Challenges and future for India’s neo-banks

Digitisation and the growing use of mobile technology have led to a seismic shift in the banking and payments industry. The so-called neo-bank, a bank that operates exclusively online without traditional physical branch networks, is the new entrant in the digital payments space.

In the Indian context, despite their nomenclature, neo-banks are not directly regulated by the banking regulator, the Reserve Bank of India (RBI), since it does not grant licences for operating virtual banks. However, it permits conventional banks to outsource certain functions, under the guidelines on managing risks and code of conduct in outsourcing financial services by banks’ banks, dated 3 November 2006. The recently promulgated outsourcing guidelines for co-operative banks have limited the ability of co-operative banks to partner with neo-banks to serve the unbanked or under banked sectors by restricting outsourcing of core management functions. Indian neo-banks typically enter into outsourcing arrangements with conventional banks to provide a host of products and services, including a digital platform for accessing banking services, co-branded cards and payment solutions. Since banks are not allowed to outsource core management functions such as internal audit, compliance function, and decision-making functions like determining compliance with know your customer (KYC) norms, sanctioning loans, and investment portfolio management, Indian neo-banks are restricted from offering key banking services.

While the outsourcing obligations will be governed by the contract, the ultimate responsibility for ensuring compliance with applicable laws vests with the banks. Accordingly, we might see banks contractually push down compliance with the newly introduced master direction on digital payment security controls on neo-banks, which must also comply with extant data protection regulations in their capacity of being an intermediary under the Information Technology Act, 2000.

Product offerings

Neo-banks target both retail and business users, helping them with opening digital savings or current bank accounts. The RBI’s recent amendments to its KYC directive will provide impetus to neo-banks to develop an entirely virtual customer onboarding process. Neo-banks also facilitate money transfers using existing payment rails, and support international payments. Business neo-banking platforms also provide automated solutions for book-keeping and payment reconciliation. Neo-banks may support their customers in availing credit lines, and often act as direct selling agents (DSAs) for financial institutions. As DSAs, neo-banks are akin to independent marketing agents, facilitating leads and connecting such leads with financial institutions.

Neo-banks also typically offer co-branded credit, debit and prepaid cards in partnership with banks. As banks must ensure compliance with outsourcing guidelines when entering into co-branding arrangements, the role of neo-banks is limited to the marketing or distribution of such cards. Credit cards cater to the working capital requirements of small and medium enterprises that would have otherwise to follow cumbersome procedures to avail loans from conventional banks.

Challenges for neo-banks

Regulatory ambiguity. The RBI does not recognise entirely virtual banks and does not regulate neo-banks. Some neo-banks choose to act as business correspondents (BCs) of conventional banks, which are typically viewed as entities furthering financial inclusion in remote areas. To act as BCs, companies are expected to have widespread retail outlets.

Technology and security. Conventional banks would expect infrastructure and security practices of neo-banks to comply with internationally accepted standards before partnering with them. Neo-banks would have to upgrade their systems and processes to expand the suite of products offered, and continue offering certain services.

Data privacy. Ensuring data privacy is the cornerstone of any successful digital offering. Given the low charges for traditional product offerings, neo-banks would depend on customer data and their ability to cross-sell products to stay afloat. Such an ability may be affected by passage of the Personal Data Protection Bill, India’s GDPR equivalent.

Future of neo-banks

In 2014, the RBI introduced payment banks to further financial inclusion through a “secured, technology-driven environment” by providing small savings accounts, and payments or remittance services, to the under banked population. The RBI clarified that it did not envisage payment banks to be virtual banks or branchless banks.

With the onslaught of the pandemic, the RBI should consider fully embracing a virtual or branch-banking services and subject such services to appropriate checks and balances with the RBI’s oversight.

Anu Tiwari and Anindita Bhowmik are partners at Cyril Amarchand Mangaldas. Utkarsh Bhatnagar, a senior associate, and Janak Panicker, an associate at the firm, also contributed to this article