Fasten your seat belts: The switch to Fintech 2.0 has just begun

A shakeout among fintech firms is very likely, as the stress on governance and compliance is set to go up many notches

Last year, Reserve Bank of India (RBI) Governor Shaktikanta Das did some plain speaking at the third edition of the Global Fintech Fest in Mumbai in September 2022, cautioning that it was imperative for fintech firms to obey traffic rules, for their own safety and that of others. And “pay attention to governance, business conduct, regulatory compliance and risk-mitigation frameworks,” he warned.

Yet two months later, an internal survey by the Fintech Association for Consumer Empowerment — in collaboration with the Center for Financial Inclusion, an American think-tank — saw governance risk being ranked as low as 19 by non-lenders, and another three spots lower by lenders. If fintechs are not getting the message from Mint Road (or worse still, ignoring it), what explains this state of affairs, given the billions of dollars in private equity (PE) and venture capital (VC) money riding on them?

“The get-rich-quick attitude, and cutting corners when it comes to governance and ethics, will have to give way,” says Mandeep Maitra, chief executive officer (CEO) of M-Suite Leadership Consulting LLP, and former country head (human resources and corporate services) at HDFC Bank. “The path to building a sustainable business model is a hard one,” she adds, having played a major role in the hiring of top management personnel at the bank in its build-out phase.

Unlike legacy entities, the young and restless at fintechs, fuelled by PE and VC, did not have to face Mint Road’s scrutiny, and could play on regulatory arbitrage.

“Fintechs have a big role to play. But governance and profitability will be the narrative from here, not valuations alone,” says Rajnish Kumar, chairman of BharatPe (a payments app that serves offline retailers and businesses), and former chairman, State Bank of India. The days of admitting that profitability is unlikely any time soon and still being able to list on the bourses is over. Fintech boards will be under the microscope.

“Boards should play a critical role in setting the direction of the firm, to ensure it has the resources and support to succeed. Additionally, they may leverage their personal networks to help gain exposure and establish partnerships,” according to Uttam Nayak, former senior vice-president, Visa Direct (Central Europe, Middle East and Africa).

 

With the Securities and Exchange Board of India revisiting the listing norms for newbies, exit options for fintech promoters and their backers are narrowing. The investment climate has also turned cloudy. On top of Mint Road’s stress on governance and compliance, and changes to business models following an RBI working group’s Report on Digital Lending through Online Platforms and Mobile Apps, a funding squeeze is on as well.

Fintechs raised $5.65 billion in calendar 2022, a drop of 47 per cent over the preceding year, according to Tracxn, a platform that tracks start-up data. Late-stage funding, at $3.7 billion, fell 56 per cent in 2022; funds raised dropped by more than 30 per cent in each successive quarter of 2022; and the number of $100-million-plus rounds halved to 13.

The mood in the wider start-up world is sombre, too. According to EY’s PE/VC Agenda: India Trend Book 2023, PE and VC activity in calendar 2022 totalled $56.5 billion, a year-on-year (YoY) dip of 26 per cent; start-up deal-making, at $18.6 billion, was down YoY by 35 per cent. Add the fallout from the failures of Silicon Valley Bank and Signature Bank, and the shotgun marriage of Credit Suisse and UBS — to prevent the former from going over the brink — and the plot has turned.

The heat is on

At the Business Standard BFSI Summit in December last year, Deputy Governor T Rabi Sankar followed up on Das’ September remark with stronger words. “An unexpected regulatory challenge has been what one might characterise as compliance-aversion.” Legacy players understand that regulation serves the larger objective of systemic stability and development. But those outside of it are still learning to adapt. “Consequently, their initial reaction to regulation is objection. Ironically enough, the narrative created to justify such objection is usually customer inconvenience, even by industry bodies,” he added.

This inability to read the regulatory tea leaves, coupled with “compliance aversion”, has led to a stage where “hard questions are being asked of fintechs by their PE and VC backers,” says Saurabh Tripathi, global head (financial institutions practice) at the Boston Consulting Group. “They will have to embrace governance and compliance by design rather than be reactive, as it has an impact on the business model,” adds Tripathi. He expects fintechs to ready a “funding-winter wardrobe” as, along with tighter regulatory scrutiny, “excess liquidity in the system is drying up”.

