[By Sukarm Sharma]
The author is a student at the National Law School of India University, Bengaluru.
Introduction
Buy-Now-Pay-later (“BNPL”), as the name indicates, is a point-of-sale credit mechanism, where consumers can purchase a product immediately, and pay it off in various installments. This is enabled by a third-party fintech firm. The fintech firm pays for the product to the merchant (like Amazon, Zomato, etc.) through a pre-paid instrument (“PPI”) and gets repaid by the consumer in installments. Although generally no interest is levied on the credit, the profit for the fintech BNPL firm is primarily through consumer default fees and merchant fees. BNPL is one of the fastest growing fintech industries in India, overtaking UPI with a growth of 637% in 2021, reaching a market size of 6.3 Billion USD.
Through a notification on 20 July 2022,[i] the Reserve Bank of India (“RBI”) clarified that non-bank entities would not be allowed to ‘load credit lines’ as per the Master Directions on Pre-Paid Instruments (“MD-PPI”). This caused major BNPL fintech credit providers like Lazypay, EarlySalaryetc. to halt their service since post-notification it was clear that the MD-PPI did not permit them to issue credit through PPIs. Consequently, the MD-PPI was criticized to be disproportionate, since it disallowed BNPL firms from issuing credit, even when tied to banks/Non-Banking Financial Companys (“NBFC”). Questions were also raised as to whether this regulation was a “flex move” by the banks in to reduce competition in the lucrative credit card market. Moreover, this degree of regulation was considered to be disproportionate to the risks posed by BNPL since they engage in micro-lending and enhance financial inclusion. The MD-PPI is therefore under question on the grounds that it restricts financial innovation and places a disproportionate burden on fintech payment platforms by preventing them from loading their PPIs.
Although this has not been hitherto applied to Indian fintech regulation, the traditional model to assess proportionality in fintech regulation as per current literature involves gauging whether the necessity for regulation is commensurate to the stringency of regulation[ii] with regards to the three core objectives of regulation: (I) fair competition, (II) market integrity and (III) financial stability.[iii]
This article argues that the MD-PPI provision which prevents BNPL fintech firms from issuing PPIs is proportionate in meeting the aforementioned core objectives. The original contribution of this article is that it introduces the concept of regulatory-proportionality in Indian fintech regulation using the example of BNPL and the MD-PPI by engaging Amstad, Restoy, and Lehmann on fintech regulatory theory. To this end, three arguments are made. First, the MD-PPI promotes fair competition by highlighting that since they engage in veiled balance-sheet lending without the license to lend rather than as payment systems, the MD-PPI is not unfair in restricting BNPLs from issuing credit. Second, relying on regulatory theory to argue that the information asymmetry and other market integrity concerns extant in the BNPL credit market justify the relatively stricter regulation as per the MD-PPI. Third, that fintech balance-sheet lending in BNPL poses a sufficient threat to financial stability, meriting regulatory intervention proportionate to the MD-PPI.
Regulatory Fairness, Protecting Competition, and the ‘Duck’ Principle
Simply put, the ‘Duck’ principle dictates fintech institutions performing the same functions must be regulated in the same way. The Duck principle rests on regulatory fairness, i.e., in so far as institutions entail similar risks and activities, they shall be regulated with proportional stringency, as to not unfairly advantage one fintech domain over the other.[iv] It is based on the principle of activity-based regulation vis-à-vis entity-based regulation. This means the legal nature of the entity (for example, whether it is a payment gateway or a bank) is less important than the actual activity it engages in.[v]
This is pertinent in the context of BNPL service providers. The MD-PPI targets only those who engage in credit lending under the fig leaf of acting as payment gateways. This is because the exposure for the loans is on the BNPL provider and not the banks/NBFC they are partnered with. For example, the fintech firms Slice and Uni are partnered with the State Bank of Mauritius and the RBL bank respectively for a ‘first loss default guarantee’ scheme. Here, the third-party bank acts to mitigate risks in cases of default but does not itself lend.
This association proves useful to the fintech BNPL firms since banks/NBFCs are authorized under the PPI-MD to pre-fund the PPIs. However, as noted by the RBI’s Working Group on Digital Lending, (para. 5.3.1.5) the risk of issuing credit is not borne by the banks/NBFCs since they don’t issue credit in PPIs. The lending and concomitant exposure are instead from the balance sheets of the unregulated fintech firms rather than by the licensed and regulated partner banks.
Consequently, even though the fintech firms are payment gateway entities on paper, their activity is that of lending (even if masked through ‘rented’ NBFCs/Banks). The risks of fintech balance-sheet (FBS) lending without regulation and licensing have been acknowledged as a risk to financial stability and market integrity.[vi] Since the fintech BNPL firms do not possess the license and the concomitant regulation of credit issuing, their debarment from loading credit lines is proportional to the risk entailed, and in line with the objectives of Duck-type regulation.
