Recasting Indian Banking System- Hurdles faced by NEO Banks

[By Aayush Panwar]

The author is a student of Gujarat National Law University, Gandhinagar.

Introduction

Banking and financial instruments are constantly evolving to suit the changing demands of the economy and business. Core banking and digitalization have contributed to the transformation of the banking industry from a traditional money lender to a modern banking system. Fintech and blockchain technology are the two fundamental components of digital banking. NEO Bank is one such evolution.

NEO Bank is similar to any other commercial bank, with the difference of no physical presence, operating solely through digital modes. This is not a payment bank or e-wallet, it includes all the features of a commercial bank, and therefore no external bank account is to be linked to NEO Banks.[i] But these banks are not yet authorized with a banking license and are dependent on a banking service partner to provide other utility services like lending loans or issuing credit cards.[ii]

This article throws light on necessity of NEO Banking, issues associated with its growth and proposing the solution to deal with this as NEO Banking will help in opening up a large horizon of fintech possibilities overcoming all the limitations of payment banks.

Factors Affecting growth of neo banks

There are various factors that are hampering the growth of NEO banks, especially in India. One of the pillars of the banking industry is the confidence of the public in the country’s banking system. For example, in Italy, only 37% of the population trusts the banking system of their country, and in France, a mere 27% of the population.[iii] In India, where a large portion of the population is not covered by the banking system, building trust through an online presence that does not involve cash is a herculean task.

The NEO Banks, in the current legal scenario of the country, do not perform the core banking functions and offer limited products, which keeps away the High-Net-worth Individuals away from them.

Another hurdle faced by them is the safety and security concerns which cannot be denied in the current scenario, where it is expected that the next world war will not be fought by arms and ammunition but will be a data war. Secured digital infrastructure, as well as awareness and assurance of customers, is a worrying fact.

However, NEO Banks can easily overcome these hurdles keeping in mind the growth potential for such evolution in the banking sector.

Legal Analysis

Currently, in India, NEO Banks are just the FinTech companies performing some of the functions that appear to be banking functions, but as such, they cannot be called a bank. RBI does not allow for the grant of virtual banking licenses. RBI, in Master Circular on Mobile Banking Transactions, has mandated the physical presence of digital banking service providers. Since they are not recognized by the RBI and are therefore required to form a strategic partnership with the existing banks to provide services like the issue of debit/credit cards etc. They are also outsourcing their core banking functions to the license holders and provide services on their behalf. In many cases, such banks and fintech companies enter into an outsourcing arrangement where the non-banks verify data for credit requests or undertake the preliminary work for opening current accounts.[iv] This arrangement is governed by RBI Guidelines on Code of Conduct in Outsourcing of Financial Services by banks and RBI Guidelines on Financial Inclusion by Extension of Banking Services. In countries like the USA and Australia, NEO banks are recognized as banks.[v] Even Singapore and UAE have recently rolled out digital licenses to such entities.[vi] 

But on the other hand, it cannot be said that the NEO Banks are working in an unregulated environment or are trying to doge the regulatory framework of various regulators, especially RBI. In one way or the other, they are regulated by the various laws, regulations, or bye-laws of the regulators, e.g., since they are in strategic partnerships with banks and NBFC, certain guidelines like Guidelines for engaging Business Correspondents under Master Circular on Branch Authorisation, Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Services by Banks, Framework on Outsourcing of Payment and Settlement related activities by Payment System Operators and Master Direction on Digital Payment Security Controls. Apart from that, as NEO Banks also offer services like Investment Advisories and Insurance Products, they are also regulated by their respective regulators like SEBI Guidelines on Outsourcing of Activities by Intermediaries and IRDAI (Outsourcing of activities by Indian Insurers) Regulations. These are just some of the regulatory frameworks applicable to them, and there are various other rules applicable to them. All these regulations are applicable only through the contractual relationship between NEO Banks and their partner organisations. They are not regulated independently, which is a matter of concern.

Notwithstanding the above rules, NEO banks are additionally committed to consent to information security regulations since they work with various administrations between the shopper and the financial establishments by giving an internet-based stage. The Indian information protection system is set out in the Information Technology Act 2000 and the Information Technology (Reasonable Security Practices and Procedures and Sensitive Personal Data or Information) Rules, 2011 (SPDI Rules). The laws will be more stringent with the passing of the Data Protection Bill, 2022.

