India's central bank and its government are playing a pivotal role in laying the foundation and continually raising the bar for fintech development in the country's banking system. The range of measures include setting up digital connectivity to reach India's grassroots, building a state-of-the-art payment infrastructure, setting up open banking and regulatory sandboxes to urge innovation, and pushing customer preferences toward digitalization.

Many banks in India have also been quick to embrace new technologies to cater to a vast and growing, young, tech-savvy customer base. S&P Global Ratings believes India's top-tier private-sector banks and State Bank of India (SBI) are well-placed to deal with tech disruptions, given their dominant market positions and continued investments in technology. Several nonbank financial companies (NBFCs) have made considerable traction in having technology-led banking solutions omnipresent in their core business models. Use of artificial intelligence and machine learning are going beyond loan underwriting to customer onboarding, cross-selling, servicing, fraud management, etc. However, we believe several state-owned banks and the smaller private-sector banks require considerable catching up; they are currently grappling with technology hurdles and weak profitability due to asset quality challenges.

We expect a rise in industry collaborations between traditional banks in India and fintechs. At the same time, considerable investments are required to upgrade legacy systems in traditional banks. The banking system's low profitability and weak asset quality present some difficulties in significantly boosting digitalization. Although we believe the industry's competitive dynamics will continue to evolve, new entrants have failed to leave their mark so far. Payment banks in India have less than 1% of the deposit market share and remain unprofitable; restrictive licenses render the model rather unviable. Big tech companies have also entered the industry, but they have not been able to encroach into the mainstays of the incumbent banks, namely lending and deposits.

COVID-19 restrictions have been a boost for India's major digital payment system, Unified Payment Interface (UPI). The value of transactions processed via the UPI almost doubled in June to November 2020 compared with the same period a year ago. We expect this shift in consumer preferences to remain. Increasing smartphone penetration and internet connectivity and the young, tech-savvy demographic segment present vast opportunities in India's underpenetrated market for existing banks and new players.

We are illustrating our current views of disruption risk with our four-factor analysis of the Indian banking system's technology, regulation, industry, and preferences (TRIP; see chart 1) relative to international peers'.

Chart 1

Technology: Disruption Risk | Low

India's banks are quick to embrace new technology

In our view, the technological infrastructure in India is developing rapidly and presents opportunities for fintech in an otherwise underpenetrated financial market. We believe Indian financial institutions have also been embracing new technology as the root of innovative product solutions. Therefore, the risks posed by technology on the banking system are currently low.

India's government efforts, among other things, have played an important role in laying the groundwork for building a fintech ecosystem in the country. In addition, it continues to push the digital agenda. The government's Budget 2020-21 proposed various measures, including building data centers, improving digital connectivity, etc.

IndiaStack, a government-led initiative, is a set of Application Programming Interfaces (APIs) that allows various entities including governments, businesses, startups, and developers to use its unique digital infrastructure. Its technological architecture is based on creating a unique digital identity, digital records, and a single interface for all bank accounts and e-wallets that facilitates secured movement of data and payments across platforms.

Aadhaar, the world's largest biometric ID system, and UPI have been the most prominent developments of IndiaStack over the years. IndiaStack has about 1.06 billion unique digital IDs (Aadhaar) and 339 million Aadhaar-linked bank accounts. Various publicly provided platforms for verification (e-KYC), digital signature (e-sign), cloud storage (DigiLocker), and payments have been developed over Aadhaar. Developers can use these platforms to leverage on the existing digital infrastructure rather than building from scratch.

UPI has also been an essential enabler of transfers between bank accounts (both merchant payments and fund transfers). In China, e-wallets such Ant Financial's Alipay and Tencent Holdings Ltd.'s WeChat Pay dominate mobile payments, causing deposit leakage from banks as money gets transferred to these wallets, moving out of the banking system. In India's case, mobile payment users are shifting away from e-wallets toward UPI. In fact, various e-commerce giants and big tech companies such as Amazon and Google use UPI in India. For example, Amazon India offers the use of both e-wallet and UPI under Amazon Pay. Google Pay has only payment via UPI. Moreover, PhonePe (parent Walmart) and Google Pay are the most commonly used mobile payment apps and have a collective market share of more than 80% of transactions done (see chart 2). Currently, these digital payment mechanisms are offered free; the tech companies are doing it to get better access to customers. That said, unlike e-wallets where the deposits move out of the banking system, for UPI, the money remains in the banking system so the banks don't lose deposit and the customers earn interest at the same time. Thus, the banking system is able to maintain an edge in the payment system and retain its deposit base.

