RBI's Paradox: Customer Centricity at the cost of Innovation (#71)
Second-order effects of the sledgehammer approach, and the need for entrepreneur-led innovation
Welcome to the 71st issue of Unit Economics. In this article, I share my observations on how RBI’s well-intentioned regulations may have led to certain unintended second-order effects on the Fintech ecosystem. Dive in!
RBI’s payments vision is often a good indicator of its regulatory intent. In its vision for payments systems of 2025, it suggested five pillars that would underline any of its upcoming initiatives: integrity, inclusion, innovation, institutionalisation, and internationalisation.
The first three pillars have an extended application to lending, investments, and any other financial domain that the RBI statutorily mandates. The last two are more particular to initiatives related to e-payment systems.
The vision document also reinforces “customer centricity” as paramount in every initiative, while emphasising “financial stability” and “financial inclusion” as ever-important objectives. These, in brief, are central values to any regulation that the RBI introduces.
Now, to the extent of RBI’s first objective, i.e. strengthening the integrity and financial stability of the ecosystem, the central bank’s efforts have been as proactive as ever. For instance, the RBI’s enforcements of the last few years seem to have pre-empted and limited many large-scale systematic risks, including breach of data privacy, high losses on unsecured credit, inadequate KYC and AML protection, and mis-selling by aggregators, among others.
The intent of these regulations has been understandable, and largely appreciated by industry participants. But there is much to argue on the extreme sledgehammer-like approach of forcing these changes.
Take, for instance, the guidelines around recurring online transactions, which mandated all online merchants to store and process recurring card transactions differently. The intent to protect customers against unsolicited payments and card fraud is fair. Yet, the immediate impact the mandate had on online merchants is harder to justify and shows the limitations of the approach. Most international merchants (and customers) continue to be worse off for its presence even today.
Now, did the regulation reduce card fraud or unintended debits for customers? It likely did, as a direct consequence of introducing more friction in the customer experience.
But, do these benefits outweigh the additional costs to the ecosystem? I’d argue that they do not yet.
The same can potentially be said of the regulations on card tokenization, the restrictions on card data storage, the shutting down of credit on prepaid, and quite a few other recent policies. Each of these, though customer-centric in their intent, had limited guidance from the RBI on their implementation, introduced more complexity & costs for online merchants and fintech participants, and worsened the customer experience at each node. I would estimate that at least half of all such policies have been net-negative for the ecosystem in their 1-3 years of enforcement.
Now, many officials claim that these initiatives attack more structural problems and will benefit customers in the long term. This is not to be argued against. Anything that promises to improve financial safety for customers will (a) command a higher moral ground, and (b) see participants adapt their operations to the guidance at a long enough timeline until it becomes business-as-usual.
But in the guise of the “long term benefits”, the above argument quietly takes away RBI’s accountability from the short-to-medium-term costs on the ecosystem of this sledgehammer approach. It also seems to justify the lack of reviews post-implementation from the regulator and their let-them-figure-out attitude towards banks, NBFCs, and fintech companies.
In my experience, the approach has led to three unintended second-order effects that need notice.
1. Reduces customer welfare in the short term
The RBI’s approach to use a one-time broad brush to force regulations appears intentional. Time and again, we have seen regulations that distort entire segments at once, with no moderation and alternate for incumbents presented. Think of limits on FLDG, on the usage of UPI through a co-branding arrangement, or the loading of credit on prepaid instruments.
These have an immediate effect on the businesses offering these services, but equally on millions of customers, who are impacted in their experience and access to financial services. Without any discourse on the potential alternatives from the regulator, this leads to customers seeking the next-best (but inferior) alternative or adjusting to a new, broken development (say, with the mandated 2FA for all recurring ₹5K+ transactions).
There may be merit in exploring an implementation approach similar to that for technical or consumer products. Launch in phases, and with each phase, iterate and improve, before the 100% roll-out.
2. Disproportionately impacts the smaller merchants and companies
Economists have long accepted that “regulation tends to be biased against entry and competition”. The rationale is straightforward. An increase in regulation directly increases business costs. Naturally, with more capital and lobbying power, incumbents are better prepared to bear the costs or adapt more quickly to the compliances than the new entrants.
Now, the RBI treats merchants, fintech companies, and financial institutions of all sizes equally. This sounds noble on the surface. But it ends up indirectly burdening those smaller in size more disproportionately. With each regulation that increases the costs of compliance, unless the RBI intervenes to enable smaller competitors, the inequality of resources will lead to poorer outcomes for those more disadvantaged.
