Can India's neobanks challenge traditional lenders and transform an archaic industry?

A new wave of FinTech start-ups in India are tapping into the country's rapidly growing dependence on smartphones and demand for digital solutions by offering consumers and businesses the option to bank virtually.

“In today's day and age, as a consumer, I get everything on my phone: I get groceries, I get a cab, I get health care and I can make payments, so why shouldn't my money be available to me at my fingertips?” says Anuj Kacker, co-founder and chief executive of Freo, an India-based neobank that is aiming at a tech-savvy generation of white-collar workers.

The company's focus is on offering credit, which has helped Freo to grow rapidly since its launch in August last year to almost one million users.

Neobanks, which are 100 per cent digital and use apps and online platforms to support customers, have been mushrooming in the US, Europe, the Middle East and South-East Asia in recent years.

But India is only now catching up with the trend thanks to the country's surging digital dependence — and the potential is enormous, analysts say. The surge in demand has been fuelled by the pandemic, which has pushed people towards greater use of technology to avoid in-person contact.

The number of internet users in India is expected to rise to 900 million by 2025, up from 622 million in 2020, according to a report by the Internet and Mobile Association of India and Kantar. In 2017, there were 357 million internet users, which was just 27 per cent of the population, figures from Cisco show.

“Neobanking in India is fast gaining momentum,” says Shishir Mankad, managing partner and head of financial services at consultant Praxis Global Alliance. “While still at a nascent stage, India has already seen a rapid emergence of neobank players in the last two years.”

Currently, there are about 30 companies that are active in India's neobanking sector, according to Praxis.

Traditional banks are trapped in archaic — and more costly — ways of working, industry insiders say. While brick-and-mortar lenders have mobile apps and online banking, they are not purely digital and customers still need to visit branches for certain processes, they add.

Neobanks have positioned themselves as being more nimble and offer services that are either unavailable or not as accessible through traditional lenders, alongside regular banking options, Mr Mankad says.

However, neobanks are not eligible for banking licences under the Reserve Bank of India regulations, despite the competition with physical banks for customers.

Because neobanks in India do not have their own licences, they have to tie up with traditional banks, a business model that is followed by the majority of the sector globally. This means that neobanks can also offer regular banking services through their platforms.

However, these are, in fact, provided in the background by partner banks, analysts say.

“The bank is responsible for regulatory, compliance, cash reserve ratios,” says Mr Kacker. “But as a FinTech, I'm able to use all my strengths, which is product, tech, data, consumer, marketing.”

The main incentive for traditional banks to partner with neobanks is to bring in new customers, says Amit Jain, chief executive and co-founder of Ashika Wealth Management.

“In today’s India, with such a low cost of internet and mobile data and the young tech-savvy population, it is the most profitable association for both banks and their customers as it saves a lot of transaction costs for both,” Mr Jain says.

Neobanking is a sector that is “growing in India by leaps and bounds”, despite the challenge of having to depend on a partnership with a physical bank, he adds.

However, neobanking will not replace traditional banks any time soon, industry insiders say.

Despite Freo's wide range of services, it is generally not the “primary bank account” of customers, Mr Kacker says, adding that the company is positioning itself to be their “primary digital bank account”.

Open, a Bengaluru-based neobank, has positioned itself as a digital banking service for start-ups and small and medium-sized businesses.

The idea for Open came about because “business banking is broken for small businesses”, says Anish Achuthan, the neobank's co-founder and chief executive.

“They struggle a lot when it comes to tracking cash flows,” Mr Achuthan says. “They have to deal with multiple interfaces, like a banking interface, a separate interface for managing their accounting and another separate interface for managing their payments. That took away a lot of their time.”

Established in 2017, Open integrates these financial elements into one digital banking platform. It now has 2 million businesses in India signed up and processes $24 billion of annualised transactions, while it is still adding 100,000 new businesses a month, Mr Achuthan says.

“When we offer Open as a solution to the customer, there are a lot of non-banking components to it — for example, automated book-keeping or expense management,” he says. “These are not the forte of the banks basically, so that's why we believe [neobanks and traditional banks] won't cannibalise each other.”

The company has raised more than $100 million in investment to date, with Google, Visa and Singapore's Temasek among its investors.

“There's a lot of investment that has flowed into neobanks and we're seeing a lot of FinTechs now getting into neobanking,” says Mr Achuthan. “It's now really growing as a larger industry.”

Neobanks in India raised about $900m in investment last year, up 800 per cent over the previous year, figures compiled by RedSeer Consulting show.

But profitability for the neobank sector is still some way off, says Mr Achuthan.

“Like any other FinTech start-up right now, our focus rather than profitability is to continue to grow the customer base,” he says.

“Some of the services are offered free to the customers.”

Currently, neobanks generate revenue through commissions on customer acquisitions and various banking products, as well as transaction and service fees. But, unlike traditional banks, they are unable to lend out customers' money to generate revenue, says Mr Achuthan.

The industry also faces other major challenges, including “regulation, compliance, and fraud”, says Raghunandan G, founder of Zolve, a neobank that is aiming at Indians migrating to the US for banking solutions.

Zolve launched five months ago and has already signed up 300,000 customers on its platform, Mr Raghunandan says.

“Any fraud transactions would hit the bottom line significantly,” he says, adding that neobanks do not want to make the user experience too cumbersome with layers of restrictions, so they have “to walk a fine line”.

Regulation and licensing are the main issues holding back the sector's growth and profitability, Mr Mankad of Praxis Global Alliance says.

“While Indian neobanks continue their market penetration with more use cases and novel offerings amid a heavily contested space, their reliance on traditional banks due to RBI mandates, lack of physical presence and unlicensed status create certain bottlenecks to their unbridled growth,” he says.

While being purely digital is the essence and main selling point of neobanks, it is also a major challenge, according to S Anand, chief executive and co-founder of neobank PaySprint.

“Unlike traditional banks, neobanks don’t have a physical presence, so customers cannot literally walk into any branch for complaint resolution,” he says.

The other main roadblock is the fact that there are no RBI licences for neobanks, he adds.

There are, however, some promising signs for the industry in terms of potential regulatory developments.

In a November discussion paper on regulating the neobank industry, government public policy think tank the Observer Research Foundation offered a “template and road map for a digital bank licensing and regulatory regime for India”.

Meanwhile, finance minister Nirmala Sitharaman unveiled plans to set up 75 digital banking units across the country during India's annual budget presentation last Tuesday.

“In recent years, digital banking, digital payments and FinTech innovations have grown at a rapid pace in the country,” Ms Sitharaman said as she presented the budget to parliament. “Government is continuously encouraging these sectors to ensure that the benefits of digital banking reach every nook and corner of the country.”

There is hope that neobanks already operating in India will “be at the front of the queue” if the country does start issuing digital bank licences, says Freo's Mr Kacker.

“It's possible that we can be stand-alone entities, where we can become deposit-taking and allowed to take a portion of that money and lend it out to make money.”