Indian banks are also getting active in garnering market share in the UPI space. For example, ICICI Bank Ltd. recently launched "iMobile Pay," where customers of any bank can link their bank account, generate a UPI ID, and make payments immediately.

Chart 2

The number of transactions done via UPI has been growing exponentially in the last few years and has far exceeded the transactions processed through e-wallets (see chart 3). The pandemic has also resulted in a multifold increase in the value of UPI-based transactions. In November 2020, the transaction value surged 107% year on year to approximately INR3,910 billion. We believe evolving customer preferences will continue to boost the adoption of digital payments and the trend may sustain.

Chart 3

The banking and financial services sector is also leading the private sector in the adoption of blockchain-based solutions. Examples include Axis Bank Ltd., launching its international payment service using Ripple's enterprise blockchain technology in November 2017 for its retail and corporate customers, and; ICICI bank Ltd. announcing in April 2018 its onboarding of over 250 corporates on its blockchain platform for domestic and international trade finance. Traditional banks have been keen to collaborate and provide access to their platforms to reap benefits from open API frameworks. In January 2020, ICICI Bank launched an API banking portal with nearly 250 APIs ranging from services including payments, accounts, deposits, cards, and loans. Using the portal, developers will be permitted to build, test, and release their API-based solution on the bank's platform. Advanced technological solutions such as big data analytics and artificial intelligence are also being adopted by many players to extend credit efficiently over digital platforms.

While there is no well-established legislative framework for open banking yet, India's own version of open banking is taking shape in the form of a central bank introduced framework for "Non-Banking Financial Company-Account Aggregators" (NBFC-AA). This will enable customer financial data to be shared within the regulated financial system with the customer's knowledge and consent. The NBFC-AAs are licensed and regulated by the Reserve Bank of India (RBI).

In our view, low smartphone penetration or internet connectivity problems have not hindered the development of fintech in the country. In fact, it has paved way for innovative products. For example, in order to overcome internet connectivity problems as a major hurdle for digital payments in rural areas, RBI announced a pilot scheme under which, authorized payment system operators including banks and nonbanks can provide offline payment solutions using cards, e-wallets or mobile devices for remote or proximity payments. Likewise, UPI is also available for non-internet based mobile devices through dialing options (*99#). At the same time, the Internet penetration level has been rising rapidly. We believe further improvement in penetration could open more opportunities for the banking system.

Regulation: Disruption Risk | Low

RBI and industry players working hand in glove toward a shared purpose

We regard regulation and policymaking as a low disruption risk for Indian banks. In our view, the Indian government and RBI are supportive in setting the stage for fintech development and competition in the financial services sector. They are also willing and open to working with other industry players toward this shared goal. That said, the central bank is also performing a balancing act by taking measured steps in fintech regulation to maintain financial stability in the sector.

There is no single universal fintech regulator in India, but the fintech companies are regulated based on the products and services they offer. RBI regulates some fintechs directly by granting them NBFC licenses (such as NBFC-P2P or NBFC-AA). RBI has been setting up regulatory frameworks across various fintech verticals such as digital payments, P2P lending, and now account aggregator. RBI also recently permitted banks and other regulated financial institutions to digitally onboard customers using video-based know-your-customer (KYC) processes. Furthermore, equivalent e-documents, including documents issued to the digital locker account of the customer, with valid digital signature of the issuing authority have been allowed for due diligence of the customer. In our view, steps like these could help reduce the cost of onboarding significantly for banks, NBFCs, and other fintech players.

