Fintech firms are reviewing their business models

“The rise of fintech – lending platforms, open banking, payment apps – is a major source of disruption for the banking industry… Regulators need to ensure that non-bank entities outside the regulatory purview of banks do not undermine the role of banks, raising financial stability concerns,” said .

T Rabi Sankar, Deputy Governor, Reserve Bank of India (RBI), at the Business Standard BFSI Summit in Mumbai on 21 December 2022.

Sankar also gave the clearest indicator so far of Mint Road’s thinking on the regulatory front, when he pointed to the concept of activity-based regulation, or the principle that those engaged in the same activity must be subject to the same regulation: “The basic point is that any entity that provides banking services must be subject to similar regulation as banks.”

The message is: arbitrage as a revenue model is out; and many fintech firms have to go back to the drawing board.

Bain & Company’s India Fintech Report 2022: Sailing Through Turbulent Tides noted that $35 billion has been pumped into the sector since 2000. It estimated that $8.4 billion would flow in 2022 – down from $10 billion in 2021.

Recent trends indicate that “the bulk of investment has gone to lending platforms, with almost 40 percent. There is also a resurgence of interest in wealth management and new banks, says Alok Mittal, co-founder and CEO of Indifi Technologies, a full-stack platform to enable debt financing for small businesses.

The fact that the lion’s share of investment has gone into fintech lending indicates that “given that the revenue model is much like that of legacy firms, it’s decent enough,” Mittal adds.

It follows that businesses that appear to be imaginative will be a no-go area for investors; and the $1.6 billion drop in investment that the Bain & Company report highlights in calendar 2022 seems to suggest, in part, that you can’t play off the scaffolding of regulatory arbitrage. Recall the two game-changing RBI circulars issued last year: The first decreed that prepaid instruments (PPIs) should not be financed through lines of credit from shadow banks (issued on June 20); and the second specified tighter digital lending norms (August 10).

Says V Raman Kumar, founder and chairman of CASHe: “Arbitrage simply cannot work. That’s why my firm doesn’t have the valuations that fintechs typically command. And people told me I wasn’t smart enough. I am a systemically important NBFC (non-banking financial company) and cannot afford to do stupid things.”

Again, India is not to be seen as an exception. The Coatue report, Fintech and the Pursuit of Prize: Who Stands to Win Over the Decade, is categorical that “the next generation of enduring fintech requires a focus on owning the balance sheet, manic re-bundling, a business-to-business leaning, and build high-margin sub-verticals”.

On September 20, 2022, RBI Governor Shaktikanta Das simply spoke at the Global Fintech Festival in Mumbai: “The Fintech road ahead will witness ever-increasing traffic, in addition to the large number of existing players already there. It is therefore crucial that every player on this road follows the traffic rules for their own safety and that of others.”

This was a wake-up call for an industry where self-styled fintech evangelists believed that legacy RBI-regulated entities would be history because they are not nimble enough to rework their business models with the changes that technology is driving. The tone of some of the comments even seemed to suggest that management in some of the old firms was tight-lipped.

All kinds of data and observations – from the mountain of bad loans, the vast unbanked hinterland, the lack of understanding of new age customers and the inability to exploit technology or data mining – were put into action to press the case that older entities will have to give up space to the new genre of businesses.

But the writing on the wall was clear on 18 November 2021, when the central bank published its working group’s (WG’s) report on digital lending through online platforms and mobile apps. The summary couldn’t have been more blunt.

The pandemic-led growth of digital lending had led to the unrestrained expansion of financial services to individuals, “susceptible to a range of behavioral and governance issues”, it said. On a larger canvas, digital innovations together with the possible entry of Big Tech companies can change the institutional role played by existing financial and regulated entities. Concretely, “the fallout of this can be reflected in the blurring of regulated and unregulated financial institutions and activities. Such a development spurred by purely commercial considerations will pose regulatory challenges to ensure monetary and financial stability and protect customers’ interests.”

And the regulatory roadmap was clarified; it will play out at three levels – regulated units of RBI; other regulated and authorized entities; and unregulated entities, including third-party service providers operating in the digital financial space.

The fintech industry’s mistake was that it did not read the WG’s report alongside the measures RBI took to improve the health of the financial sector – like cutting out regulatory arbitrage between banks and NBFCs; tighten the governance code in private banks and urban cooperative banks; or the fact that marquee names like HDFC Bank, MasterCard International, American Express and Diners Club International have been on the receiving end of the RBI’s displeasure over the past two years (although it’s backfired on them now).

But a wide range of fintechs, venture capital and private equity (PE) firms that have pumped billions of dollars into these firms preferred to see many of the WG’s recommendations as symptomatic of bank lobbying. There was talk of unrelated fault lines. This lobby had earlier stalled the entry of NBFCs into the credit card business despite the central bank’s circular of July 7, 2004, which had only set the net owned fund at Rs 100 crore. There is some truth to this, but it was not relevant to the issues raised by the WG.

According to Vinayak Burman, founder and managing partner, Vertices Partners, a law firm, due to the RBI moves, the fintech space has witnessed correction in valuation and investment flow. “It has led fintechs to try their best to extend cash runways as far as possible, to avoid seeking expensive external funding, thereby preserving their valuation.”

Take RBI’s Payments Vision 2025 (June 17, 2022): It envisioned a 150 percent increase in PPI transactions. “However, the banking regulator’s move to ban non-bank issuers of PPIs from loading PPIs seems contrary to the principle of uniformity across the sector, which may also lead to blocking of innovation in the market,” adds Burman . The Short Bottom Line: Fintech fortunes can change in the blink of an eye.

The reality is that the fintech valuation games of the past are over – whether they are wallet companies or those that mirror instant-noodle makers in their approach to credit and service to the public. What no one addressed was why, among legacy entities, even the relatively better private banks took time to respond to the fintech challenge.

First, they are strictly regulated; banks all the more as they are part of the payment settlement system; and as depositors are trustees of the public trust. Second, they do not have the privilege of playing off PE financing; and their shareholders are “more real” in terms of valuations. Can anything justify the valuation given to firms that have, at best, only stripped a certain segment of the banking business to make a play?

It’s time for most fintech firms to start over.