Looking at the legal requirements for neobanks

In our previous blog post we discussed how to go about building your digital bank with particular emphasis on the target operating model, processes and activities, technology & systems, human resources, and implementation. In this post we look at the regulatory framework required to provide financial services.

Financial services are regulated in a variety of ways. For example, the scope of activities that banks can undertake is limited; there are capital requirements to lower risk; interest rate caps to protect customers; and reporting requirements for supervision and transparency.  All this regulation is designed to protect the stability of the economy, protect customers and achieve desired societal outcomes.

Before being able to provide financial services, therefore, one typically needs a financial licence of some form. Licences differ in the scope of permitted activities and requirements on the organisation and are typically issued by local regulators such as central banks and financial market supervisors as well as governmental bodies.

Regulatory frameworks and licensing requirements vary widely across jurisdictions and type of financial service. The choice of regulatory licensing depends on the value proposition and business model that was previously created.

Generally, licensing can be divided into (full, traditional) banking licences and (partial, lighter, modern) fintech licences.

Full banking licence

A banking licence allows a financial institution to accept customer deposits and issue loans using those customer funds. It allows for the broadest scope of services, but is also the most heavily regulated (note that only institutions with a banking licence may call themselves a ‘bank’).

A banking licence is issued by the competent regulatory authority, typically the central bank. The relevant authority will depend on the geographical location of incorporation and also the geographical markets you operate in.

These can include supranational regulators, such as the European Central Bank (ECB) in Europe or the Federal Reserve (Fed) in the United States, as well as local national bank regulators such as the Saudi Arabian Monetary Authority (SAMA) or Hong Kong Monetary Authority (HKMA).

A banking licence application can be a rather complex and costly option for a new digital bank. The benefit is that it allows for the broadest range of banking services to be provided, but this comes with higher regulatory and compliance obligations and often higher capital requirements.

The application process for a banking licence is also very lengthy and can take up to 15 months depending on the jurisdiction.

Fintech licence

The rise of financial technology companies in recent years has also brought a new wave of banking regulation. Many jurisdictions around the world are embracing innovation and facilitating the entrance of new digital players into their financial systems with lighter regulation, as a way of modernising their financial services landscape and enhancing competition.

As part of this regulatory approach, new types of financial service licences have been created. These are typically light versions of full banking licences designed to accommodate digital business models, allowing these institutions to offer banking-like services but at a lower regulatory and compliance threshold.

In December 2020 the Monetary Authority of Singapore (MAS) announced that a consortium comprising Grab Holding and Singapore Telecommunications, and an entity wholly-owned by internet platform Sea had been selected for licences to operate as a full digital bank.

Elsewhere, Bank Negara Malaysia (BNM) has set a deadline of 30 June 2021 for applications for its first round of digital banking licensing.

Fintech licences are often combined with regulatory sandboxes, which provide testing grounds for business models.

Other options include the European e-money licence (also called an EMI, electronic money institution or sometimes the ‘e-wallet’ licence), which supports payment services such as transfers and card transactions by means of a digital account or digital wallet, where the customer can hold funds in the account.

An EMI licence enables holders to provide the same customer banking experience for daily payments as a full banking licence. However, there are some limitations to EMI licensing.

Firstly, it does not allow for credit issuance, which is often an important revenue stream for banks. Secondly, an EMI cannot hold custody of the customer funds and must instead use a partner bank. Thirdly, an EMI may face limitations around the maximum amount customers can hold in their e-wallets and also certain transaction limits, depending on the level of due diligence/KYC conducted on the client.

An EMI licence can be a cost effective option for a new digital bank. The application process usually takes 6-12 months and legal fees range from €75,000-€150,000 for the regulatory licence application, with the average total cost to set up the whole organisation varying from €1-€2 million.

The partnership model

The above describes the generic regulatory framework for digital banks. However, start-ups and other organisations do not necessarily need to hold these licences themselves; they also have the option to operate white label under the auspices of a licensed financial institution.

This allows start-ups to establish themselves more easily and operate under a third party until they have reached sufficient scale to obtain their own licensing.

There are many players in the market that offer licensed financial services, for example for BIN sponsorship for payment cards, account management, and loan issuance. In fact, many neo banks operate a white label debit card and e-wallet or offer credit issuing delivered by third party institutions.

Depending on the commercial agreement and type of service, these typically require an initial set-up fee together with a monthly fee and/or fee per use.

The benefit of the partnership model is that it allows start-ups to circumvent the lengthy and complex licence application process and operate in a cost-efficient way before they have achieved scale. The downside is the dependence on the third party, with less flexibility and also less control and insight into money flows.

The business case for whether to work with a partner or to obtain your own licensing depends on your scale and timing.

Coming up

In the next – and final – blog post in this series we will look at how to run a digital bank, including how to use marketing to drive customer acquisition and managing the path to profitability.

How to successfully build a digital bank blog series