The central bank has set up a regulatory sandbox framework to enable live testing of new financial products and services in a controlled regulatory environment. The regulatory framework also provides a list of indicative innovative products, services, and technology which could be considered for testing under the sandbox and a suggested list of exclusion (see chart 4). Under RBI's first round of experiments within its regulatory sandbox, where the theme was retail payments, the central bank received various applications last year and recently shortlisted six entities for a test phase. Although the kick-off for the test phase was delayed due to COVID-19 (all six entities started testing of their products in November and December 2020), we expect this framework to evolve to become a key enabler for innovation in the sector. In December 2020, RBI announced its second regulatory sandbox initiative with cross-border payments as its theme. The central bank also said micro, small and medium enterprise lending will be the theme for its third initiative.

Chart 4

To widen financial inclusion, RBI issued differentiated banking license namely, small finance banks and payments banks in 2015. Nevertheless, RBI does not allow any digital-only banks to operate in the country. It continues to place its emphasis on physical networks and mandates purely digital loan companies, operating through mobile apps, have at least one physical presence for customers to connect. The RBI also highlighted in its 2014 Guidelines for Licensing of Payments Banks that it does not envisage payment banks to be "virtual" or branchless banks. Various traditional banks have launched their own digital banking platforms, for example Kotak Mahindra Bank Ltd.'s 811 or SBI's Yono.

Earlier this month, RBI announced that it has constructed a composite digital payments index, with March 2018 as the base period, to capture the extent of digitization of payments across the country. As of March 2020, this index stood at 207.84, indicating high growth in last two years with a doubling of digitization.

The government launched its Digital India campaign five years ago to transform India into a digitally empowered society and knowledge economy. The vision is centered on three key areas-–digital infrastructure as a core utility for every citizen, governance and services on demand, and digital empowerment of citizens.

In 2014, the government launched "Pradhan Mantri Jan Dhan Yojna" to foster financial inclusion. The program involves opening a basic savings bank account for those without one. Approximately 414 million beneficiaries have been added since the launch and it continues to gain traction. The government is also using the Jan Dhan platform for direct benefit transfer for its welfare and subsidies schemes. In our view, these steps should go a long way in improving the financial inclusion.

Along with the digital push, the government of India and RBI have been prioritizing cybersecurity measures, especially against privacy breaches. There are a number of legislative actions underway covering various aspects, including data protection, digital payment security, and cybersecurity.

The central bank has taken a cautious approach toward virtual currencies, including cryptocurrencies. This stems from various factors, including the lack of transparency, which increases risk of illegal activities like money laundering and terror financing. While the Supreme Court has lifted the ban on cryptocurrency exchanges, we expect this to gain some ground with the regulator when the models are proven a success in other leading banking systems around the world.

Preferences: Disruption Risk | Moderate

Robust ground zero infrastructure provides an impetus to digital adoption

We assess the disruption risk from customers preference as moderate. India's young population, rising internet and smartphone penetration along with a banking system that is not fully entrenched in the rural segment creates a demand for digital financial operations in India. Banks, especially the large ones, have been fast to sense this opportunity and have been upgrading their infrastructure continuously and improving their product and service offerings through digital platforms. The use of online and mobile banking has been rising rapidly. About 65% of SBI's transactions for the six months ended Sept. 30, 2020, were through digital means (i.e., internet, mobile, UPI, YONO, and green channel). For HDFC Bank, 95% of its customer-initiated transactions were through the internet and mobile. Given that India is an underpenetrated market, digitalization helps in financial inclusion. Along with reach, digitalization also benefits banks by reducing cost and enabling them to provide an efficient service.

Within the cashless mode, mobile payments have been growing faster than cards in India. Transactions via mobile apps formed more than 50% of total payment transactions in October 2020. India's cost of mobile data is among the lowest in the world and its mobile penetration has been rising rapidly, thereby acting as a strong enabler for growth in mobile payments (see chart 5).

Chart 5

We believe many bank clients still prefer being able to visit a branch and have face-to-face meeting. We expect this to remain for some time. Also, rural areas are still not sufficiently well served by branch networks. Hence, we expect the number of branches to continue to rise, although at a slower pace as banks try to balance the physical versus digital presence. The pace of growth of bank branches has already slowed since 2015, as the number of mobile and internet banking transitions for commercial banks increased exponentially (see chart 6). In India, cash is still a highly preferred mode of payment, evident in the relatively higher proportion of currency in circulation as a percentage of GDP. India's currency in circulation is higher than some other Asian peers, such as China, Indonesia, and Korea, but lower than Hong Kong and Japan. Although the proportion of currency in circulation to GDP has been rising in the past few years, it is still somewhat lower than 12.1% in fiscal 2015-2016 (prior to demonetization). It was 11.2% in fiscal 2018-2019 and estimated to be about 12% in fiscal 2019-2020. Demonetization in November 2016 pushed the general public to opt for cashless payment options. Although the use of cash has been rising since, but from unusually low levels, retail consumers have continued to use digital payments (mobile and card).

