Should You Consider Holding Your Money in Digital Banks?

The COVID-19 pandemic has led to wide-scale digitalization across industries. The lockdown led to a massive spike in the usage of digital payment platforms. The development of financial services by non-bank competitors led to further acceleration in the digitalisation of banking processes. On the other hand, Digital banking, with its real-time assistance, individualised services, highly customised options, significantly lower turnaround times, and availability and accessibility of 24x7x365, led to a higher rate of adoption.

Given that, the global pandemic may have brought the significance of digital banking platforms to the surface. Traditional banks have often relied on a strong brand reputation and financial products to attract and retain customers. But with a new wave of youthful and more digitally-savvy consumers emerging, simply being reputable may no longer be enough to stay competitive in this market. Customers are looking for a more flexible and accessible proposition with value-added services that help enrich their lives. Digital banks have an advantage in this area.

In recent years, many of the developments in the financial sectors have been driven by digital banks. A growing number of fintech companies are offering fully digital accounts, which are less bureaucratic, more transparent, free of cost, and easy to manage. With technology and the user experience as their starting points, digital banks compete with traditional institutions by offering online operations that are simple and cost-effective.

What are Digital Banks?

Digital banks are online financial institutions that have virtual presence for the customers. Customers are served through digital mode, their creditworthiness is assessed, and they are accepted or rejected digitally at a distance. In the financial market, digital banks are becoming prominent as they are being marketed as an alternative to standard service, queues, physical locations, and other characteristics of traditional banks.

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Digital banks, unlike traditional banks (branches and service stations), do not have a physical structure, which lowers their operational costs but makes it more challenging to create new market differentials due to customer distance.

In India, digital banks have now revolutionised banking by providing rapid account opening and other value-added services via digital platforms. Digital banks are using technology to fill in the holes and flaws in the existing banking system, and they now provide a variety of new and customised solutions.

However, Digital banks have limitations and cannot be taken as a substitute for the traditional banking service. Even though many fintech firms use the common suffix "bank," this does not imply that they are regulated in the same way the banks are. In India, there is currently no formal legislation for digital banks (also known as neo banks). In India, all Neo Banks actively collaborate with traditional banks as a marketing platform.

Digital Banks operate by partnering with traditional banks ("Banks") to provide licensed/regular banking services to their customers as outsourced agents or business correspondents. Application processing (loan origination, credit card processing), document processing, marketing, etc., are all listed as outsourcing activities.

Digital Bank/Neo Bank's current operating model is hampered by several ways, including the fact that they are not authorised to construct 'ground up' credit products and user experiences. Instead, they are required to sell items from partner bank's product buckets. In addition, digital banks have limited revenue generation potential because their revenue sources are confined to fee-based revenue from customers.

The National Institution for Transforming India (NITI Aayog) has produced a discussion paper titled Digital Banks: A Proposal for India's Licensing and Regulatory Regime ("Licensing Framework"). The Discussion Paper attempted to address some of the limitations of digital banks by proposing a full-stack digital bank licence, which would fill in the holes in the present Neo Bank Model.

As a result, the proposed Licensing Framework will provide an enabling environment for Digital Banks to overcome their restrictions by allowing them to provide a full range of banking services, including deposit and loan issuance. Accordingly, Digital Banks would be able to offer new and efficient goods and services with unique user experiences. In addition, the framework would improve regulatory monitoring of Digital Banks and prevent unauthorised reproduction of data.

You must be wondering that when you already have a bank account that offers online and mobile banking facilities, then... why do you need a digital bank account?

It is the product innovation, convenience, and user experience where not all traditional banks offer great digital solutions, and this is where these digital banks excel. When compared to traditional banks, digital banks have a faster onboarding process, a better user interface, 24x7 customer support, and new online investing services like 'Change Investing.' Digital banks also provide services that include a digital financial assistant powered by artificial intelligence, similar to a Robo-advisor, to aid with financial decisions.

Furthermore, tech-savvy millennials anticipate a lot from their mobile apps, which is where many of these digital banks have an advantage. In comparison to digital apps, the user experience for neo banks is much more appealing to urban millennials and Gen-Z. A few examples of Neo Banks in India are Jupiter, FI Money, Niyo, etc. these digital banks, however, are not under the direct supervision of RBI.

However, just because the RBI doesn't directly regulate digital banks or fintech companies, it doesn't imply that they're out of the RBI's reach. These fintech companies are indirectly regulated by the RBI. Almost all digital banks sign a collaboration agreement in which they pledge to comply with RBI audits. Depending on the financial product, RBI has direct or indirect oversight of fintech.

Digital banks are addressing the regulatory situation by outsourcing their banking obligations to those with licences, forming strategic relationships with traditional banks, and expanding their offerings. Basic banking products such as savings accounts, debit/credit cards, loans, and so on can be sold by neo-banks in collaboration with suitable partners. Digital banks, on the other hand, are unable to accept deposits or provide lending products on their books. As a result, some digital banks have a Non Banking Financial Company (NBFC) as their parent to engage in lending activities, while most others partner with banks and other financial institutions.

Currently, it is difficult to blindly trust any digital bank as an entity with your money due to the lack of direct supervision by the RBI. Traditional banks enjoy a high degree of trust from customers primarily because accountholders know that they are under RBI's regulation and are being closely supervised by the regulator. Furthermore, you must confirm that the financial data security of these Digital banks is adequate, as you will be entering sensitive financial information and maybe conducting banking transactions. Incorrect transaction processing, data integrity and confidentiality compromises, illegal access to the bank's systems, and even other transactional risks exist.

To Conclude...

Digital Banks will be principally relying on the internet and other proximate channels for the delivery of their products and services. This makes banking more convenient and efficient for both banks and their customers. However, not all people have equal access to the internet or the smartphones or technical skills to use and access such services.

Currently, Neo-banking (Digital banks) in India is at a nascent stage. The business models around digital banks in India will have to evolve beyond their existing limitations in the next few years. The success of the digital bank model will be determined by how innovative it is in generating new revenue sources and acquiring users with a high lifetime value.

Although digital banks have the potential to help reimagine the banking ecosystem and address the rising concerns of financial inclusion, there are a number of practical and regulatory issues that must be addressed, as stated above. As a result, before opening an account with a Digital bank, one should conduct thorough research and evaluate the services provided.

You must consider to empower yourself with financial knowledge to be financially aware about any such fintech advancements around and be able to make informed financial decisions.

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Warm Regards,
Mitali Dhoke
Jr. Research Analyst