Take, for instance, the payment aggregator framework of Mar-20, which mandated payment gateways to take a PA license to onboard new customers. While incumbents like Razorpay and Cashfree had to pause onboardings until their license approvals, the regulation only benefits them in the long run by removing many smaller, less efficient competitors and by setting higher barriers for new entrants.
The same can be argued for card tokenization, where the smaller merchants are disproportionately disadvantaged due to higher customer friction and increased costs of tokenization. What would most customers do rather than re-enter a card number at a new merchant? Go back to the old, trusted merchant.
The argument is not that the RBI should not regulate. But rather to regulate with more consideration to the smaller actors.
3. Stifles innovation and inclusion in the long-term
We earlier saw that innovation and inclusion are two critical pillars of RBI’s policymaking. I argue that, paradoxically, while acting on the customer’s behalf, the RBI may be making the customers worse in the long term by limiting (a) the potential innovation and (b) efforts at financial inclusion from new entrants. Let me elaborate.
Joseph Schumpeter, in 1942, introduced the world to “Creative Destruction”, a theory that is seen as foundational to how capitalism operates. It suggests a continuous process of how disruptive technologies emerge from entrepreneurs and workers in new technologies, replacing the old-standing practices and the incumbents. When it was introduced, the theory talked more particularly about manufacturing, but it has since largely been accepted in how technology, in general, improves and evolves.
Fortunately, in India, the regulator has impressively led financial innovation, particularly in payment systems, and driven the adoption of the likes of RTGS, IMPS, and UPI in-masse. But note that the RBI cannot limit the opportunity for creative destruction to the regulators, since that would limit innovation to the knowledge and motivations of its think tank.
It needs the entrepreneur to disrupt. And the entrepreneur needs an environment where they can (a) innovate in good spirit, without the fear of the regulator, (b) access capital and partners for their endeavours, and (c) capture profits from building and distributing with new technology. Only then would an entrepreneur want to explore uncharted, riskier territories of financial inclusion or think outside the box of RBI circulars and notifications. Unfortunately, creating sandboxes here would not be sufficient.
For instance, think of Slice in its earlier form, which offered a credit-based prepaid card and bought millions of new-to-credit customers onboard. Slice could have done the same with a co-brand credit card, but each component of their operation, say credit approvals, KYC, or bank partnerships, would have cost them more. Or a Jai Kisan, who took credit to thousands of unserved farmers. If they were forced to adhere to a 5% FLDG limit, then they would find it unlikely to get NBFC or bank partners with the risk appetite to justify their business economics. Both, Slice and Jai Kisan, were net-positive for the broader financial ecosystem but both were negatively impacted by regulations.
Similarly imagine a Razorpay, which may have never been built with the $2Mn+ capital requirements that the RBI suggests today for payment aggregators. Or tens of UPI apps, which should have been but were never developed due to the zero-MDR rule. Who knows what we may be missing out on.
Enabling an Ecosystem for Entrepreneur-led innovation
Participants in Indian financial services are fortunate to have a well-intentioned and active regulator, but the approach of the regulator suggests that there may still be a long way before this could translate into an environment where regulations and commercials allow a SoFi, Revolut, Ramp, or a Starling to be imagined from India.
Unfortunately, an average entrepreneur in the Indian fintech ecosystem today faces an environment where innovation is seen as a business risk, accessing capital is challenging, and there are hardly any public or open soundboards with regulators. For the regulator as well, to imagine creative disruption, it is this entrepreneur who needs to be enabled. Not the incumbents, as the history has shown.
To enable an entrepreneur-led environment, I imagine that the following would help tremendously:
Official channels for continuous dialogue with the regulators, including on any draft regulations, implementation-related details, case-specific exemptions, post-implementation support, and licensing, among others
Phased and controlled roll-outs of regulations with select participants. This will allow more time to adjust for those less equipped, and will also allow polishing of the edge cases for a better eventual roll-out.
Technical papers and guidance from the RBI on matters of fund movement, KYC, new functionalities, and license-related test cases, among others. The present definitions often have vague interpretations. They also lead to a lot of duplication in communication, and long waits for implementation.
Enforce higher commercials on payment products as incentives for market entry and innovation. It may be better to balance the equation for service providers and merchants / customers than to be completely customer-centric. Also, if we don’t even ask, how would we know if they can pay or not?
Build a consortium for bank partnerships and a technical framework for bank integrations, particularly for co-branding arrangements. This would enable India to imagine a similar playground to the West, where hundreds of use-case-based co-branding arrangements exist simultaneously.
I hope these thoughts provide another perspective to industry participants and regulators and enables more efforts to protect the motivations of an Indian fintech entrepreneur.
If you have any views or want to casually chat on the topic, drop me a message here. Until next time!