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Regulatory Framework: Gaps & Opportunities to Support Growth of Neobanks

There are over 1.7 billion people across the globe who are outside the ambit of formal banking. While governments take their own sweet time to make financial inclusion a reality, technology has embraced everyone. Neobanking is part of this reality, which is making financial services accessible to everyone.

In recent years, it has been argued by different observers that conventional physical branch banking institutions are not only losing their relevance owing to the convenience of digital systems but also that FinTech neobanking institutions are being seen as a possible alternative and counter to the widespread distrust in conventional banking systems since the global financial crash of 2008.

Neobanks can be entities with a full banking license, digital-only offerings of traditional banks, or over-the-top banks that offer select products or services in partnerships with other banks or FinTech players. These neobanks have spread across the world. Europe has been the bright spot for neobanks for the best part of this decade. In comparison to Europe, the US seems to be lagging in the growth of neobanking. It is important to point out that the US is home to some of the oldest neobanks like Simple (founded in 2009), Moven (founded in 2011), and some relatively new neobanks such as Chime, Varo, and Aspirations. However, neobanking has failed to attract US customers in the last 10 years, and just 3% of millennials have opened a primary checking account in a digital-only bank. European neobanking appears to be the only success story so far. That does not mean other geographies are not promising for neobanking players. The secret lies in a supportive regulatory landscape and growing customer needs in key pro-neobanking countries.

Neobanking and Regulation in Europe

The birth of neobanks, in general, is considered to be the result of the consumer need for lower banking costs and the need to cater to populations with low or no access to banking. In addition, neobanks also offer lower interest rates and greater transparency. Today, one of the primary reasons for the emergence and development of neobanks in Europe is attributed to the relatively easier regulatory mechanisms at work. Regulatory support in the form of Payment Services Directive Law has helped the birth and emergence of neobanks in Europe by affording them similar functions and access to customer’s data as conventional banks.

According to recent research, the customer base in Europe for neobanks has grown by almost 15 million since 2011, while nearly 2 million individuals have closed accounts in conventional and traditional banks (also known as “incumbent” systems) with regards to their status vis-a-vis neobanking systems.

The Payment Services Directive (PSD) was aimed towards the regulation of payment services in the Europe Union area. The directive was originally claimed to be instituted to increase competition in the pan-European setting and also to better articulate the rights and obligations of payment users & providers in the EU. Nevertheless, the PSD was realized to be inadequate on some counts, such as not enabling the enforcement of this directive to payments and transactions outside the economic territories of the European Union area and also exhibited different loopholes that could not guarantee user safety. In response, the PSD2 that was passed in 2016 and enforced from 2018 onwards claims to make online banking easier and safer, with new provisions for payments and transactions made outside or received from outside the EU economic area. 

One of the significant ramifications of the PSD2 was towards reducing or eliminating the monopoly of banks over customer data and granting permission to third-party service providers for the use of this data. By giving access to customer data to third-party service providers as well as increasing authentication and security measures for online payments & transactions, the PSD2 has been seen and realized to be a revolutionary move towards a standardized uniform digital market that is more customer-centric than any other policy before. Overall, the implications of the PSD2 are argued to be significant for the establishment of Open Banking in Europe and elsewhere by allowing users to conduct a variety of financial transactions and processes through easier access and greater assurance of security. This sense of security and control over their data has played a role in increasing acceptance of neobanks’ service offerings in Europe.

Neobanking Regulations in Asia & the Middle East

In addition to Europe and Latin America, Asia is seen as one of the major regions of the world exhibiting a prospective environment for neobanks and the development of the open banking paradigm. China, for instance, is expected to become one of the biggest markets for neobanks by 2025. This is attributed to a large population that is underserved by banking facilities. Moreover, major e-commerce players such as Alibaba and WeBank have collaborated to create institutions such as the MyBank that have lent out nearly $300 billion in the last four years to more than 16 million companies. With a default rate of around 1%, neobanking seems to have significant prospects in China and seems to be reflective to some extent of the overall trend in Asia.

In 2019, both Taiwan and Hong Kong have become some of the first regions in Asia to issue licenses to neobanks operating solely as digital banks. Currently, in Asia, the two main factors that are attributed to the increase in popularity and usage of digital banking and payment services are the low costs associated with the medium for both providers and consumers, and the large proportion of young users between the ages of 18 and 25 that are familiar with and willing to use online banks for deposits well as transactions.

