Moving towards differentiation: The evolving bank-fintech ecosystem in India

Modern money is but a piece of security paper containing a promise coded in unique alphanumeric combinations. It is intuitive to visualise its replacement with digital money. Globally, the ‘fintech revolution’ is underway, and is slowly inching towards ‘unbundling’ the bank. While regulators in other countries have largely adopted a wait-and-watch approach towards the fintech disruption; in India, the RBI is attempting to proactively create a space for non-bank digital companies to compete and collaborate with banks within the differentiated banking framework.  

Here are the ten ways in which we think the fintech-bank ecosystem will play out post-licensing:

Universal banks will struggle with complete process revamp, but will focus on digitising the front end.

Becoming a digital bank encompasses complete digitisation and seamless integration of back-end systems as well as customer-facing applications. Globally, few large banks have been able to undertake this transformation. Most of the banks, however, are beginning to tweak their customer-facing applications to include digital capabilities, even while their back-end processes continue to be weighed down by legacy systems. In India, too, banks will invest heavily in changing customer perceptions and making front-end technology digital, while continuing with their existing technology for back-end processes.

E-commerce will shape customer expectations and put pressure on banks to match up.

In India, e-commerce has become a defining force of customer experience. Consumers are quickly getting used to being pampered by e-commerce players as well as other service providers, who use digital technologies to differentiate themselves largely on the basis of customer experience. Customers will start to expect similar differentiation from financial services providers.  

There will be client segmentation at multiple levels.

The banking system today, largely segments clients on the basis of their wealth and earning lifecycle. Thus predictability of income becomes the major selection parameter for banks. At least for the banks targeting small-value, high-volume transactions, the notion of a ‘customer’ will change, from being the middle-class salaried employee to anyone who can use technology to power their financial decisions and enhance their life conditions. Such customers may not to be wealthy or urban, but will be tech-savvy and may value financial services providers who deliver products over digital platforms and communicate through social media, be guided by online community reviews and, hopefully, be willing to pay for convenience and time-saving.

With greater competition will come greater collaboration.

Market segmentation will continue, as each niche provider looks to dominate a specific part of the banking value chain. Since customers have multiple financial needs, niche players will look to collaborate with complementary service providers, in order to retain their customers and deliver value for ‘stickiness’. The market will therefore go from ‘build, scale, compete’, towards more specialisation and collaboration.

Niche banks may be more transparent and facilitate price discovery.

Universal banks, until now, have had the opportunity to cross-subsidise across their product lines, which has resulted in expectation of ‘free’ service and kept customers from knowing real prices of banking products. Niche banks will not have the ability to cross-subsidise and will therefore need to bring in real value addition to their products, pushing customers to a ‘paid service’ model. This will facilitate price discovery in the market and a more nuanced understanding of customer expectations from banks. Interestingly, this will be determined by the nature of banks that receive licences now, because there is also a real possibility of some player(s) disrupting price discovery completely by burning cash, like their e-commerce peers!

The potential for disruption is high.

In the absence of entry barriers, technology companies are driven to be nimble and smart as they are constantly under threat from more nimble and smart players. Banks on the other hand, have always had the protection of high entry barriers and have, therefore, had little incentive to differentiate or innovate. As the market shifts away from rewarding RoE or market capitalisation and tilts towards becoming valuation-driven, the potential for fintech companies to disrupt the financial services ecosystem will grow multi-fold. This will allow different players within the banking ecosystem to choose their niche or to compete, based on their cost of capital.

Financial inclusion will be more meaningful under the ‘principal-principal’ collaboration model.

Traditionally, financial inclusion has been viewed as a bottom–of-the-pyramid segment being provided with standardised bundled products. While standardisation reduces costs and makes scale and delivery possible, in reality, low-income households and individuals require greater customisation, being very diverse in nature. The principal-agent model, wherein banks work with multiple ‘agents’, has been the primary delivery model for inclusion services. But in these arrangements, the agent—who faces customers—has little say in the product creation and the bank—which creates products—has little opportunity to engage with the last mile. The new paradigm under differentiated banking will change this dynamic as the ‘agent’ side acquires greater ability to create products and also greater ‘power’ in the relationship with the ‘principal’. This may finally provide customers with the opportunity to meaningfully access financial services.

Banks will be pushed to create real value for customers.

The microcredit and remittance markets will continue to be business drivers in the short to medium term. It is likely that the fee structure in these segments will get disrupted and revenues will flatten out quickly. Service providers will then need to think about going beyond servicing the ‘low-value, high-volume’ customer and create real economic value for each customer segment. With a large unbanked population, that opportunity is huge. Digital and policy paradigm will hopefully create the right ecosystem for this value creation. These customers, too, are likely to be a mix of ‘fractional customers’ (i.e. retail and business consumers that bank with universal banks, but prefer differentiated banks for specific services) and ‘new customers’ (the hitherto underbanked and unbanked).  

There will be a steep learning curve in designing efficient risk- and fraud-management techniques.

KYC documentation has been a key pain point and a major barrier in providing financial access to a larger section of the population. In the differentiated banking regime, this will be one of the fundamental processes that will need to change. In order to scale up and acquire greater numbers of customers, niche banks will need to move towards identifying consumers digitally and instituting time-efficient, convenient processes. Similarly, fraud management will also need to undergo a radical shift, become less invasive and facilitate faster, smoother transactional experiences, while picking up early warning signs and potential issues to minimise risk. Any large fraud will hamper the much-needed restoration of trust, which has routinely suffered in the past due to unscrupulous elements in the informal financial system. Risk management is not just about regulatory compliance, but the very basis of banking growth.

Regulation will need to be differentiated to fit the realities of differentiated banking.

The existing guidelines for payments banks and small finance banks are broad. The guidelines identify the principles but also refer broadly to existing banking guidelines and regulations. The experience with prepaid payments instruments indicates that applying the banking framework to these niche digital players creates many difficulties and often does not address the right risks. The results are sub-optimal for both market participants as well as regulators. Clearly, differentiated banks will not be able to bear the compliance cost structure of universal banks. As differentiated banks evolve and become more integrated into the formal financial system, regulatory approach may need to similarly evolve and differentiate.