Fintech challenge is a fantasy

The government is poised to launch 75 digital banks soon, so the headlines proclaimed. If you thought a sleek set of new banks was going to challenge incumbents, you would have been mistaken. What will be launched are Digital Banking Units (DBUs). These are a new way of making available digital products of existing banks and non-banking financial companies (NBFCs).  

What exactly are DBUs? The Reserve Bank of India (RBI) has a definition that runs into four lines. In essence, these are outlets where people can avail of banking products mostly on their own. There will be personnel to assist them but these will be kept to the minimum. In other words, a DBU can be seen as a branch that operates mostly in a digital (or paperless) mode. 

If the idea is to increase penetration or inclusion in under-served areas, scepticism is in order. Even highly literate customers prefer the convenience of walking into a normal branch to meet many of their banking needs. To suppose that in under-served areas, people will be able to help themselves to any but the most basic banking products (say, deposits) is a stretch. 

DBUs may be able to grow deposits quickly but they are unlikely to be able to do much on the asset or fee income side. To be able to push a range of digital products in under-served areas, banks will need adequate and highly trained staff. At best, by eliminating paper, DBUs can reduce processing time and help enhance employee productivity.  

DBUs are one way in which digital products can be offered. In this model, the digital products stay within the bank. Digital products can also be offered through digital banking subsidiaries or by standalone digital banks. In the late 1990s and early 2000s when online banking came into vogue abroad, banks did experiment with digital banking subsidiaries. These did not work and were subsumed into the parent. Standalone banks based on internet banking did not survive either.

Standalone digital banks (also called neo-banks) have made a comeback, thanks to the mobile phone. They are part of the broader category of players labelled fintech. Fintech, which is the provision of financial products through electronic platforms, can happen in three ways. One, through entities that compete with banks (such as digital banks). Two, through entities that collaborate with banks by providing a range of services, such as customer acquisition, KYC checks, loan processing and screening, loan collection, risk management, customer management and so on. Three, through entities that eliminate the need for financial intermediation, for example, peer-to-peer lending platforms.

The most direct threat to banks comes from standalone digital banks. These have not happened in India. But we do have evidence of their record elsewhere. The Global Financial Stability Report (April 2022) provides a useful summary. The threat posed by digital banks, it turns out, is vastly exaggerated. 

Digital banks have grown fast in places such as Brazil, the UK and South Korea. The best among them have market capitalisation comparable to that of the top banks, thanks to rapid loan growth. The high valuations ignore the higher risks that digital banks take and their poor margins and profitability.  

Illustration: Binay Sinha

Digital banks don’t quite take banks head-on. They typically target high risk customers that banks tend to avoid. These include: Individuals with lower incomes or lower credit scores, commercial real estate and unsecured lending. Despite the higher risks they take, digital banks have a lower provision coverage than traditional banks. Their yields on loans are about the same. They have a less loyal depositor base but their liquidity ratios are lower.  

Digital banks’ potential for fee income is lower because they deal with lower income clients. You might think they would have lower operating expenses because of the absence of brick-and-mortar. Not at all. What they save on branches is more than offset by huge marketing expenses. Not surprisingly, most are loss-making.  So much for digital banks threatening traditional banks and taking away market share from them.

Digital banks are connected with banks through the inter-bank market and also through the various services they provide. They are lightly regulated at the moment. But as they grow bigger, regulation will have to be tightened, as the GSFR report observes. Digital banks are a threat, not so much to banks, as to banking stability on account of the systemic risk they pose. 

That goes for the broader world of fintechs too. Fintechs have made an impact in the payment space. But that does not mean that they can mount a serious challenge to the core banking functions, taking deposits and making loans. 

For one thing, the experience of the past two decades suggests that the centrality of the branch to banking remains. Digital banking cannot wholly substitute the branch when it comes to customer acquisition. It is a tool for customer retention, an added service that banks provide by way of holding on to customers. 

Branches remain relevant, first, because of the sense of solidity they give customers, the ability they confer for cross-selling more than the most basic products and as a 24x7 means of advertising a bank’s presence. As mentioned earlier, digital banks have to spend enormous amounts on acquiring customers. Lacking any overall cost advantage, digital banks necessarily have had to seek out riskier, higher-yielding products and customers.

Secondly, banks have not been idle in response to the perceived threat from fintech. They have adopted many of the tools of fintech and sought to reinvent many of their businesses. They have acquired fintechs. They are collaborating with fintechs by outsourcing activities they think fintechs can do better. 

We have seen this happen with other challengers or innovators. NBFCs were at one time seen as a big threat because they were nimbler than their bigger banking rivals. Banks responded by themselves offering the high-yield products that were considered the preserve of NBFCs. They have done so either within their existing business or through NBFC subsidiaries. We have reached a point where an NBFC’s nirvana lies in turning itself into a bank! The same has happened with micro-finance. Banks have found one way or another to venture into micro-finance. Ditto with payment products. 

What players such as NBFCs, micro-finance institutions and payment entities have done is to get banks to think through their business models and get better. Fintech is likely to serve the same purpose. The notion that fintech will displace banks is a fantasy. Banks will imitate fintechs or swallow them, they aren’t going to disappear.

ttrammohan28@gmail.com