Fintechs show interest in becoming SFBs, but transitions involve risks

Analysts at BofA Securities pointed out that a hybrid model would become inevitable for fintechs
On Wednesday, the Reserve Bank of India (RBI) said digital lending platforms used on behalf of banks and non-banking finance companies (NBFCs) should disclose the names of such lenders to customers. This may be the first sign of a tightening regulatory regime for digital, or fintech, companies. Perhaps in anticipation of a faster compression in the regulatory arbitrage between payments banks (the most popular fintech model) and traditional ones, the RBI’s internal working committee suggested that the term of conversion to small finance banks (SFBs) be reduced from five to three years for payments banks (that is, banks that can accept deposits but cannot lend or issue credit cards), and such SFBs must be listed within six years of conversion against three years specified earlier.

Fino Payments Bank, with a 2.5-million customer base and monthly transactions of Rs 13,000 crore, was the first to state its intentions to seek an SFB licence after the working committee’s recommendations. Recently, the Centrum group and BharatPe joined hands to bid for the troubled PMC Bank, which is set to transition from a cooperative bank to an SFB.

If the final guidelines are as attractive as the recommendations, it could mark a new chapter for Indian banking. As Ashish Fafadia, partner, Blume Ventures, a start-up finance company, put it, “There’s only so much spread to be made from payments”. A BofA Securities report said even if fintechs earn a yield of 15–25 per cent against 12–15 per cent made by banks and NBFCs, their net return on assets is 2-3 per cent versus traditional lenders’ 2.5-3.5 per cent owing to higher customer acquisition and credit costs. The urge to improve the bottom-line has forced some to branch out into segments such as insurance and asset management as Paytm and PhonePe have done. In Fafadia’s view, fintechs’ SFB aspirations could be a by-product of such a valuation enhancement process — an issue that assumes importance for private equity investors, who seek an exit in three to five years depending on their investment lifecycle.

Whether fintechs want to go down the banking channel route or remain a distributor of bank products by partnering with many or a combination of both is a choice most players would have to make in the evolution process. Globally, fintechs have been successful as a distribution platform. Some of India’s established payments bank CEOs say it works better for them to remain a distributor. “The fee-based model will be more lucrative for us than a bank structure. We have the scale and penetration,” said a CEO requesting anonymity.

For a few such as Rishi Gupta, MD & CEO, Fino Payments Bank, however, the huge opportunity in India makes a good case for combining traditional and innovative banking. Gupta’s payments bank started in June 2017 and turned in operating profits in three years. Explaining why being a bank makes sense, Gupta points to customers seeking credit on his platform. “Credit would be an add-on function for customers and merchants asking for it,” he said.

But here’s the tricky part: The fintech model is conceptualised as asset-light, which, in fact, played a huge role in Fino Payments Bank’s early breakeven. On the other hand, the need to add branches, diversify loan products, mop up deposits and add layers of human resources may become unavoidable costs in the process of scaling up as SFBs, contradicting the premise of a fintech’s relevance.

Vivek Belgavi, partner and fintech leader, PwC India, argued that a virtual bank can be created within a unified payments interface (UPI) framework, but the fact that BharatPe has shown interest in PMC Bank suggests that a virtual setup may be necessary in the long run to retain customers. Fino’s Gupta, however, emphasises that even as an SFB his company will remain asset-light. He expects only 20-30 per cent of income to come from lending; transactions would continue to dominate even as an SFB.

Analysts at BofA Securities pointed out that a hybrid model would become inevitable for fintechs. “In India, 100 per cent digital lending is neither practical nor scalable,” they said, given that digitalising functions such as loan origination, underwriting, disbursal, risk management and collection depends on the lifecycle of the lender. Moreover, a fully digital approach may reduce the efficacy of risk management, in which fintechs have limited experience. “There is no shortcut to balancing risk, and credit fintechs will have to grow leaps and bounds on this aspect,” said Fafadia. Balancing between delinquencies and profitability or net interest margin will be a tightrope walk. How long fintechs can price products exorbitantly, at 40 per cent in some cases, and expect all the risks to be covered is a question raised by many and is also rapidly attracting the regulator’s attention. Gupta acknowledges his concern and says that a lot of work needs to be done to mitigate credit risks. “The key is to ensure that we don’t overlend,” he reiterated.

The other objective of digital lending platforms was to cater to an underserved and unbanked population that may not be eligible for a bank loan in the normal course. Fafadia said meeting the SFB requirements of elevating borrowers to a formal credit platform, with its higher standards of credit filtering, may solve this issue, though it defeats the objective of financial inclusion.

Overall, the ability to handle credit risk would be the deciding factor for fintechs to scale up as SFBs and for the RBI to moot this transition. Just as fintech-led banks have emerged as the accepted hybrid model in Singapore and Hong Kong, India too may be on the brink of a similar change. Sustaining the SFB interest beyond Fino Payments Bank and BharatPe would, however, depend on how much groundwork others are willing to do towards improving credit underwriting and customer acquisition.

Attaining scale would be a decisive factor, too. Despite 76 per cent of private equity capital infused into payments-oriented fintechs out of the $13 billion poured into the space since 2014, only four players have reached a certain valuation strength (see chart). Without scaling up at a rapid pace, the transition to an SFB may remain an aspiration for many.

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