COVER STORY OF THE MONTH

APUL NAYYAR

Executive Director at Capital First. Responsible for SME and Retail Lending business.

Previously, he has worked in leadership positions across companies like India Infoline (IIFL), Merrill Lynch and Citigroup.

Qualified Chartered Accountant with 18+ years of experience in Financial Services

Thought Leadership Article by Apul Nayyar, Executive Director at Capital First
The views expressed in this article are personal and not necessarily that of the organization

Digitization and disruption have become synonymous with each other and the entire financial services industry is witnessing a transformation. The traditional fundamentals of the financial services industry are being challenged and new business models are emerging. However, key demand side and infrastructural challenges still remain in place which makes us ~3-5 years behind China.

If one looks at the trends, one will realize that the key reasons for an emergence of digital innovation in financial services are in the areas where customer friction is the highest and secondly all these innovations are on a cloud based model thereby bringing in scalability. The innovations are increasingly adopting a platform approach and streamlining of technology infrastructure. Disintermediation is a key theme of digitization in the financial services space with emerging fintech players offering solutions directly to the customers. Data is playing an important strategic role, with emerging innovations allowing for access to new data sets such as social data for new ways of understanding customers and markets.

Coming to the Indian market, there are several aspects one needs to consider before we attempt to understand how digital disruption will impact the Indian market.

Internet and Digital Banking Penetration (sources: BCG, estimates)

We currently lag in the adoption and penetration of internet and digital banking. However, the silver lining is that India has more than a billion mobile phone users with 15% penetration expected to increase to ~25% by 2018 (reference: “Credit Suisse, December 2015; BCG).

Most Indians access the internet through mobile. The internet infrastructure is very nascent and high speed broadband/ 3G/ 4G connections is still not available for large parts of this country. India has the largest digital identity database through ‘Aadhaar’ and is also one of the most sophisticated databases created with biometric identities. More than 1 billion population is registered on the database. This database is extremely useful and the regulator has been extremely forward looking, allowing financial institutions to utilize Aadhaar to conduct KYC using a completely digital mechanism – eKYC. eKYC can be conducted through biometric device or through an OTP. This enables a KYC processes to become extremely efficient, paperless and fraud proof. This is a right step by the regulator and we expect a wider coverage on ticket size and validity for longer tenures for eKYC through OTP.

As we looked at the demand side of the dynamics, let us now briefly touch upon the supply side mechanics. A key development which is common across the entire industry is the increased focus on customer centricity. The traditional product centric approach is no longer relevant and companies are now moving to the customer centric approach. Majority of the customers are now moving towards using mobile – companies would need to implement a digital first/ mobile first strategy.

Here is a summary, of the impact of digital disruption in financial services across sub-sectors:

1. Payments

Payments space has been one of the first sectors to witness digital innovation. If we look at the RBI Payments and Settlement Indicators data, we find that adoption of prepaid instruments is higher than mobile banking.

Table: Number of transactions (source: RBI)

Transactions on prepaid instruments are nearly 1.9x of mobile banking transactions. There are a number of Indian companies leading the entire payments revolution by helping customers shift their transactions from banking channels to payment platforms. The eco-system has seen a dramatic change with availability of easy to use apps, better interfaces, smarter integration with merchants through APIs. Bigger e-wallet providers have created a strong interlinked consumption-merchant ecosystem. Number of e-wallets in India estimates would be upwards of 150 – 200 ml. as compared to 24.5 ml. credit cards in India. However, with the recent launch of the Unified Payments Interface (UPI), we will see a much larger transformation in the way India makes payments.

Digitization of the NACH/ ECS mandates would be a key step forward in the payments ecosystem enabling the lenders to collect payments digitally from the customers. The key challenge for lenders is the inability to enforce digital repayment NACH mandate which is covered under the Negotiable Instruments Act, 1881.