Market Integrity, Information Asymmetry, and Consumer Safety: Justifying Tighter Regulatory Scrutiny on BNPLs
Another essential element of proportionate regulation is that the stringency of regulation should be correlated to the threats to the market integrity of the domain being regulated.[vii] A greater risk to consumers would permit proportionately closer scrutiny by the regulators. This is rooted in an understanding of regulation theory, that regulation functions for the public interest, which requires the elimination of information asymmetries since they lead to market inefficiencies and consumer detriment.[viii] The potential counter-argument to the MD-PPI being proportionate is that BNPL is a convenient, user-friendly, and quick way to access credit typically at 0% interest rates. In that light, questions arise as to why BNPL firms should comply with similar restrictions as credit-card issuing banks, based on the June 20 notification.
Information asymmetry is aggravated in BNPL since fintech balance-sheet lending does not have to comply with the ‘fair disclosure’ requirements of bank-issued credit cards. Moreover, some fintech firms, Uni and Amazon, explicitly shifted the burden of assessing credit-line suitability on consumers, which would not have been permitted under the regulatory system of bank credit. Other aspects of market integrity and consumer welfare have also been threatened by an unregulated BNPL system. Concerns have been raised about the high hidden costs in BNPL. While most BNPL fintechs do not charge any interest rates, as opposed to bank credit, they raise revenue from default/late fees. A survey by Lendingtree on BNPL payments in the USA revealed that 70% of BNPL customers missed payments and the charges on such missed payments amounted to far higher than any bank credit interest rates, reaching up to 30%. In India, this has reached up to 36%. Therefore, the ‘free’ and ‘no interest’ nature of BNPL has not translated into effect and can be misleading.
Moreover, data and predatory lending-related concerns have been highlighted in the context of BNPLs. While banks are only permitted to retain financial data of customers, BNPLs not being in the same regulatory ambit can collect behavior and spending data, which is one of the major drivers of their growth. In fact, US regulator Consumer Financial Protection Bureau has recently launched an investigation against leading BNPLs including Apple for integrating browser-search, geo-location, and expenditure data into curating its customizing its BNPL product ‘Apple Pay’, which could lead to predatory lending.
The aforementioned factors highlight the strong risks to market integrity in an unregulated Finetch Balance-Sheet Lending (“FBL”) by the BNPL players, even in a comparative sense to the heavily regulated credit-card space. If anything, the inference is that of relatively lax regulation, let alone disproportionate stringency. Hence, the MD-PPI regulation post July 20 is defended as proportionate to market integrity concerns as well.
Fintech Balance-Sheet Lending, Financial Stability, and the MD-PPI: Functional and Risk-Weighted Regulation
The third prong of proportionate regulation of fintech entails that the rigor of regulation must be commensurate to the potential threats posed to the financial stability of that activity.[ix] The rationale for this is efficiency and promoting financial innovation so that less risky activities need not face as high scrutiny as the risky banking system.[x] The potential counter-arguments for MD-PPI’s proportionality stem from it not allowing fintech lending (in the form of FBL in BNPL) even when they don’t pose threats to financial stability similar to that of banks since most BNPL loans are micro-finance, not meeting the threshold of financial stability concerns.[xi]
As discussed earlier, proportionate regulation entails regulating similar risks with similar stringency. This ‘risk-based’ approach would therefore require consideration of whether BNPL balance-sheet lending could risk financial stability at a macro-level.[xii] However, BNPL, despite having lesser systemic importance can still pose a similar risk. This can be seen in the growing concern about ‘Bank Like Financial Stability Risks’ by fintech credit.[xiii] Broadly, (a) credit risk (b) procyclicality, and (c) contagion are the three key factors in assessing the potential risks of fintech lending on financial stability.[xiv] I shall argue that in BNPL, the macro-risks are of a similar level to the bank/NBFC structure due to the new functionality and interconnectedness in fintech lending, justifying proportionate regulation.
