RBI signals greater scrutiny of fintech industry amid funding drought

Financial technology firms (fintechs) are among the fastest growing sector of the financial services sector. But their regulation has long been a source of uncertainty. In January 2022, the Reserve Bank of India (RBI) set up a fintech department, indicating the newbies are to be mainstreamed; they will have to fall in line like legacy regulated entities (REs) such as banks and non-bank financial companies.

Even so, it’s long been whispered that fintechs are yet to get the full import of what it’s like to live under the RBI’s watch. Last week, Reserve Bank of India (RBI) Deputy Governor, T Rabi Sankar, speaking at an event in Bengaluru on “RBI & Fintech: The Road Ahead”, suggested that things may change for fintechs. He underlined that financial services are one of the most regulated industries, if not the most regulated, because they are key to growth and development, involve public money and are the conduit through which financial integrity is enforced. In that context, he suggested that “Fintech firms should… be subject to similar regulatory oversight”.

This signal from the central bank should come as no surprise. A survey by the Fintech Association for Consumer Empowerment — in collaboration with the Center for Financial Inclusion — saw respondents accord very low priority to governance risks. Defined as “weakness at the board level leading to poor oversight and control”, it was ranked 19th by non-lenders and 22nd by lenders.

The survey argued the responses came in at a time when other factors were top of mind, “which could explain the lower ranking.” It didn’t flesh out what these “other factors” were.

The survey (titled “Fintech Lending Risk Barometer 2022-2023: Understanding the Perception of Risks in the Fintech Lending Sector”) was conducted in November 2022 — a mere two months after governor Shaktikanta Das voiced his concerns about the industry at the Global Fintech Festival in Mumbai. “We would expect the ecosystem to pay attention to governance, business conduct, regulatory compliance and risk-mitigation frameworks.”

A year earlier the executive summary of the RBI Working Group’s “Report on Digital Lending through Online Platforms and Mobile Apps” (November 2021) singled out the explosion of digital lending during the pandemic -- leading to an unbridled extension of financial services to retail individuals --  as “susceptible to a host of conduct and governance issues”. And digital innovations along with the possible entry of Big-Tech may alter the institutional role played by existing financial and REs, such as banks and non-bank finance companies.

That fintechs may not be getting the governance message is evident. Speaking at the <i> Business Standard <p> BFSI summit in Mumbai (21 December 2022), deputy governor Sankar used strong words. He referred to an “unexpected regulatory challenge that one may characterise as compliance-aversion.” Financial entities traditionally subject to regulation understand that it serves the larger objective of systemic stability and development; but “those outside this space are still learning to adapt to a regulated environment, and so their initial reaction to a regulation is to object.”

So, what would it take to fall in line?

Fintechs will need to devote their attention to governance, compliance, business conduct, and adopting risk mitigation practices for long-term business stability. This mirrors what Das conveyed at the twin town halls of the full boards of state-run and private banks in New Delhi and Mumbai in the last week of May.

What is clear is that the governance stakes are getting higher for fintechs. Data from Tracxn shows that fund-raises by fintechs in calendar 2022 at $5.65 billion, was a drop of 47 per cent over the year; late-stage funding at $3.7 billion, a fall of 56 per cent. There was a slide of more than 30 per cent in each quarter of 2022, and the number of $100-million-plus rounds halved to 13.

To be sure, this is part of the general funding freeze for start-ups worldwide. But it could get worse. Funding in the Indian start-up ecosystem in H1FY23 at $5.5 billion is a fall of 24 per cent over the year, and a staggering 72 per cent drop compared to H1FY22. And unlike India Inc, fintechs have to reckon with Mint Road – regulatory compliance and governance standards are in a different league.

As Naveen Surya (chairman of the Fintech Convergence Council, and chairman-emeritus, of the Payments Council of India), and Nilesh Naker (partner in financial services technology at EY India) wrote in a report on “Trends Shaping India’s Fintech Sector’ (September 2022), it is imperative for fintechs to closely monitor regulatory, compliance, and governance risks, because “compliance is costly, but non-compliance is costlier.”

Mint Road recently put an end to existing first-loss default guarantees (FLDGs) — financial buffers offered by unregulated fintechs to REs on loans originated by the former; they are to be capped at 5 per cent of such exposures. This has been done to arrest the tendency of REs being less stringent when underwriting credit, taking comfort from the FLDGs.

For finetchs, clever collaboration arrangements will now be a thing of the past. And gloating over valuation (entirely in the private space at that) will no longer be enough. As Sankar put it: “While focus on short-term valuation gains may look attractive, creating long-term value should be the basic goal.”