Digital Banks: optimising focus on financial inclusion and innovation

The Licensing and Regulatory Framework for Digital Banks unveiled by the State Bank of Pakistan (SBP) in January 2022 not only heralds afirm resolution by the central bank to shake up Pakistan’s banking industry, it does so while reinforcingits commitment to several objectives already being pursued, including the promotion of digital financial services, financial inclusion, and increased competitiveness in and innovation by the financial industry.

The first of the salient features supporting these objectives include the distinction between the two types of licenses — the Digital Retail Bank (DRB) license and the Digital Full Bank (DFB) license, without the compulsion to transition from the former to the latter license.

While the DRB license may be viewed as a limiting option as it allows the incumbent to only service retail customer segments excluding corporate and commercial, with less than half the minimum capital requirement (MCR of Rs4 billion) compared with what is required for commercial banks and the DFB license (MCR Rs10 billion), it is a significant opportunity for license takers to focus on segments previously not catered to successfully by the financial and banking industry.

Much like the MFI Ordinance which ringfenced service provision to a particular client segment, this focus on niche segments, it is hoped, will propel license takers to break new ground in terms of customer segments, models and products and services.

Experience in other countries demonstrates the ability of digital banks to penetrate certain segments more successfully than the incumbent banks—in the UK 18–21-year-olds constitute 26% of the customer age mix, compared to 12% for traditional banks; in India it is 31% compared to 7%. Similarly, Hello Bank by BNP Paribas, Ila Bank in Bahrain and TNEX in Vietnam have penetrated non-core client segments of banks including the youth, low-income individuals and Micro Small and Medium Enterprises (MSMEs).

This is a vital consideration in Pakistan given that agri lending is 3-4%, SME financing is 6-7% and consumer loans 5-6%of overall private sector lending.

A second feature is the varied pool of sponsors eligible to apply independently and/or in collaboration for the license—local and international commercial banks, international digital financial services entities, microfinance banks (MFBs), and EMIs. This pool has been significantly expanded from what was envisioned when the draft framework was unveiled in February 2021, signaling the SBP’s openness to exploring a healthy variety of models and approachesto meet the objectives of the regulation.

In Singapore, Malaysia and Hong Kong, where digital bank licenses were recently awarded, the applicant mixwas extensive including banks, platform service providers, fintechs, telecom service providers, and even an airline company and a media house.

Reportedly, the interest Pakistan’s framework has generated, globally, could result in north of 20 applications in this first round, and it can be expected that traditional banks will not be the only recipients of the license.

A third feature is the emphasis on a digital-only entity, with a requirement to phase out any smart branches within seven years of starting operations. This requirement will not only reduce the brick-and-mortar footprint of the financial services industry reducing the end price for consumers, but also push incumbents to use artificial intelligence and big data analysis, and give much-needed attention to the client experience and product offerings.

According to research by Price Waterhouse Coopers, Pakistan, the average cost of customer acquisition and servicing for digital banks is 5-15% that of traditional banks. In China, Mybank is estimated to have a per transaction cost of 0.15% of traditional banks, while WeBank’soperating cost per account is estimated at 3 RNB compared to 20-100 RNB for traditional banks. Birthing digital-only entities in Pakistan’s banking industry, which will operate purely on digital platforms, are expected to yield benefits such as real-time updates, quicker account approval times, quick investing services and personalisation.

Moreover, as the digital bank cadre grows, traditional banks in Pakistan will have to catch up with the competition. This was witnessed on a significant scale in China after the entry of digital banks in 2013.

And finally, by carving out digital banks as a separate cadre, these entities will have no choice but to live, breathe and sleep digital banking, rather than running boutique units patching into legacy technology infrastructure built fora brick-and-mortar model of outreach. While SBP issued the Branchless Banking Regulations in 2008, which have also undergone several iterations, and are now supported with additional regulations, guidelines and large infrastructure undertakings such as regulations for the digital onboarding of clients and merchants, cloud policy, and the instant retail payment system infrastructure, RAAST, digital transformation of the banking industry has fallen short of expectations.

Even the microfinance industry continues to rely primarily on a physical model of outreach. In short, theseentities will receive the focused attention and governance steer required to grow into Pakistan’s large market offering.

The SBP has announced that five digital bank licenses will be issued. While this is broadly in line with the number of licenses issued in countries with a bespoke digital bank licensing regime—Singapore has issued four licenses out of 14 applications, Malaysia six against 29 applications, and Hong Kong eight—the SBP may consider expanding this number to eight for the following reasons:i). During the pilot and transition phases there could be exits; ii). Given the larger mix of sponsors that are allowed to seek this license, the SBP may want to expand the pool of incumbents that will be granted licenses in order to have a larger number of test cases to learn from; and iii). The timeline for re-opening applications is longer than three years.

In the run up to the March 2022 deadline for applications, it is not yet certain what the split between DRB and DFB license awards will be. However, to ensure adherence to and maximize achievement of the underlying objectives stated in the framework, it is hoped the balance will be in favor of the DRB license.

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