For (a), credit risks run high in BNPL. BNPL credit is almost completely unsecured and relies on a minimal KYC process to smoothen onboarding. Moreover, the key market of BNPL is people with low credit scores who are often unaware of their borrowing capacity, leading to an ‘adverse selection’ of borrowers, which in turn can lead to systemic credit risk.[xv] A study by Moody revealed that BNPL poses twice as high a credit risk as heavily regulated credit cards. With regards to (b), procyclicality refers to a form of lending which exacerbates the market cycles of boom or recession, posing a serious threat to financial stability. Bank of International Settlementacknowledged the special danger of pro-cyclicity in fintech balance-sheet lending due to a greater role of investor sentiment.[xvi] This again becomes exacerbated in BNPL because as discussed earlier, they rely on lending from their own capital rather than banks which lend from deposits and help break cycles. Finally, in (c), contagion refers to the interconnectedness of the financial institution, and how a default in one institution can translate across the financial structure. Contagion is especially risky in BNPL for two reasons. Firstly, under the Credit Information Companies (Regulation) Act, 2005 (“CIC Act”), BNPL not technically being ‘credit’, isn’t reported to credit bureaus. This can cause problems across other financial institutions like banks and NBFCs since because of this a large chunk of loans and their performance by the debtors is veiled to them. Secondly, most BNPL firms operate under a ‘first-loss-default-guarantee’ agreement with banks/NBFCs, which means in cases of credit defaults the banking system also gets implicated.[xvii] Therefore, it is clear that by precluding fintech firms from loading credit in the PPI-MD, the regulation is at the very least not disproportionate to the threat to financial stability posed by them.
Conclusion
Through this article, an attempt was made to highlight how the MD-PPI’s prevention of BNPLs from loading credit is not disproportionate to the risks of the industry when seen concomitantly with the objectives of fintech regulation. To this end, I identified and analysed the 3 key objectives of fintech regulation, i.e., regulatory fairness, protecting market integrity, and maintaining financial stability. For regulatory fairness, this article relied on the duck principle to argue the current regulation of BNPL firms on par with some NBFCs is justified since they engage in similar functions. Secondly, this piece highlighted how BNPL is a significant threat to consumer safety and market integrity. Thirdly, it was argued that BNPL poses a “bank-like financial stability risk.” Therefore, this piece contextualized the three major regulatory objectives i.e., fair competition, consumer safety, and systemic financial stability to the risks associated with BNPL balance-sheet lending, showing the proportionality of the MD-PPI in each case.
Moreover, the model of regulatory-proportionality developed here could be a useful tool for evaluating any further regulation of BNPL or even fintech lending more broadly. For example, this three-pronged model may be used to assess the necessity and degree of regulation of newer fintech products like NFTs.
[i]Amitabh Khandelwal, ‘Loading of PPIs Through Credit Lines’ (Reserve Bank of India, 20 July 2022)
[ii] Mathias Lehmann, ’The Goals and Strategies of Financial Regulation’ in John Armour and Dan Awrey (eds) Principles of Financial Regulation (1st edn, OUP 2016) 138, 155; Fernando Restoy, ‘Proportionality in Financial Regulation: Where Do We Go from Here?’ (Bank of International Settlement, 2019) 7.
[iii] Marlene Amstad, ‘Regulating Fintech: Objectives, Principles and Practice’ ADBI Working Paper Series No. 1016 1-4, 6-7<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3541003> accessed 17 August 2022.
[iv] Fernando Restoy, ‘Fintech Regulation: How to Achieve a Level Playing Field’ (Occasional Paper No. 17, Bank of International Settlement 2021) 5-6.
[v] Fernando Restoy, ‘Regulating Fintech: is an Activity-Based Approach the Solution’ (Bank of International Settlement, 16 June 2021) <https://www.bis.org/speeches/sp210616.htm> accessed 17 August 2021.
[vi] Johannes Ehrentraud, Denise Ocampo and Camila Vega, ‘Regulating Fintech Financing: Digital Banks and Fintech Platforms’ (FSI Insights on Policy Implementation No. 27, Bank of International Settlement 2020) 32.
[vii] Amstad (n 4) 3, 6.
[viii] Mathias Lehmann (n 3) 129.
[ix] Mathias Lehmann (n 3) 132.
[x] Amstad (n 4) 2, 6.
[xi]See e.g., Anja Eickstädt and Andreas Horsch, ‘Financial Technology and Systemic Risk’ in Iris H-Y Chiu and Gudula Deipenbrock (eds) Routledge Handbook of Financial Technology and Law (1st edn, Routledge 2021) 107.
[xii] OECD, ‘Risk-Based Regulation’ (OECD Regulatory Policy Outlook, 2021) <https://www.oecd-ilibrary.org/sites/9d082a11-en/index.html?itemId=/content/component/9d082a11-en> accessed 17 August 2022.
[xiii] Financial Stability Board, ‘Global Monitoring Report on Non-Bank Financial Intermediation 2019’ (FSB, 19 January 2020) <https://www.fsb.org/wp-content/uploads/P190120.pdf>accessed 17 July 2022.
[xiv] IMF, ‘Grappling with Crisis Legacies’ (Global Financial Stability Report, 2011) 27, 125, 135.
[xv]Anja Eickstädt and Andreas Horsch (n 15) 104.
[xvi] Monetary Authority of Singapore, ‘Balancing the Risks and Rewards of Fintech Developments’ (Paper No. 113, Bank of International Settlement 2020) 282-283.
[xvii]Anja Eickstädt and Andreas Horsch (n 15) 106.