Akil Hirani
Majmudar & Partners, Mumbai
akil@majmudarindia.com

Swati Agrawal
Majmudar & Partners, Mumbai
​​​​​​​swati@majmudarindia.co

Introduction

Neobanks (commonly known as online banks, internet-only banks, virtual banks or digital banks) are fintech entities that exclusively operate online without traditional physical branch networks. They offer services like online cards, corporate credit cards, digital savings accounts, cash management and other ancillary services.

Neobanks have gained significant traction in India since the onset of the Covid-19 pandemic. There are many players, including Novo, Yelo, SaveIn and Jupiter, who have all raised significant funding this year. Large Indian private banks like ICICI Bank are also partnering with neobanks to offer services to their clients. Additionally, some traditional banks have set up their own digital-only banks. For example, DBS has launched its platform, called digibank, which offers all kinds of banking services online.

The reason for the success and growing popularity of neobanks is simple – customer convenience. Neobanks are making cumbersome banking processes like opening a bank account, funds transfers, expense tracking and invoice management easier for the end user. For example, Novo has integrated its technology into various platforms like Slack, Shopify and others, and provides easy funds transfers, virtual cards and other banking services.

The business model of a neobank in India

A neobank’s business model differs from that of a traditional bank. Some of the key features of neobanks are as follows.

• A neobank does not charge its customers high fees for services. Instead, its revenue mostly comes from the interchange fee paid by integrators when a transaction is undertaken through its application. Typically, a neobank has lower operational costs than a traditional bank, and it can offer many services to customers for free or for a lower fee structure.
• A key facet of a neobank’s business model in India is collaboration or partnership with traditional banks, financial institutions and card networks to provide its services. The partnership model offers various benefits. It helps a neobank offer different services and it helps the partner bank leverage the neobank’s technology to increase its customer base.
• A neobank’s digital-only model allows it to be highly flexible and provide personalised services to customers. For example, Uno Bank uses an artificial intelligence platform, Cognito, to collect customer data and provide customised services to clients. This gives a neobank added advantages over a traditional bank, which may not have embraced technology and AI fully.

Regulatory framework

The Indian regulatory regime for neobanks is in a nascent stage. Neobanks are not as yet allowed to obtain a banking licence, unlike in other Asian countries, and are not directly regulated by the Reserve Bank of India (RBI). The collaboration model discussed above categorises neobanks as third-party technology service providers. These service providers are indirectly governed by the outsourcing guidelines^[1] applicable to regulated entities like banks, payment system operators and non-banking financial companies (the Guidelines).

The Guidelines mandate partner banks to have an outsourcing policy and contract in place to monitor the activities of technology service providers, as well as to evaluate their risk mitigation mechanisms. A robust IT infrastructure and business recovery plan is a must for service providers. Neobanks are also obliged to comply with the data protection and security regime for financial and payment data in India.

Challenges and opportunities: is India ready for digital only banks?

Neobanks have expanded their scope of services; entering the lending, MSME^[2] and healthcare financing space, among others. However, they have their own set of challenges, as follows.

• Regulatory uncertainty: India does not have a comprehensive framework governing neobanks. While this currently gives leverage to neobanks, any fetters imposed by the RBI on neobanks can halt or restrict their growth trajectory.
• The Guidelines discussed above limit the operation of neobanks and do not allow regulated entities to outsource all core banking operations to a neobank. The Guidelines also make it difficult for banks to partner with neobanks, as the compliance burden is ultimately on the banks and not the service provider (ie, the neobank).
• Data localisation: The RBI has been focusing on protecting customer financial data and has mandated data localisation norms for all payment companies. Many neobanks do not have a physical presence in India, storing customer data on offshore servers. As neobanks are indirectly regulated through their partner banks, they are also obligated to comply with data localisation requirements.
• Customer protection: Neobanks offer products that are customer-centric, mostly catering to the retail segment. It is important for neobanks to have a proper grievance redressal mechanism in place prior to offering any esoteric financial product or service in India.

Despite the challenges, neobanks have tremendous growth prospects in the Indian market. The ‘online only’ approach of neobanks bridges the gap between rural and urban India, and helps in promoting financial inclusion. Digital banks are also playing a significant role in developing India’s fast-growing start-up sector. For example, neobanks like Mahila Money, Niyo and Tide focus only on specific segments of the population and provide lending support to that segment. This segmented approach can go a long way in changing the banking system.

Global developments

Neobanks abound in many countries around the world. In the US and the UK, this industry is growing exponentially, with an estimated growth value of $47.1bn in 2021 and $722bn in this decade. In the US, these digital banks are more commonly referred to as ‘challenger banks’.

Two approaches have been adopted by neobanks globally. One, a phased approach where neobanks first operate on a limited scale and gradually convert into fully-fledged banks (as has been the case in Singapore and Australia). Two, they directly apply for a banking licence and comply with all regulatory requirements applicable to traditional banks from the get-go. This approach has been followed in the US and the UK.

In other jurisdictions, the regulators have implemented a separate framework and licence regime for digital-only banks. Hong Kong, Malaysia and South Korea are some of the jurisdictions which follow this approach.

The way ahead

This industry has immense potential. The RBI has so far given neobanks a relaxed environment (regulatory sandbox) to develop and launch new products. The need of the hour is to create a level playing field for these entities and provide them enough space for technological and product innovation.

The growth of the neobank space in India depends on customer acceptance and risk management of the digital platforms. The retail customer base in India is diverse. Many people are still apprehensive of the digital-only model, finding traditional banks a safer option. Customer trust and regulatory support will help neobanks align with traditional banks.

It is imperative to strike a balance between regulation, product offering, and consumer benefits and safety. Universal licensing of neobanks may not be the right approach; all stakeholders will have to caucus and come up with a nuanced approach so as not to kill this industry.