And despite all the chatter that banks will have to tango with fintechs, it’s not going to be easy. “Our partnerships (with fintechs) are subject to rigorous standards and oversight,” points out Shyam Srinivasan, managing director and CEO of The Federal Bank. “It can’t be any other way, as it is the interests of the bank’s customers which have to be taken care of. If anything, such arrangements may have to pass stricter tests going ahead.”

Since September last year, the RBI top brass has delivered six speeches on fintech governance and compliance. In the most recent one, Deputy Governor M K Jain argued that fintechs should set up a self-regulatory organisation (SRO). “This approach can also help in the objective of protecting the interests of customers and promoting a high level of governance standards…The role of such an SRO can include setting the standards for conduct as well as acting as a bridge between the sector and regulators,” Jain observed.

It’s a maze out there

Fintechs appear to mirror the journey of non-banking financial companies (NBFCs) — from relatively light oversight in their infancy to the current scale-based regulatory framework. For fintechs too, regulatory arbitrage as a business model is dead (exemplified by the crackdown on pre-paid card issuers). Playing fast and loose with consumer data (Chinese apps), or a less-than-adequate quality of governance (BharatPe), are things of the past.

With systemic risks (say, on payments) and their speedy on-boarding of customers, fintechs of all genres will be on RBI’s radar like never before. That said, the setting up of a SRO may prove tricky, since there are fintechs of various hues, as is the case with NBFCs. The NBFCs’ SRO — the Finance Industry Development Council — even now cannot claim to speak for the entirety of this space. 

Yet another layer of complexity is that “the mandate of central banks globally did not envisage the issues they are facing with regard to fintechs on the horizon,” notes Ravi Duvvuru, partner at Duvvuru & Reddy LLP, and a member of the RBI’s second Regulatory Review Authority. Central banks can be stretched, too.

A standalone fintech regulator?

An International Monetary Fund paper, The Impact of Fintech on Central Bank Governance: Key Legal Issues, suggested in 2021 that the authorities could decide to appoint a deputy governor specifically to oversee fintechs, given the workload of other executives, and the need for a separation of functions. Will we see the emergence of a standalone fintech regulator in some jurisdiction?

This may be some time away, but connect the dots, and it’s clear that board-level oversight at fintechs will become critical. It raises a related issue: at a time when picking top-flight independent directors for private banks’ boards is proving difficult — a clutch of them had sounded Mint Road on their struggle on this front, and sought extended timelines to get suitable appointees — how are fintechs to tackle it?

“In reality PE and VC, for obvious reasons, exercise disproportionate influence. It’s the right time to drive more balance, with the role of directors being standardised to enable them to play an optimum role to support the company. Regulators have to define some of these standards,” points out Nayak.

Take Indifi Technologies, an online platform that provides loans to small businesses. It has P S Jayakumar (former MD and CEO of Bank of Baroda) and Tabassum Inamdar (former MD and co-head of India Research and Asian Financials at Goldman Sachs) on its board. Not many fintechs can rope in such marquee names. 

The firm’s co-founder and CEO, Alok Mittal, is clear that governance will be key from here on. “As for what you term an excessive stress on valuations, this was a conversation when money was plentiful. But, they are not to be ignored; they reflect your ability to get funded. The challenge is to move from a private market valuation to one that is in the public domain,” he explains.

Duvuuru has a suggestion: “I think there’s a case for insisting that investors in fintechs also stress the same kind of governance frameworks as exists in legacy entities.” And if the RBI were to go down this road, the stakes for PE firms will get even bigger.

Of the 21 recommendations accepted by the RBI from the 31 made by its Internal Working Group (IWG) on the extant ownership guidelines and structure for Indian private sector banks, its stance on non-promoter holdings in private banks is seen with excitement.

Though it doesn’t refer to PE firms explicitly, the RBI said non-promoter holdings in private banks will be capped at 10 per cent of the paid-up voting equity share capital in the case “of natural persons and non-financial institutions and entities”; and at “15 per cent for all categories of financial institutions, entities, supranational institutions, public sector undertakings, or the Government.”

While this is a modification of the IWG’s stance on the non-promoter holding in banks at up to 15 per cent, it does open up a huge window for PE firms all the same. What if RBI were to link their entry into these banks to the governance standards they enforced as investors in fintechs?

The switch to Fintech 2.0 has begun. And it’s set to become a whole lot more exciting.