Pakistan-based fintech startup Sadapay raised $10.7 million ahead of its mass rollout — making it the country’s most-funded fintech in the past five years.

With the neobanking system sprouting up across the globe, Pakistan too has recently steered towards this emerging form of banking. As opposed to traditional banking, neobanking is solely grounded in an online presence — it has no physical branches — and partially mimics existing digital banks’ operations.

Its potential to parallel traditional banking is primarily inspired by the former’s scope for significant digital innovation enabling seamless digital customer banking experiences.

However, one of the reasons why neobanks are still in a nascent phase as opposed to the traditional brick-and-mortar banking structures is their limited capacity in terms of the product and service range they can provide as per regulations.

While the caution shown by Pakistani regulators is understandable, the sector should not be completely strangled in the name of consumer protection

While neobanks are restricted to savings accounts, payments services and money transfer facilities, physical and digital banks extend a multitude of services including the former but also not limited to investment services, credit services and financial advice.

Nevertheless, neobanks are still gaining momentum, as their lower costs and greater transparency against that of traditional banks compensates for their limited service range. By leveraging technology and AI, they offer low-cost and secure personalised services to customers and so bridge the gap between traditional banks or digital banking, by-products of traditional banks, and customer expectations.

This rationale has thus broken new ground for new market players such as TAG, Finja, Sadapay and Nayapay, which are now swiftly offering innovative technology driven financial solutions to their customers. Coming to the current legal landscape in Pakistan, the main license that governs is the Electronic Money Institutions (EMI) License.

Under this license, an EMI is empowered to take and route e-money; lending, paying interest, investing the funds, or any other sort of speculative activity is explicitly barred. Further, there are multiple compliance requirements that EMIs have to adhere to.

First, at a C-suite level, the upper management has to comply with the Fit & Proper Test of character, which sets the standard too high for a nascent founder, because if they have been “subject to any adverse finding in civil and or criminal proceedings”, they will be barred from operating a neobank.

Second, the C-suite must have an “impeccable track record” in their previous companies, including no removal as an employee or director in a previous company; such a record is hard to prove for first-time, young founders.

Third, from a capital standpoint, an entity wanting to be an EMI must have a minimum ongoing capital of Rs200 million at all times, and 10 per cent of this capital shall be stored with the State Bank (SBP) as a security deposit.

Fourth, from an operations standpoint, clause 16 of the EMI regulations compels all espousing EMIs to have an interoperable rails network with other banks and payment service providers. It also allows the SBP to have full oversight over any agents that an EMI may employ, including having an unfettered veto to compel an EMI to terminate relationships with an agent. Unsurprisingly, these requirements create multiple challenges from a fintech-enablement and industry development perspective.

In terms of systemic challenges, because the license does not allow the neobank to lend or invest, except 50pc of the outstanding funds, and those too specifically in government bonds, there are very few revenue-earning opportunities for the fintech player. They are forced to capture revenue simply through Interchange Fees (IFS) with the merchant, which is split between the neobank, and the payment provider (Mastercard, Visa, PayPak, UnionPay).

In essence, this means a lack of diversification in terms of revenue stream, shaky cash flow, and constant dependence on raising external funds and diluting shareholder equity. This is also not commercially viable because from a profitability standpoint, it’s very difficult for neo-banks to scale to a level where simply the IFS can help them break even against the massive tech, talent and maintenance cost of running the neobank.

For customers, this creates an enablement challenge because they have very little access to e-money products beyond a simple digital wallet. The EMI License restricts customers to a maximum of Rs10,000 cash withdrawal per day, and an in-bound credit limit of Rs 200,000, creating a class of customers who can use neobanks but not fully explore its potential offerings.

Ultimately, the regulations force neobanks to compete with traditional banks, who have an entire suite of offerings, but with a product that is inherently very inferior and preliminary to that of traditional banks.

Globally, regulatory regimes have adopted one of the two broad approaches: sticking to traditional banking licenses or introducing dedicated digital licenses, with Pakistan clearly falling in the latter. Regardless of the approach followed, countries have continued to integrate innovative clauses into their regulatory frameworks to account for and accommodate for the digital shift from which Pakistani regulators can definitely learn.

A bank focused on lending and one focused on payments require different degrees of security, capital and expertise; enforcing identical requirements on them makes no sense. Pakistan’s regulators could look towards making their licensing requirements more flexible. This potentially may result in neobanks being able to better plan, and offer better and innovative products overcoming some of the challenges they currently face.

Moreover, the regulator must share and grant further clarity regarding the license timelines. As of now, no one can accurately estimate when they will be granted the licenses in Pakistan, evident from the fact that some companies were granted the EMI license in a few months, for others it took over a year.

A clear timeline and progression of a bank’s license and greater clarity surrounding the requirements and the products it can offer may go a long way in alleviating the challenges neo-banks face.

Finally, the European Union requires each neo-bank to submit an exit plan as a prerequisite for a license, which ensures the depositors’ security in case the entity goes under. A similar requirement in Pakistan could help alleviate some of the regulator’s concerns which could, in turn, then allow neo-banks greater leeway in terms of their product offerings and restrictions, alleviating some of the major challenges they face.

In conclusion, the caution the Pakistani regulators show in this sphere is understandable. Letting neo-banks go unchecked may have created great systemic risks for the entire system or a cycle of consumer exploitation. However, they must differentiate between being cautious and completely strangling an entire sector’s potential — an outcome easily avoided by adopting some of the few simple recommendations identified above.

The writers are commercial and financial law students at the Lahore University of Management Sciences

Published in Dawn, The Business and Finance Weekly, December 5th, 2022