticism of stifling innovation, is often the best way to ensure customer protection…”RBI, like any other regulator, likes each of the entities it regulates to be stable, profitable and to grow steadily. But fintechs have so far signalled that size and scale are critical for their valuations—an attribute on which the regulator places no emphasis. Unless the business pivots to “consumer insights-led sustainable growth in banking solutions, with utmost consumer protection and profits (in the making)”, the regulator may not even acknowledge licensing possibilities.

Banking promoters need deep pockets, and patient capital at that. Importantly, regulators globally have worries about the ultimate ownership of banks being clear and clean, and preferably resident in their jurisdiction. This could be a challenge for many aspirants of digital-only bank licences!Banking is not just about lending. It also is about creating a liabilities-franchise. The challenge for digital banks will be to show that they can raise a liability pool, instead of just using large equity capital as a debt-funding source. We have seen that younger banks are still struggling to have a robust CASA and have many challenges within the Indian debt market, which is moodier than a teenager (no offence meant to the youngsters)!In terms of consumer protection, everything related to cyber security/digital data security/privacy rights will have to be above board.

Until more robustness can be demonstrated by the industry in this regard, one cannot justify the licence demand based only on the market-development logic. It is only a matter of time before RBI steps in and acts on the usage of the label “neo bank”. Even stable NBFCs, with large capital bases, are not allowed to use the word “bank” in describing themselves in any consumer communication, whereas many a new-age fintech platform has christened itself a “neo bank”, with public communication proclaiming so. Is this fair ?

Supervisory strength is vital for any regulator. RBI might want to build larger and deeper tech-based supervisory capabilities, tools and capacities. For the sake of probity, RBI does not let banking sector stakeholders come close, lest it be accused of being too close! RBI has a ‘brahmastra’ called “fit & proper”; it is almost like the Harry Potter’s Voldemort character, in the minds of bank promoters and KMPs! RBI does not reject a licence application. It’s only radio silence until an applicant hears a ‘yes’! Until a decision on digital banks is taken, it is parkalam (wait and watch)!

Corporate advisor & independent markets commentatorTwitter: @ssmumbai