Role in Economy

In India, it is very much evident that technological advancement has led to an increase in digital banking transactions. As per PWC, digital payments have increased many folds. In 2020, the country recorded around 50 billion digital banking transactions, and was expected to rise even more. In the span of one-year, mobile banking users have increased by 13% in value and 92% in volume.[vii] A study suggests that by 2025, around 70% of the transaction will be undertaken digitally, either over internet banking or mobile banking.[viii] This shows the tilt of the population towards the new digital banking solutions, which are more efficient and cost-friendly than the traditional banking system.

As per the reports of Venture Intelligence, in India, NEO Banks raised $116 million in 2019, which is a seven-fold increase when compared with the previous year. As per the Report of KPMG, the global market is expected to reach $333.4 billion by 2026. The market is expecting a Compound Annual Growth Rate of 47.1% over the next five years. On the contrary, as per Global Findex Database, 80% of India’s population is severely underbanked; hence NEO banks can tap such potential clients who have not yet been covered or satisfied by the traditional banking system. The growth of financial-cum-digital literacy in India would provide a boost to the NEO banks in India.[ix]

Targeting MSME’s

The pandemic has hit the banking industry from the core. Its disruptive impact would act as a push to the NEO banks in India. MSME is the strategic sector for India’s industrial development as it accounts for more than 95% of the total industrial units. But it is a sad picture that their various banking needs have not yet been satisfied by the traditional banks.

The banking landscape is now shifting to the satisfaction of the customer, and traditional banks have failed to fulfill that to a great extent. NEO banks are trying to fill the gap, especially with respect to MSME, by providing services like invoice software, cash management, etc. Their decisions are governed after analyzing the data collected through their modernized platforms so that they can understand the behavior of their customers. Hence, they can meet the financial needs of a large portion of the population. This is the reason the NEO Banking market is projected to reach $50.2 million, thanks to the region of Europe and Indo-Pacific that could provide the business opportunity, but there is a need for central banks to provide regulatory support. The increased use of digital and contactless transactions would enhance their growth opportunities.

Way Ahead

After going through the legal framework applicable to the NEO Banks, it cannot be denied that it is high time that NEO banks are recognised by the RBI. But considering the present literacy level and digital literacy, it is not feasible to provide them with a banking license without any physical presence. The foremost pillar is building trust in the banking system. On the contrary, we cannot deny the technological developments in the financial sector around the world. The best possible solution in this situation would be to provide them with a different license, like that of Payment Banks or Small Finance Banks, which will have two-fold benefits. Firstly, the NEO banks will be able to perform more efficiently and will be able to build trust, and secondly, RBI will be able to directly regulate them without giving them a banking license. One thing to be considered is that they should be prohibited from using the word ‘Bank’ as it will confuse the minds of people. This is evident from the Report of the working group on Digital Lending by RBI. Further, the concept of limited licensing or differential licensing was also advocated by NITI Aayog in a paper titled ‘Digital Banks- A proposal for licensing and regulatory regime in India.’ Hence, the legal framework concerning the NEO Banks should be clarified.

[i] NEO Bank- Revolution in Indian Banking Sector- A Critical Analysis, 3 Int’l J. L. Hum.  361-374 (2020).

[ii] Asia Business Law Journal, https://law.asia/challenges-future-india-neo-banks/

[iii] World Finance, https://www.worldfinance.com/banking/the-unstoppable-rise-of-neobanks (last visited January 14, 2023).

[iv] Mondaq, https://www.mondaq.com/india/financial-services/1059342/neo-banks-in-india-the-way-forward (last visited January 14, 2023).

[v] KPMG, https://home.kpmg/in/en/home/insights/2021/08/neo-banks-digital-customer-client-experience-disruption-mantra.html (last visited March 11, 2020).

[vi] Mondaq, https://www.mondaq.com/india/financial-services/1059342/neo-banks-in-india-the-way-forward (last visited March 23, 2022).

[vii] DataQuest, https://www.dqindia.com/neo-banks-future-indian-banking/ (last visited March 19, 2022).

[viii] The Economic Times, https://economictimes.indiatimes.com/industry/banking/neobanks-the-disruptor-that-has-indias-beleaguered-bankers-scrambling/articleshow/87549609.cms?from=mdr (last visited March 10, 2022).

[ix] OECD, https://www.oecd.org/competition/digital-disruption-in-banking-and-its-impact-on-competition-2020.pdf (last visited March 15, 2022).

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