India’s RBI looks to Rein in Fintech – The Diplomat
The COVID-19 pandemic ushered in a golden age for fintech, accelerating the global adoption of fintech products of all kinds. Driven by fear of pollution, contactless, cashless forms of transaction were encouraged at all levels. Shutdowns squeezed household finances, pushing consumers to borrow from digital banks. The central banks once again reduced interest rates to almost zero with no end in sight. Cryptocurrencies reached all-time highs and Bitcoin gained a foothold in the mainstream financial sector, even being adopted as the national currency in El Salvador and the Central African Republic. Persistently low yields and soaring US equity valuations pushed investors into new markets, and emerging market fintechs were suddenly flush with cash and resources. Worldwide, $125 billion in venture capital was invested in fintechs in 2021.
Much of that $125 billion went to US and European mega rounds, but $14 billion went to the crown jewel of fintech in emerging markets: India, which now has 21 fintech unicorns out of a total of 2,000, 6,000 or 10,000 fintechs, depending on the source . On the consumer side, the pace of fintech adoption in India is amazing. In 2019, 75 percent of all retail payments were made in cash. In 2020, that figure was just 38 percent, with the balance routed through payment systems, wallets, credit and debit cards, according to Fitch. Indian Prime Minister Modi said in May this year that 40 percent of digital transactions in 2021 took place in India, home to 16 percent of the world’s population.
Globally, governments have encouraged the growth of fintech ecosystems for several reasons. First, digitizing your finances simplifies tracking and taxation (in case you haven’t heard, the taxman is coming for your Venmo account). Increased digital payments infrastructure has helped halve India’s informal economy, according to the chief economist at State Bank of India. Second, locally owned and operated toll rails and systems are preferable from a security point of view. Third, reduced payment and settlement times mean faster capital cycles, which strengthens the economy.
Few major governments have been as gung-ho on fintech as India’s, which laid the foundation for its modern fintech infrastructure in 2014 by linking the so-called JAM Trinity: zero-minimum bank accounts for the unbanked (known as Jan Dhan), linked with Aadhaar ( India’s National Biometric Identification System), linked to mobile phone numbers. In the past decade, the government funded fintech-friendly initiatives including e-RUPI, India Stack and Unified Payments Interface (UPI), and supported the fintech sector with guarantees, grants and reforms, earmarking 15 billion Indian rupees ($200) million) for additional to incentivize digital payments in the 2021 Union Budget.
Indian fintechs are increasingly systemically important to the overall financial system. Far from the simple bank-versus-fintech design of the modern financial services sector, Indian banks and fintechs are collaborating to leverage their respective advantages. The banks provide regulatory knowledge and balance sheet weight; fintechs provide new underwriting and risk scoring analysis, better user experience and greater flexibility. But as foreign capital pours into fintech coffers and new products and partnerships blur the lines between banks and non-banks, the Reserve Bank of India (RBI), initially a staunch supporter of fintech, has started to throw its weight the other way.
Fintech services are evolving on a spectrum that corresponds to consumers’ overall financial sophistication, spending and borrowing habits, and smartphone penetration. In wealthy countries, investment and neo-banking fintechs (Ally, SoFi, Robinhood) are dominant, but digitization of payments is the starting point for fintech in low-income countries. Breaking consumers’ exclusive reliance on cash (usually through payment services) is the first barrier to fintech adoption, and other services generally follow.
India’s fintech space is particularly unique. India is home to UPI, the world’s busiest real-time payment system. Established by the RBI in 2016 and managed by the country’s major banks, UPI allows real-time transfer of customer funds between participating banks via mobile phone, even via flip phone. UPI is an open network that allows non-banking technology companies to build applications on top, fostering an ecosystem of interconnected networks that are even used for interbank transfers and IPO allocations, as well as texting a friend your share of the dinner bill. By all accounts, it has been very successful, so much so that Google encouraged the Federal Reserve to create a similar system.
UPI enabled India’s huge digital payments market, spawning thousands of payment startups. It has attracted the attention of US corporate heavyweights, and the two biggest payment providers in India today are Google Pay and Wal-Mart’s PhonePe, which together have a market share of 83 percent, ahead of offerings from Amazon, Facebook, Alibaba and local players. (a federal antitrust investigation into Google Pay is ongoing).
However, being a payment provider in India “doesn’t pay”. By government mandate, all UPI transactions are free; That means payments fintechs (including those run by Google and Wal-Mart) have additional offerings to generate revenue, typically lending and buy-now-pay-later (BNPL) services. Issuing credit in India is tightly regulated, so payment providers and other non-bank fintechs work with licensed lenders to provide digital consumer loans, which tend to be small, short-term and one-time loans.
India’s digital credit market has exploded in recent years. Total lending volume doubled from 2017 to 2021, but total digital lending grew an astounding twelvefold during the same period, according to RBI’s 2021 Working Group Report on Digital Lending. In particular, unsecured (not backed by collateral) loans grew twice as fast as secured loans over the same period. The Boston Consulting Group estimates that digital loans will represent 50 percent of all personal loans by 2023, a total market of $300 billion. The same RBI task force found that of the 1,100 digital loan apps available on app stores, 600 were illegal under RBI definitions. A number of these illegal apps were run by Chinese shell companies (India is not a welcoming environment for Chinese apps, with 273 apps banned at last count, including TikTok).
Unlicensed fintechs were initially limited to issuing one-off consumer loans. But in recent years, fintechs have entered the credit card market by loading prepaid purchasing instruments (PPIs) with lines of credit provided by licensed lenders. These instruments often flouted certain Know-Your-Customer (KYC) regulations and charged above-market rates. According to the Payments Council of India, 600,000 such cards are issued each month, mainly to young Indians who might not otherwise be able to access credit.
These businesses, which technically operate in a legal gray area as PPIs were not designated as credit instruments, suspended operations in June 2022 when the RBI banned the issuance of credit PPIs. Taken alone, this is a minor development (although the fintechs directly affected have raised over $700 million, mostly from US investors), but the move indicates cooler relations between the fintech community and the government.
Theories abound for the expected regulatory tightening. Firstly, it is suspicion that the RBI puts a finger on the scale of India’s traditional banking system. There is an assumption that as the fintech market matures, participants will be shaped like traditional banks and subject to comparable rules. Most importantly, given the meteoric rise of digital credit, there is a sense that consumer loans could spin out of control, plaguing consumers with unserviceable debt incurred in legal gray areas and away from the RBI’s watchful eye.
India’s government is among friends as it turns a more critical eye towards digital lending. China’s late-2020 meltdown was ahead of the curve, sending a clear message with the eleventh-hour IPO of lending giant Ant Group and the subsequent disappearance of its founder, Jack Ma. In October 2021, Indonesian police raided lending fintech offices and have shut down 5,000 illegal lending operations since 2018, according to Fitch. Kenya passed a bill regulating lending practices in February 2021, backed by the financial services industry. Even the IMF has called for increased oversight of high-growth fintech.
Until now, restrictions in other countries have bolstered Indian fintech investment, as investors prioritized markets with a lower risk of regulatory disruption. But even a worm will turn, and the RBI’s rumblings of improved lending regulation in February 2022 have crystallized into its first meaningful action. Bank shares rose after the announcement in June, indicating expectations of future restrictions.
“The treasury is based on mining, the army on the treasury; he who has an army and a treasury can conquer the whole wide earth.” So wrote Kautilya in the Arthashastra, a treatise on political economy written during India’s Mauryan dynasty (321–185 BC). Taken together, these actions are a reminder that while high-flying fintechs may have the treasury, they don’t have the army – and until they do, they’re beholden to those who do.
