Navigating The Neo-Banking Wave: Insights Into India's Digital Financial Future
Dhruv Harjani and Subhojeet Mazumdar
10 Jan 2025 11:27 AM IST
The novel point of neobanks is that they operate sans physical branches, utilizing dynamic business models and upscale technological tools to improve customers' ease of use, transparency, and service efficiency. The concept of neo-banking emerged in the UK and Germany in 2013 and 2015. It is disputed over when the neo-banks entered the Indian market. Key players like NIYO[1] and PayQ[2] claim to be the initial neobank in the industry. Irrespective of the first entrant, the neo- banking sector in itself has seen significant growth in the past decade, acquiring close to a billion dollars in their fundraising rounds.
Neobanks have the prospect of elevating financial services via their customer-oriented, only available, and effective banking products. Through the utilization of their agile business models and proficient technological capabilities, neo-banking service providers have become capable of tapping into modern banking chains.
Neo-banking emerged as a concept to challenge traditional banks and their rigid banking techniques. Their purpose is being served and achieved in countries like Brazil[3], Mexico[4], the US[5] where the regulatory authorities have granted them banking licenses. However, instead of locking horns against each other as competitors, the neo-banks in India are forced to co-exist in collaboration with the traditional banks. The neo-banking entities in India are not subject to direct regulation by the RBI, they operate under a veil of indirect control owing to their partnership with a traditional bank. At the moment, the RBI has not granted any digital banking licenses to any neobank. The same does not seem viable in the near future.
INFRASTRUCTURE OF NEOBANKS
Neo-banks must possess a robust and secure technology framework that complies with the current regulatory requirements. Neo-banks possess the potential to be the future of the banking sector given their distinctive approach to using KYC (know your customer) to verify and identify clients as per their unique requirements.
Neo-banks being digital, do not have to establish successful anti-money laundering ('AML')[6] programs, but they do it for their safety and reputation. Neo-banks are not subject to direct regulation instead, the banks they partner with are subject to regulation by National Competent Authorities ('NCA')[7].
The regulatory framework for neobanks in India is complex, encompassing various regulatory authorities such as the Reserve Bank of India ('RBI'), the Securities and Exchange Board of India ('SEBI'), and the Insurance Regulatory and Development Authority of India ('IRDAI'). Neobanks have to traverse an intricate set of regulations and obtain many licenses and approvals in order to operate in this system.
R.B.I Guidelines
Although the RBI's regulations do not explicitly address neobanks, several key guidelines provide a structure for their operation.[8] Notably, these include:
- Banking Regulation Act, 1949, Section 23: Master Circular on Branch Authorization[9]
- Framework for Outsourcing of Payment and Settlement-related Activities by Payment System Operators[10]
- Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Services by Banks[11]
- Master Direction on Digital Payment Security Controls[12]
- Directions on Managing Risks and Code of Conduct in Outsourcing of Financial Services by NBFCs[13]
- SEBI and IRDAI Guidelines
Neo-banks face major regulatory implications. As a way to ensure compliance with all legal prerequisites, it is key that they establish legally binding contracts with their regulated partners. This also involves abiding by the data protection and cybersecurity standards mandated by the RBI as designated in the SPDI Rules, 2011, and Section 43A of the IT Act, 2000.
To thrive in India's regulatory landscape, neobanks have to build robust partnerships with traditional banks. Neobanks can run effectively within the legal framework, deliver new and customer-centric financial services, and guarantee security and compliance by complying with particular standards.
Neo-banks have forced the hands of Indian law makers to introduce certain short-term regulations and licensing changes in their policies. These changes will help facilitate the inclusion and growth of Neo Banks. This will facilitate the customers getting the greatest value out of the partnership model's benefits and close the short-term security gaps.[16]
LEGAL FRAMEWORK
As per RBI guidelines, it is mandatory for banks to have a physical presence to offer mobile banking services in India. This is covered by Clause 6 of the RBI's Circular: “Mobile Banking Transactions in India - Operative Guidelines for Banks (2014)”.[17] Clause 6.1 mentions the conditions for providing mobile banking services, and Clause 6.2 deals with the customer's qualification to avail mobile banking services. Given that neo-banks typically operate without a physical presence, they must partner with traditional banks and Non-Banking Financial Companies ('NBFCs') to comply with these regulations.
Neo-banks are often hired by traditional banks as an outsourced partner. This aspect primarily aids the banks in speeding up certain customer verification processes, credit requests, and overall account operations. The 2006 instructions of RBI "Managing Risks and Code of Conduct in Outsourcing of Financial Services by Banks"[18] apply in these scenarios. Specifically, banks must not outsource core management functions like internal audit, compliance, and decision-making related to KYC norms, loan sanctions, and investment portfolio management (under Annex-1, Para 2).
Neobanks are not allowed legally to operate individually, without partnering with an existing bank or NBFC. Neo-banks must comply with data protection laws, which are set for significant updates to align with the EU General Data Protection Regulation (GDPR).[19] SBI launched the 'YONO' app as a digital platform which serves as an example of the integration of traditional and neobanks.