Other regions in Asia, such as Singapore, are also speculating and experimenting with ‘digital-only’ neobanks like OneConnect that seem to be showing enough potential to upset already existing conventional banks in the region. The Singapore government also launched a regulatory sandbox for FinTech institutions in recent years – an initiative that is aimed at developing faster, leaner, and meaner financial services in the region. In the Middle-East, the Dubai International Financial Center (DIFC) has already taken decisive steps towards financial innovation by creating sandbox frameworks for testing new financial and banking startups in the region. Amidst the general mood towards creating avenues for open banking to serve the present transnational nature of the global economy, it might not be too soon to speculate the RBI’s move towards integrating India in the larger open banking economy quickly emerging in Asia and elsewhere.

Neobanks & Regulatory Frameworks in India

In India’s case, neobanking has begun to emerge as a specialized tool not only for areas that are underserved by financial and banking services but for small and medium businesses as well. However, owing to regulatory policies by the RBI that do not recognize or rather deny the legitimacy of online-only banking institutions, neobanks in India are not strictly 100% digital. In India, neobanking institutions such as 811 and YONO have branched out from existing banks such as Kotak and SBI. Nevertheless, while neobanks as strictly digital financial service providers are not recognized, there are signs of increased funding for neobanks which is also reflected in the emergence of various neobanking institutions such as NiYo, Open, Yelo, and Ezoto, which all offer specialized services ranging from salary account management, to microcredit solutions, and banking services for travelers.

With more than 2,00,000 customers onboard within just a few months of being established, Bangalore-based neobank ‘Open’ is fast emerging as a successful model of future FinTech and neobanking services in India. By offering a variety of services to MSMEs ranging from managing multiple bank accounts to automated bookkeeping services, and payment services, Open functions both as a payment portal & finance management platform, processing transactions worth $6.5 billion each year.

One of the great challenges with respect to neobanking services across the world and especially in India’s case could be argued to be the high trust deficit when it comes to the deposits and transaction of money through digital mediums. For instance, in the case of the UK, which is frequently argued to be one of the pioneers of neobanking services, only 11% of banking customers have claimed that they are likely to be using neobanking services in the coming years. 

Taking a tough stance, in 2018, the Reserve Bank of India banned all forms of cryptocurrency, arguing that these kinds of financial systems and the transactions entailed therein were harmful and a major security risk. In what has been argued by the Internet & Mobile Association of India (IAMAI) to be an unconstitutional move by the RBI, various developments in online currency, blockchain, and associated banking services seem to have come to a standstill in India. The end result of such a move is the shaken confidence of new business models where regulatory guidelines are still blurry. On the other hand, in August 2019, the RBI also instituted a new regulatory sandbox (similar to the DIFC model) for the testing of new financial technologies in a controlled environment, which is seen as an encouraging move for the development of new digital financial innovations. With new FinTech companies that are being seen as the primary stakeholders in these ‘experiments,’ the new regulatory sandbox is being viewed as a welcome move towards new innovations in digital finance and banking.

The Future of Regulation in India

While the regulatory concerns of the RBI with regards to cryptocurrency and neobanking services cannot be discounted, it is important to consider the reasons for the differences in regulatory attitude. For instance, one of the main arguments by financial experts in both Hong Kong and Taiwan for the granting of licenses to neobanking services is in consideration of specialized sectors such as SMEs that are seeking out financial portals for expedited credit approval systems that are more efficient and specialized. Hence, in India’s case and the RBI’s role in enabling open banking, the specialized needs of MSMEs will likely play a huge role in the creation of new reforms in regulatory frameworks. While the new move towards creating regulatory sandboxes is a big step towards enabling the growth of new digital financial systems, the RBI will need to relax its regulations over new possibilities in FinTech.

A rigid stance is not going to be a by-default move of the RBI, especially when the fellow regulatory authorities such as MAS, FCA, HKMA, and Israeli regulators are all progressive towards neobanking. We expect RBI to follow the trend and chalk-out virtual banking license roll-out in India in the near future.

While neobanks in Asia are making their presence felt in a strong way, most regions do not possess adequate regulatory frameworks for neobanks or what are now known as ‘challenger banks.’ Hence, most neobanks in India and elsewhere in Asia are associated with existing incumbent banks. This reveals a fairly slow acceptance of neobanking institutions; the emergence of neobanks as associations with existing banks may prove to be one of their strengths in the coming years when regulatory frameworks are better equipped to address efficiency and security.

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