Future of Banks in India- Either Fintechalise or Perish

 

Future of Banks- Fintechalise or Perish

 

Subhash Chandra Garg

Economy, Finance and Fiscal Policy Strategist; Former Finance and Economic Affairs Secretary, Government of India

 

 

Banks are industrial era match-makers between savers and borrowers

Industrialisation expanded the basket of goods and services produced and consumed. Industrial era also did away with the constraints of localised production and consumption by developing means of transportation and communication. Production and consumption of goods and services became truly global.

This expansion of the goods and services to be produced and distributed and the scale at which it could be done necessitated financing. Expanding riches generated lot of savings. The banks emerged as the intermediators between savers and borrowers at local, national and global scale. The banks provided opportunity to earn an interest on the savings handed over to them and earned income by lending those savings to the borrowers. Expansion of reserve money and fractional banking enabled the banks to multiply savings to meet the ever growing demand for loans from the expanding industries and services.

The banking company needed to create trust in the minds of savers to hand over their deposits and have risk assessment abilities to lend to the credit worthy borrowers. The banks earned good margin in the process after providing for bad loans. Depositors’ trust and creditworthiness risk assessment capability were the two key elements of a successful banker. The government is quite a trusted organisation. In many countries, including India, government took over private banks to make the banks trusted organisations to depositors. The government did not, however, have the creditworthiness risk assessing ability. India’s nationalised bank suffered from excess trust of depositors and inability of bank managers to do proper creditworthiness assessment. As a result, while deposits piled up in the nationalised banks, they could not lend enough and their non-performing loans ballooned.

The nationalisation of entire banking industry in India in 1969 and 1980 was soon followed by the collapse of credit discipline and consequential poor lending and profitability in public sector banks. The banking industry was opened up again for private industry from 1993 onwards. By now about 40% of banking assets are in private banks. The government is now moving to the next stage of reprivatizing the nationalised banks. The announcement to sell-off two public sector banks in the last budget should be seen in the light of this broader development. The wheel is going to turn full circle in next few years- banks in private sector, nationalisation of banks, opening of banking to private sector and now privatisation of nationalised banks.

The world is witnessing transition from the industrial age to digital age. The banking industry has adopted some features of digital age, but at the core is still industrial era institutions. Fintechs are bringing digital era features to banking much more aggressively. Fintechs are at the door of banking to knock them over. Banking in the digital era will have to adapt- Fintechalise or it will perish.

March of FinTech in financial businesses

FinTech firms are surging in the financial businesses. There are three main segments of financial businesses- payments, investments and credit. Credit is the principal business of banks. Banks were also the principal medium for non-cash segment of the payments. Banks were not significant players in the investment space.

Fintech firms are disrupting all the three segments.

Most non-cash payments are now made using fintech platforms- UPI, Bill-pays, IIMPS, NEFT, RTGS and numerous others. Bank drafts, cheques are getting phased out fast. Payments are fast becoming technology-enabled or let us call- fintechalised. Banks still hold the customers’ accounts, but are getting relegated to be background. Front end has been massively taken over by the fintech platforms. UPI actually makes the banks bit players in the payment business. Payment banks, which are actually not banks but payment platforms, might grow. Digital wallets might become bigger. If the currency gets digitalised with much more direct relationship between the currency issuer RBI and the people, the banks will formally get squeezed out of the payments.

Credit segment is witnessing significant fintech action currently. There are four major segments of credit- large businesses, small businesses (small and micro businesses with at least one employed person), own account businesses (individual run businesses without employing any person) and personal loans.

Large businesses do not need fintech services.

It is the small businesses- about 25 million in number including shops and establishments- which have credit needs for both working capital and fixed assets.

The Fintechs, promoted by e-commerce and financial services companies are making large inroads in this space. A number of Fintech firms have set up businesses in the credit space- bill discounting, vendor payments, better cash management, peer-to-peer credit, extending of credit under digital environment by digital non-banks and so on. While still there is a long way to go, but the credit growth is in this segment. Growth of credit by banks in this space has slowed down considerably. Soon it might turn negative if the banks do not act.

The own account businesses (roughly 55 million) do not get any credit from banks. These ultra-micro businesses don’t get the credit from anyone, except money lenders and family/friends. The fintech has not reached this segment either. However, given the ability to strategically deploy digital technology, including for identity, saving accounts and other information, fintech is likely to get into this space soon.

Banks are focussing on retail loans- the loans to individuals/households for asset creation and consumption (not for business)- these days. This space is also quite vulnerable for banks. What has happened in the payment space and what is happening in the small loans space is likely to happen soon in the retail loan space. If the banks are not able to match efficiency and service of the fintech, the banks might lose ground in the retail loans as well.

Fintech imperative for banks

Credit is the most complex of the three key financial functions- payments, investments and credit. Credit is not simply a single transaction carried out without any settlement risk like payments. For credit, a decision has to be made in each individual case about the credit risk lender faces. This assessment of credit risk then leads to other credit decisions- period of credit, interest to be charged, collateral to be taken, capital to be allocated and the like. These decisions require lot of supporting data, information and security. Availability of savings/lendable funds was the pre-requisite for credit business.

