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 is one of the most heavily regulated sectors of the global economy. Since the 2008 global financial crisis in particular, regulators have implemented a wide range of directives designed to improve the security of customers’ deposits and minimise the potential for bank failure and the destabilising effect this has on the wider economy.
This translates into a number of key requirements for providers of banking services, such as limiting the range of activities they can undertake; requiring them to hold sizeable amounts of capital; and limiting the interest they can charge to ensure customers are not paying punitive rates.
A digital bank can have all the other elements of its business model in place, but without the appropriate banking licence it will be unable to offer its services to consumers or business customers.
Inevitably, licencing requirements are different in each market. The three main types of organisation tasked with licensing banks are central banks, financial market supervisory bodies, and governmental bodies.
We can divide the types of licence into two – the full or traditional banking licence; and the partial or lighter fintech licence. The type of licence required in each case will depend on the value proposition and business model, which we discussed in previous blogs.
The Bank of England’s Prudential Regulation Authority notes that technically there is no such thing as a ‘banking licence’. For example, in the UK bank will have Part 4A permission (referring to the relevant provisions of the Financial Services and Markets Act 2000) to carry on the regulated activity of accepting deposits and it is this permission which is often termed a banking licence.
Regardless of the terminology, banks must be licensed in order to offer services such as customer deposits and loans using customer funds. The type of permission outlined above enables the authorised party to offer the widest range of services, but will also come with the most onerous compliance terms.
In the UK licensing is the responsibility of the Bank of England and in most jurisdictions the competent regulatory authority will be the central bank. In some cases the national bank regulator will have responsibility for licensing, as is the case with the Saudi Arabian Monetary Authority (SAMA) or the Hong Kong Monetary Authority (HKMA).
There are also regulatory bodies that operate across multiple jurisdictions, as we see in Europe with the European Central Bank or ECB.
Regardless of how licensing is overseen, start-up digital banking entities need to be aware that the application process can be both lengthy and expensive. Completing the process may enable them to offer a wider range of services, but this brings with it increased regulatory and compliance obligations and in many cases the need to hold higher levels of capital.
The time taken to complete a licensing application will depend on the body to which the application is made, but it is not uncommon for the process to take up to 15 months.
As the banking industry evolves, so does regulation. The emergence of financial technology companies has demanded that regulators find a way of limiting the activities of these companies without stifling competition.
In November 2020 the Philippine central bank Bangko Sentral ng Pilipinas (BSP) announced its rules for the establishment and licensing of digital banks, stating that it expected at least half of all payments to be made digitally within three years. Tonik was the first pure-play digital bank to confirm its plans to offer licensed services in the Philippines.
The bank’s governor described digital banks as ‘additional partners in further promoting market efficiencies and expanding access of Filipinos to a broad range of financial services’.
A parallel development is the emergence of regulatory sandboxes, where fintech companies have the opportunity to develop and test services without fear of enforcement action or regulatory fines.
One licensing option for fintechs is to pursue a European e-money licence. Holders of this licence are able to offer payment services such as transfers and card transactions by means of a digital account or digital wallet.
In the EU, apart from credit institutions, post giro institutions and (under certain conditions) national and local public competent authorities, only e-money institutions that are licenced are allowed to issue e-money. Member states are obliged to keep a public register of all authorised e-money institutions.
Limitations on holders of e-money licences include the inability to issue credit or hold custody of customers’ funds. There may also be restrictions on the size of transactions and the maximum amount customers of these entities can hold in their e-wallets.
The attraction is that such licences can be secured within six months and total set-up costs could be as low as €1 million.
Digital banks that don’t hold a licence can operate under the auspices of a licensed third party until they are in a position to obtain their own licence. It is quite common for neo banks to offer ‘white label’ debit cards/e-wallet or have their credit issuing delivered by third party institutions.
This approach enables start-ups to get up and running without going through the licensing process, although they will be heavily dependent on the white label provider and have less visibility of money flows.
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.