FinTech’s, Banks, Regulations - still in spaghetti mode

Lots of announcements and other events in the month of May that are of interest and perhaps requires us to pause and reflect on what the tea leaves are telling us!

Mid May, speaking at a press conference, the new CII (Confederation of Indian Industry) president said that India needs more banks (India currently has 78 banks across public sector, private sector, and foreign banks – not considering the 1500+ urban cooperative banks and over 97000+ regional rural banks).

Soon thereafter, the RBI (Reserve Bank of India) rejected the applications from 6 entities for new universal banks and small finance bank (SFB) licenses. It is reviewing another 5 applications.

Towards the end of May 2022, the RBI cancelled the licenses of 5 non-banking finance companies (NBFCs). This was primarily because the regulator was of the view that the digital lending operations of these entities were in violation of RBIs guidelines on outsourcing and the fair practices code. They apparently worked through third party apps to issue loans at very high rates of interest and the recovery tactics used on borrowers translated to harassment allegations.

?Meanwhile in the startup space - funding seems to be evaporating. The largest VCs (like Softbank and Tiger Global) are taking on huge losses and therefore are reviewing their portfolios to trim their holdings and cut losses. This translates into bad news particularly for fintechs. We are already seeing news in the Indian media (apart from viral whatsapp updates) on the number of people being laid off by prominent fintech, ecommerce and edutech players in India. Hardest hit are the fintechs in the lending business. Having just about clawed back from harrowing losses during the pandemic closures, they now face the additional blow of funding drying up. Add to that the pressure from the RBI which has starting hiking rates and has also amended rules governing partnerships between regulated entities and fintechs in the lending space.

Banks are also concerned that fintechs which perform pseudo-aggregator functions may not necessarily be adhering to AML (Anti Money Laundering) guidelines of the central bank. This potentially means that the banks which handle the underlying movement of funds must bear the brunt of any KYC/ AML lapses linked to the customer and/ or the transaction. Another concern raised by the banks is the possibility that some of the loans offered by fintechs may not be reported to the credit bureaus and this can result in increased risk to lenders who use the bureau data to make credit decisions.

On the 27th 0f May, RBI published its annual report 2021-22. The 321 page document provides a lot of insight into the focus areas of the regulator and a taste of what’s to come. RBI reiterated its focus on leveraging technology to facilitate digital penetration, innovative payment options and consumer orientation to a “less cash” dependent society. Let's dive in.

Digitization and Innovation

To firmly set a path towards achieving technology driven innovation, RBI set up a Fintech department in January 2022. The RBI innovation hub (RBIH) setup in the past year was tasked to build an ecosystem for development of prototypes, patents and PoCs. In payments- the focus will be on enhancing awareness of digital payments, extending outreach of payments systems across India and beyond, linking of India's payment systems to similar systems in other jurisdictions (e.g. UPI with PayNow in Singapore).

CBDC Introduction

(RBI has consistently maintained a negative view on crypto currency for several years now (starting with a caution note in 2013). In 2018, it asked the banks not to facilitate transactions in crypto currency (a supreme court order subsequently put a stay on this). There is no outright ban yet (in fact the central government has introduced taxes on digital assets!), but the thinking of the central bank is quite clear on this front.)

RBI’s annual report spoke about the Introduction of a Central Bank Digital Currency (CBDC) – RBI is already planning on a proof of concept, pilots and launch in the coming year.

Framework for Digital Banking and Fintechs

RBI aims to finalize this year, its vision, mission and strategy and policy framework for digital banking and fintechs. This will of course be eagerly awaited by the industry (banks, fintechs and other stakeholders).

Meanwhile, the regulatory Sandbox is planning the 3rd and 4th cohorts which will focus on MSME lending and prevention and mitigation of financial frauds

Regulatory Reporting

The report also alluded to the data capabilities of RBI being upgraded and a revamped Data Warehouse that all banks would be feeding into (Centralized Information Management System – CIMS) – the ambitious regulatory reporting project that the RBI launched some years ago.

Digital Lending

(As of December 2020, there were over 1200 digital lending startups in the country (possibly the highest in the world). These have been innovating in the lending space with models likes “sachet” credit and BNPL (Buy Now Pay Later). They have taken over the space where traditional lenders like banks and NBFCs have been cautious to offer credit. An RBI panel studying the sector determined that about half of the digital loan providers are operating illegally.

While BNPL has found enthusiastic takers from both lenders and borrowers, clearly there are gray spaces that the regulator is concerned about. A popular fintech, Slice was issuing over 200,000 cards per month (almost on par with the biggest card issuers in the country, HDFC Bank and ICICI Bank). Slice has recently taken a conservative turn and started filtering customers who are eligible for the flagship offering (paying in 3 months). Part of the push for change also comes, presumably from the pressure to demonstrate a more profitable business model.)

RBI’s annual report spoke about the recommendations from the working group on digital lending which included:

1.??????Restrict balance sheet lending by digital lending apps (DLA) to regulated entities (RE).

2.??????Separate legislation to prevent illegal lending activities

3.??????Treat BNPL as part of balance sheet lending. Prohibit non-RE from offering FLDG (first loss default guarantee)

4.??????SRO (Self-Regulatory Organization) for the digital lending ecosystem

5.??????Set up of Digital India Trust Agency (DIGTA) to verify DLA and maintain a register of all verified apps

6.??????Loan servicing and repayment via bank accounts and fully KYC compliant PPIs (pre-paid instruments)

7.??????Prescription of baseline tech standards for DLAs

Payments and IT

-?????????Release of Payments System Vision 2025 document expected. This will be quite interesting given that RBI pretty much did everything it set out to do in the Payments System Vision 2021 which was published in 2019. So, this is a space to watch out

-?????????Adoption of ISO20022 for NEFT – can potentially have interoperability between NEFT and RTGS (the two domestic centralized payment systems in the country)

Other Comments

-?????????Greater use of technology accentuates concerns relating to cyber security

-?????????Involvement of big tech increases systemic risk

-?????????Balance innovation with regulation without compromising on principles of risk management

The picture is still muddy. The regulator has taken a keen interest in promoting greater use of technology in the banking services space while carefully ensuring customer centricity is not lost sight of. At the same time the RBI has come down heavily on actors who are trying to exploit customers and not following the regulatory framework under the garb of being fintech players. The banks are slowly rising to the challenge (having lost the fast payments battle a couple of years ago). The partnership model between banks and fintechs will be redefined, particularly with the RBI now laying down rules of play. It will be some time before the dust settles and we have a new order in place. Until then, there is still a lot of spaghetti which is tangled!

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-Shrinath

Shrinath Bolloju is the Chief Strategy Officer of KGISL (KG Information Systems Private Limited, www.kgisl.com ), a BFSI centric multiproduct enterprise software company. KGISL has been partnering with some of the largest global organizations in their transformation journeys for over 25 years.?

Shrinath has spent over 30 years in the banking and securities services industry and has worked in technology, operations and run a business, in various geographies across Asia, Europe and the Americas.?