Back to the drawing board: Fintech firms review their business models

Fintech firms will be under pressure to review their business models, even as early signs of a funding winter appear on the horizon

“The rise of fintech — lending platforms, open banking, payment apps — is a major source of disruption to the banking industry…Regulators need to ensure that non-bank entities lying outside the regulatory perimeter for 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 December 21, 2022.

Sankar also gave the clearest indicator so far on 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 fundamental point is that any entity providing banking services needs to be subject to similar regulation as banks.”

The message is: arbitrage as a revenue model is out; and scores of fintech firms will 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 — lower than the $10 billion in 2021.

Recent trends indicate that “the bulk of investments have gone into lending platforms, at nearly 40 per cent. There is also a revival of interest in wealth management and neo-banks”, says Alok Mittal, co-founder and chief executive officer of Indifi Technologies, a full-stack platform for enabling debt financing for small businesses.

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

It follows that businesses which appear to be fanciful will be a no-go area for investors; and the $1.6-billion fall in investments which the Bain & Company report highlights in calendar 2022 appears partly to suggest that you can’t play off the scaffolding of regulatory arbitrage. Recall the two game-changing RBI circulars issued last year: The first stipulated that prepaid instruments (PPI) are not to be funded through credit lines 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 hasn’t got the valuations that fintechs typically command. And people were telling me that I wasn’t clever enough. I am a systemically important NBFC (non-banking financial company), and can’t afford to do silly 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, maniacal re-bundling, a business-to-business leaning, and building high-margin sub-verticals”.

On September 20, 2022, RBI Governor Shaktikanta Das did some plain-speaking at the Global Fintech Festival in Mumbai: “The fintech road ahead will witness ever growing traffic, in addition to the large number of existing players who are already there. It is, therefore, imperative that every player on this road follows the traffic rules for his/her own safety and the safety of others.” 

This was a wake-up call for an industry in which 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 foisted by technology. The tone of some of the commentary even appeared to suggest that the management at some of the old-world firms were dense.

All manner of data and observations — from the bad-loan mountain, the huge unbanked hinterland, lack of understanding of new-age customers, and inability to leverage technology or data-mine — were bandied about to press home the case that legacy entities will have to cede space to the new genre of businesses.

But the writing on the wall was clear on November 18, 2021, when the central bank put out its Working Group’s (WG’s) Report on Digital Lending through Online Platforms and Mobile Apps. Its executive summary could not have been blunter.

The pandemic-led growth of digital lending had led to the unbridled extension of financial services to retail individuals, “susceptible to a host of conduct and governance issues”, it stated.  On a larger canvas, digital innovations along with the possible entry of Big Tech companies may alter the institutional role played by existing financial and regulated entities. Specifically, the “fallout of this may get reflected in blurring of regulated and unregulated financial institutions and activities. Such developments spurred by mere commercial considerations would pose regulatory challenges in ensuring monetary and financial stability and in protecting the interests of the customers”.

And the regulatory road map was made clear; it would play out at three levels — regulated entities of the RBI; other regulated and authorised entities; and unregulated entities, including third-party service providers functioning in the digital financial realm.

The fintech industry’s mistake was that it did not read the WG’s report alongside the measures the RBI took to improve the health of the financial sector — such as cutting out regulatory arbitrage between banks and NBFCs; tightening the governance code at private banks and urban co-operative banks; or, the fact that marquee names such as HDFC Bank, MasterCard International, American Express, and Diners Club International had over the past two years been at the receiving end of the RBI’s displeasure (though it’s back to business for them now). 

But a large swathe of fintechs, venture capital and private equity (PE) firms that have pumped in billions of dollars into these firms preferred to view many of the WG’s recommendations as symptomatic of lobbying by banks. Unrelated fault lines were spoken of. This lobby had earlier nixed the entry of NBFCs into the credit-card business despite the central bank’s enabling circular of July 7, 2004, which had merely set the net-owned funds floor at Rs 100 crore. There’s some truth to this, but it was not germane 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 the valuation and investment flow. “It has led to fintechs trying their best to extend cash runways as far as possible, to avoid seeking expensive external funding, and thereby, preserving their valuation.”

Take the RBI’s Payment Vision 2025 (June 17, 2022): It envisioned an increase in PPI transactions by 150 per cent. “But the banking regulator’s move to prohibit non-bank PPIs issuers 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 point: fintech fortunes can change in a jiffy.

The reality is that the fintech valuations game of the past is over — whether it is wallet companies or those mirroring instant-noodle makers in their approach to credit and servicing their audience. What nobody went into was why, among legacy entities, even the relatively better private banks took time to respond to the fintech challenge.

For one thing, they are tightly regulated; banks all the more so, as they are part of the payments settlements system; and as deposit-takers are custodians of public trust. For another, they do not have the privilege of playing off PE funding; and their shareholders are “more real” when it comes to valuations. Can anything justify the valuation given to firms that have, at best, only stripped a particular segment of the banking business to make a play off it?

It is time for most fintech firms to reboot.