While much of the country, particularly prime-time TV anchors and politicians, was hooked to the issue of the central bank’s independence and its possible impact, another major development took shape last Friday: the State Bank of Pakistan (SBP) unveiled the Digital Bank Regulatory Framework draft. It lays out the regulations and procedures by which challenger banks will come into being and function.

Over the past few years, we have seen a number of regulatory regimes introduced, with the aim of promoting digital financial services. So some people might get confused. Let’s try to make that clear. First came the Payment Service Operator/Provider rules, which enabled routing, clearing and processing of electronic transactions and included entities like 1LINK.

Then the Electronic Money Institutions (EMI) Regulations were brought in, eliminating fintech players’ dependence on banks for the distribution of e-money. However, their mandate was still limitedand they had to turn to those financial institutions often for settlement. Currently, none of the entities with approval has commercially launched yet. With the latest policy draft, a proper full-stack digital bank capable of lending and investing is being envisioned.

In fact, the draft document lays out a plan for EMIs to transition to a digital bank and requires at least one year of delivering digital financial services. Other possible sponsors can be existing local or international development finance institutions (DFIs)/microfinance banks (MFBs) with their eligibility criteria specified.

Under the draft policy, a digital retail bank will be allowed to deal with retail customers while a digital full bank can offer services to corporate and commercial clients as well

Under the draft policy, the SBP identifies two categories: digital retail bank (DRB) and digital full bank (DFB). As the name suggests, the former will be allowed to deal with retail customers while the latter can offer services across segments, including corporate, commercial and retail. Both, in turn, can either be conventional or Islamic.

Similar to the previous SBP regulations with respect to fintechs, there is a phased process that begins with the submission of relevant documentation and a Rs4 million non-refundable deposit as processing fee, accompanied with a feasibility study and sponsors’ financial strength.

A possibly interesting pointer here is that: “A reliance on undue subsidies or financial incentives from the group that creates an unsustainable quicker path to profitability shall be discouraged.” Appreciation for sound unit economics aside, challenger banks around the world aren’t exactly known for this. Their modus operandi revolves around raising huge rounds and burning cash aggressively in order to carve a market share for themselves.

Moving on, once a Fit and Proper Test is done and a no-objection certificate given for the incorporation of a public limited company with the Securities and Exchange Commission of Pakistan, the fintech can apply for in-principle approval from the SBP. After that come the pilot operations stipulated for at least a three-month period. Once all of these stages are done and the regulator satisfied, the applicant may finally go for a commercial launch.

The proposed policy also lays out the structure and competencies of the board, which should have seven members, including at least one woman, have experience in providing DFS and knowledge of emerging technologies among other things.

As for the minimum capital requirements, the draft suggests a floor that progresses as an entity moves from licensing to commercial launch as well as the subsequent three years. For a DRB, at least Rs1.5 billion is needed at the first stage. It increases to Rs2bn at the time of commercial rollout, Rs2.5bn a year after that, Rs3bn in the second year and Rs4bn in third — a period defined as the transition phase during which the sponsors will be barred to dispose of their shares.

On the other hand, a DFB needs to have at least Rs6.5bn for the pilot/licensing phase, Rs8bn a year after commercial launch and Rs10bn in the second year — having a two-year progression phase instead of three. At the conclusion of that period, they are required to be listed on the Pakistan Stock Exchange unless a subsidy of a traditional bank. Similarly, there are capital adequacy as well as advances-to-deposits requirements specified for each type.

It remains to be seen how big of a challenge meeting these funding needs will be, considering the ticket size of investments into local fintechs. The biggest round raised by anyone in the sector is Finja’s $9 million, which translates into Rs1.44bn even at a Rs160 exchange rate. Obviously, startups are progressively raising more capital at every stage now and that trend is only growing. But remember, these are the minimum requirements. For the smooth functioning of the entity and its growth — which should be based on lending instead of investing in risk-free assets — a lot more money will be needed. This isn’t to even remotely suggest that the capital requirements are high or not, as it’s a full-stack digital bank with customers’ deposits involved. So erring on the higher side is always wiser.

Banks on the other hand should theoretically have little trouble in arranging these sums. But again, if they were really interested in lending, they could have done it decades ago. Expecting them to change their rent-seeking modus operandi of feeding off government securities to actually making some effort and lending to customers without a recorded risk profile is like living in a fool’s paradise. Existing DFIs might still go for the approval and use any opportunity at every conference about being a tech company with a banking licence. My heart sinks at this thought.

All said and done, it will take a few years for us to see any impact of this regulation which, by the way, took two years to get to the current draft stage and might drag on here for God knows how long. Till then, enjoy going to the torture that your bank is.

Published in Dawn, The Business and Finance Weekly, March 29th, 2021