2. Investments (savings and personal financial management)

Traditional banking channels for investments and other third party products are getting challenged by new age digital platforms offering better interfaces, strong and easy to use analytics, customized advisory and lower costs. The technology based applications evaluate the cash flows; understand the investment goals and by using AI and machine learning algorithms help the customers make better investment and savings decisions. The process has already become seamless with some of the new fintech investment and personal financial management players in India – demat account opening happens in a few minutes without any paper document through eKYC and e-Sign; based on your investment goals and risk appetite the website will direct you towards investment ideas and can directly help you invest in mutual funds and also enable you to purchase insurance online. It provides you advisory on portfolio performance, your peer rank and what actions could be additionally taken to optimize returns.

3. Financing (credit/ lending)

The financing industry is also undergoing an interesting digital change. We see that while customers may have lower interest rates for consideration but speed, transparency, access over multiple channels and responsive customer service have become very important. The traditional physical channels are getting challenged and a web/ mobile first strategy is becoming paramount. Also, one key development is in the area of risk appraisal is using AI and machine learning to analyse additional alternative information available on the customer. These models are still under testing phase by the companies in the market.

From a channel perspective – physical channels will get augmented by digital channels and a hybrid structure will exist. Physical channels will not get eliminated; however their productivity will improve aided by digital channels. Many fintech start-ups have emerged in niche spaces and we will possibly see a consolidation amongst them.

VC Fintech Investments (Sources: KPMG, estimates):

The traditionally dominant sectors such as payments and lending are seeing saturation and deals and investments have slowed in these areas. Blockchain technologies globally have seen a high interest from the investors. Going forward, there is a rising interest in the technology enabler space with AI expected to emerge as a key area of investment. In India, we see an emergence of several fintech start-ups in the lending space which will be the major focus of investments in near future.

Networked Digital World and the impact of Blockchain:

One of the biggest advantages in the digitized world is the creation of the network economy. Devices getting interconnected with each other have the potential to break the requirement of a Third Party centralized authority, to a whole network authorizing and clearing the transactions. This is the foundational basis of a distributed ledger system. One of the key structures for a distributed ledger systems is the blockchain technology. Blockchain decentralizes the entire transaction flow which can potentially disrupt the current structure of the financial services industry if adopted rightly. Blockchain offers unforgeable record of identity, payments history, supply chain transactions and can also help in creation of a core banking system.

Consider the classic case of payments. Currently the payments infrastructure has a centralized clearing house and is essential to authorize and clear the funds. The banks need to be members with the clearing house to receive and transfer payments. It is currently a complicated process with many failure rates. Consider a decentralized model, wherein a centralized clearing house is not present and all the banks are connected to each other as peer to peer nodes. All the banks are members of the same blockchain network. When a payment transaction is initiated, the transaction is recorded on the network as a “block”. The network of nodes then verifies the transaction “block” by running the algorithms. If the block is verified, then it is added to the existing chain of such “blocks” and is now recorded in the ledger. The recording of blocks is immutable and transparent. Hence, there is a high level of security feature already built in. The underlying infrastructure for the blockchain is the internet and there is no requirement of other banking infrastructure. The ability to scale by simply using the internet and requirement of very little investment and allowing for direct connectivity between the nodes helps the blockchain to provide higher speed and lower costs.

Similar applications can be for supply chain finance – the invoice discounted becomes the transaction “block”. Once a bank approves an invoice over the blockchain network, no other financier will be able to finance it again helping prevent frauds if the borrower approaches another bank on the network for financing against the same invoice.

One of the biggest use cases for blockchain is at an infrastructure level for KYC. If the financial services participants are all brought on the blockchain infrastructure with each identity document serving as a “token”, every KYC submission or pull is a transaction getting recorded as a “block” and stored on the network and can be retrieved by another bank when the same customer approaches them. The entire KYC history of customer will also be available helping in weeding out frauds in the process.

Blockchain can also potentially help in digitization of land and property records. Blockchains can be considered for creation of official registry for land or housing or other assets. It will create each land record or a housing ownership record and register it on the network as a “token” recorded on the distributed ledger. Once a new transaction occurs for transfer for title then the transaction will get recorded as a “block” on the blockchain and the entire history of the property can be followed on the blockchain.