The banks had the lendable funds and the bankers were the best guys to make credit assessment. The credit assessment, in the non-digital world of yesterday was, however, quite complex, time consuming and never really fully convincing. Gathering documents about the business cash flows, assets for collateral etc. and even for the reputation and credit history of the person/company concerned was usually quite difficult. Taking control of cash flows and registration of security interest was still more cumbersome and, in many cases, not really possible.

Regulators have also tried to sterilise credit businesses by making many parts of credit decision formula or bench mark driven. It is the bankers expert knowledge and instinct, like doctors, which is most critical for making credit decision. Unfortunately, complex credit decisions, like what diagnostics have sought to do in medical field, have been sought to be made automated taking out the human intelligence.

Digitalisation of businesses, cash flows, assets, registration of charges etc. has made it much easier and quicker to assess the creditworthiness (and with much more datapoints than before), secure the security and take control on cash flows, when necessary. Digitalisation of businesses and digitisation of data has also made it possible to break down the credit businesses in more than one separate and discrete businesses.

Credit information bureaus collect all relevant information and provide it to the lenders for a charge. Credit rating agencies have much more information and tools to make assessment about the credit worthiness. Specialised institutions and businesses enable faster and more comprehensive know your customer (KYCs). Digitalised processes and specialised institutions make registration of security interest facilitate securing collaterals. Taking control of cash flows is facilitated by the banks holding the bank account of the business concerned, including by way of creating escrow mechanisms. All these and many other supporting institutions enable fintech companies to make faster credit decisions. The banks have still not fintechalised their credit businesses. The credit in 59 minutes, that too only preliminary check for eligibility, is glacially slow in comparison of the credit offered by fintech companies.

Deposit rates have fallen notably over the years. Depositors in savings bank earn only about 3% return. Banks, however, try to get margins of 3% in lending for them. Banks love CASA deposits. Savings deposits have bigger share in CASA deposits. Low rates of interest on savings deposits effectively work as tax on small savers. Fixed deposits returns have also fallen in sympathy with the savings deposit rates. Savers are actively looking for alternative avenues for earning higher returns on their savings.

Peer to peer lending and other emerging platforms enable savers/ high net worth individuals to earn higher returns by directly lending to borrowers instead of retaining their deposits with the banks. The shift is small so far but it shows the winds of change.

This emerging scenario have serious implications for banks:

a.    Banks are no longer the only game in the town for credit. Numerous other credit avenues have emerged and are emerging fast. Banks share in total credit assets has reportedly already fallen to less than 40% in India.

b.    Credit business is getting unpacked in number of smaller and distinct business making it unnecessary for the banks or any other lender to do all these discrete activities- credit information, credit rating, KYC, recording of charge etc.

c.    New tools to assess the credit-worthiness have emerged which allow collateral free credits to be extended.

d.    Savers/depositors are likely to shift to other investment opportunities, including becoming lenders themselves seriously threatening intermediation.

Fintech companies, including fintech-NBFCs, are developing APIs and other technological tools to beat the banks in the credit business and its components. The banks have been slow to fintechalise themselves. This is making the banks cede competitive advantage to the fintech companies.

The choice before the banks today is quite stark- fintechalise or perish.

Wither banking industry

Banks in India have adopted core banking solutions. This makes bank customer accounts data digital in the country. Solutions like UPI leverage the digitalised bank accounts to creatively use fintech in payments. The credit assessment, review and delivery decision support data however still is partly digital, especially in the public sector banks. Credit businesses of banks are still not digital. Unlike payments, banks have not also entered into partnerships with fintech companies to deliver digitally.

Globally, however, there is faster movement in banks becoming digital banks on credit side as well. Banks have become open banks in some countries. These banks allow access to the customer data to fintech companies to build credit delivery programmes.

In some parts of the world, the banks are getting licenced as and becoming virtual banks or digital banks, which exist only digitally, without any or very nominal physical presence. Besides allowing very strategic and intense use of technology in delivering credit, the virtual banks also help in reducing the cost of intermediation substantially.

With such transformation, the banks have become competitive with fintech operators.

Unfortunately, in India, open banking is not favoured by regulators. In fact, the regulators and the government want to treat all financial data as personal data and have also built walls around freer use of financial data by mandating data localisation. While some parts of the banking have become virtual, the idea of virtual banks are nowhere in the lexicon of the regulator and policy maker.

Private banks have aggressively adopted digital technology though still their cost of doing business is very high on account of still relatively high manpower and non-performing loans. The public sector banks have been technology hesitant and are still hugely manpower based. The credit side of the public sector banks is still digitally laggard. The quality of credit decision made in this traditional system has been below par is evident by high non-performing and fraud cases in the public sector banks.

It seems likely that most private banks will transform themselves by aggressively fintechalising credit delivery. These banks will thus be able to withstand threat posed by the fintech. However, public sector banks don’t seem to be generally readying themselves for the new age banking. This will be another reason of relative under-performance of public sector banks and their weaker finances. The PSBs will probably fintechalise once these are sold. Most of the rest will probably perish.

 

New Delhi 03/05/2021