SHOULD NEOBANKS BE GRANTED LICENCES IN INDIA?
There is a long-overdue need for neo-banks to obtain the necessary banking licenses. It is in the interest of the customer, regulators, and the industry at large for neo-banks to take this next step to facilitate financial inclusion using the latest technology and push for a digital India.
Neo-banks face a significant paradox that threatens both their survival and their prospects of obtaining a banking license. To be considered for a banking license, neo-banks must secure a pre- required amount of capital. However, their primary target customers are MSMEs, which typically fulfill their debt needs through informal markets. This reliance on a customer base with limited formal financial engagement makes it hard for neo-banks to gather the capital needed to obtain a banking license and survive.
It would seem imprudent and a protracted endeavor for neobanks to chase a banking license, considering the complexities outlined in the NITI Aayog report, “Digital Banks- A Proposal for Licensing & Regulatory Regime for India”.[20] The complex legal requirements set by the RBI and the Banking and Regulation Act, 1949[21] coupled with competitive challenges, render the pursuit of a banking license unfeasible. Despite these obstacles, there exist some positive aspects that could help bring positive change in the industry. Currently, the potential benefits for an average consumer from the banking industry and the negative aspects of granting a license to neobanks outweigh the advantages.
To sum it up, neo-banks are perceived by the old banking industry as a threat. Their existence is threatened, and they are trying to navigate this catastrophe by any means necessary. The ever-evolving framework plays a crucial role in determining the future of neo-banks. Neobanks are in their nascent stages and will require the guidance and support of existing industry members and the proper framework and support of the authorities and government to flourish and thrive.
The authors are students at Gujarat National Law University. Views are personal.
Niyo, The Concept of Neo-Banking, Niyo Blog ↑
Bhaumik S., Forbes India. Will PayQ Be India's First Neo Bank?. Forbes India., (2024 May 30.)
https://www.forbesindia.com/article/brand-connect/will-payq-be-indias-first-neo-bank/64297/1.
Valentine Hilaire, Nubank's Mexico Arm Seeks Banking License to Grow Product Portfolio, Reuters (Oct. 19,
2023), available at https://www.reuters.com/business/finance/nubanks-mexico-arm-seeks-banking-license-grow-product-portfolio-2023-10-19/. ↑
David Feliba, Neobank Era Ushers in New Wave of Competition in Mexico, Fintech Nexus (Apr. 25, 2024), available at https://www.fintechnexus.com/neobank-era-ushers-in-new-wave-of-competition-in-mexico/. ↑
Tom Groenfeldt, Varo Gets A Banking License And Moves Operations To Temenos Transact Platform, FORBES (Sept. 16, 2020), available at https://www.forbes.com/sites/tomgroenfeldt/2020/09/16/varo-gets-a-banking-license-and-moves-operations-to-temenos-transact-platform/?sh=16f5d98077cc. ↑
Groww Blog, Neo Banks: All You Need to Know, Groww (July 27, 2023), https://groww.in/blog/neo-banking-in-india. ↑
Id. ↑
Ali A., Neo Banks in India, ClearTax. ↑
Reserve Bank of India, Section 23 of Banking Regulation Act, 1949 – Master Circular on Branch Authorisation, Gazette of India, pt. III sec. 4 (Jul. 2, 2012). ↑
Reserve Bank of India, Framework for Outsourcing of Payment and Settlement-Related Activities by Payment
System Operators, Gazette of India, pt. II sec. 3(i) (Aug. 3, 2021). ↑
Reserve Bank of India, Directions on Managing Risks and Code of Conduct in Outsourcing of Financial Services by Banks, Gazette of India, pt. II sec. 3(i) (Nov. 3, 2006). ↑
Reserve Bank of India, Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Services by NBFCs, Gazette of India, pt. II sec. 3(i) (Nov. 9, 2017). ↑
Id. ↑
Securities and Exchange Board of India, Guidelines on Outsourcing of Activities by Intermediaries, Gazette of India, pt. II sec. 3(i) (Dec. 15, 2011). ↑
Insurance Regulatory and Development Authority of India, IRDAI (Outsourcing of Activities by Indian Insurers) Regulations, 2017, Gazette of India, pt. II sec. 3(i) (Apr. 20, 2017). ↑
Mundhra, L. (2022) NITI Aayog proposes licencing & Regulation for Neobanks, Inc42 Media ↑
Reserve Bank of India, Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Services by Banks, Gazette of India, pt. II sec. 3(i) (Nov. 12, 2021). ↑
Id. ↑
Sethia T., Rising challenges for Indian neo-banks. Economic Times. ↑
NITI Aayog, Digital Banking: A Global Perspective, https://www.niti.gov.in/sites/default/files/2023-02/DigitalBanking07202022_compressed.pdf. ↑
Banking Regulation Act, 1949, No. 10, Acts of Parliament, 1949 (India). ↑