To conclude, blockchain has multiple applications in the financial services industry from KYC to supply chain finance to payments. It is highly versatile and requires the financial institutions to jointly participate on a common network of nodes.

Regulations in the digital financial services

The regulator has been extremely forward looking and has taken right steps to enable digital initiatives for the financial services participants. In 2016, the RBI set up an inter-regulatory Working Group to study the entire gamut of regulatory issues relating to FinTech and Digital Banking in India. One of the key areas where the Group will contribute is to help broaden and strengthen the regulatory framework to help in enhancing fintech opportunities in India while managing the evolving risk aspects.

Some key considerations across the industry:

1. Payments:

The RBI has allowed for the “pre-paid instrument” issuers to participate in the payment execution and settlement activity which was restricted to traditional banks by giving in principle approval for 11 payments bank licenses. These specialized banks are expected to leverage heavily on technology to provide niche services in the areas of payments and demand deposits and particularly to help in financial inclusion.

2. Investments:

Personal financial management (PFM) applications typically aggregate the customer accounts to create a unified view for the customer. The RBI is considering issuing guidelines for these “account aggregators” and has proposed for them to be registered as Non-Banking Financial Companies (NBFCs). Thus, the current PFM players may have to invest for compliance with the RBI requirements.

3. Financing:

The RBI last year put up a consultation paper on P2P lending service providers. The RBI is contemplating of regulating these p2p marketplaces as NBFCs to have a larger oversight. The consultation paper actually helped clear significant uncertainty in the market; however, it is yet to be seen if there would be additional compliance cost for these marketplaces.

The regulator has been progressive and has allowed for eKYC through OTP. However for lenders, it is restricted for ticket sizes up to INR 60,000 and can be availed only once. We expect the regulator to consider opening up to higher ticket sizes and for multiple applications.

Currently, a key challenge in the repayments is unavailability of a digital NACH/ ECS instrument which is also enforceable under the Negotiable Instruments Act, 1881. We are given to understand there is some development on this front and digital NACH is expected to be in the market soon.

There is a whole set of companies focusing on regulatory technology – called as “regtechs” helping financial services players to manage regulatory requirements using technology. For example – technology companies are now offering specialized services to assess identity and fraud on a real time basis enabling KYC and AML norms to be met in a much more efficient way.

Customer Centricity and Customer engagement in the digitized world

Customer engagement is rapidly getting redefined in the digitized new world. There is a huge amount of customer data getting analysed real time helping companies to customize their interactions at a micro level to provide additional value to the customer at each touch-point. The industry has witnessed a transformation from a product led approach to a customer centric approach. The industry has moved from inflexible and rigid bank-led products to flexible, customizable solutions for the customers.

Seamless customer experience across channels, touch-points and products is now a reality and a requirement of the customers. Key developments that organizations are seeing are

• Availability across all channels – physical, web, mobile and seamless experience across all these channels
• Enabling single view of the customer across channels – helps in better resolution of customer queries and better cross sell/ upsell
• Usage of social media for customer support
• Rapid data analytics with AI and machine learning to create predictive models to enable higher retention, higher cross sell and an overall higher value addition for the customer
• 24×7 service and customer resolutions instantly or within an hour
• Experimentation with AI and machine learning “chatbots” to create a gamified customer engagement
• Micro level customization for each customer becoming possible through micro-sites and their past transaction data

Companies are intimately analysing the customer journey and are constantly finding ways to improve and enhance their customer experience. A digital and a networked world offers the companies the ways and means to create stellar customer experiences.

Concluding Remarks
The Indian market is driving towards increasing digital penetration. We are progressing rapidly aided by a strong demand side factors, favourable regulations and a strong focus by the financial institutions on customer centricity. A few key challenges once resolved by the regulator will widen the scope and applicability of technology for the industry helping in financial inclusion. To conclude, digital is actually enabling the financial institutions manage the emerging needs and helping comply with the regulations in a much more efficient manner.