Chart 6

Industry: Disruption Risk | Low

New entrants paving new roads--not inroads

We assess the risk posed to the incumbent banks' longstanding market position due to disruption in the industry as low. In our view, digital disruption is unlikely to change the structure of the Indian banking industry, and we expect large banks dominating and gaining market share for at least the next two years. New private-sector banks and top-tier public-sector banks with better franchises, higher internal capital generation, and a focus on digital banking technologies are likely to continue to gain market share and consolidate the industry.

The top five banks accounted for 55% of total system deposits as of Sept. 30, 2020, and we expect the proportion to remain somewhat similar for next two to three years at least. NBFCs also play an important role in credit delivery in India with about 25% market share by assets (see chart 7). In addition, the introduction of payment banks and small finance banks in India has failed to move the needle materially. The big tech companies did enter the payment space but are staying away from lending and savings due to regulatory restrictions. In handling payments, they have been using UPI's framework. Thus, banks still tend to have the upper hand. That said, the Indian banking system continues to be underpenetrated and growth opportunities are ample for new and existing market participants.

Chart 7

While the banking system continues to grapple with high credit costs and poor asset quality in a weak credit cycle, leading NBFCs, new private-sector banks and SBI remain at the forefront of technology adoption. Several leading NBFCs have made considerable traction in having technology-led banking solutions in their core business models. We believe the large incumbent banks in India are ready to get on the bandwagon. They have adopted various technology-led banking solutions, created ecosystems to increase their customers, and bridged gaps with fintech collaborations.

A large number of traditional banks have supplemented their banking propositions with a full-service digital banking platform to meet evolving customer needs and increase customer engagement rates. They have deployed virtual banking assistants, chatbots or virtual relationship managers that use machine learning, artificial intelligence, and natural language processing to assist customers with not only regular banking transactions but also lifestyle services that are beyond banking. For instance, HDFC Bank launched myApps, a suite of customized white-label apps that will enable large institutions such as urban local bodies, housing societies, clubs, and religious societies to digitize their ecosystems completely.

We believe the strategy of adding value beyond basic banking services and consequently becoming a part of the customers' lifestyle will boost customer engagement and relevance for the bank. The top three private-sector banks along with SBI command a market share of more than 50% of the banking system's mobile banking transactions in terms of both value and volume, with SBI alone at 22% (see charts 8 and 9). Small and midsize banks are not only grappling with this emerging tech order of the day but also weak profitability. We expect these banks to accelerate investments in technology or risk falling back. On a positive note, we have seen contribution from some of the other government-owned banks (other than SBI) to the banking system's mobile banking transactions also rising, partly due to the recent consolidation.

Chart 8

Chart 9

In our view, fintech players have a complementary role to banks. Although fintech companies have superior technological know-how and new ideas, banks benefit from customers' trust based on long-standing relationship and size over fintech companies. As such, Indian banks have been collaborating with fintech companies for various operational functions to create a win-win solution for banks, fintech companies and the customers. For example, Bank of Baroda has tied up with CreditMantri for technology to draw data of small and midsize enterprises and assess the customers on the strength of personal and business data points. The alliance is also helpful in offering small loans to first-time borrowers and gradually capturing other business requirements from them.

We expect the dominance of banks to continue. For activities other than digital payments, commercial banks with physical branches are expected to remain the primary choice for customers, particularly when applying for personal and business loans, and seeking investment advice.

Interesting times lie ahead for the Indian financial industry landscape. Fintech has been entering the Indian market in a big way. India is the fastest-growing fintech market and the third-largest fintech ecosystem in the world. According to Ernst & Young's Global Fintech Adoption Index, an index that gauges the broadness of local consumers' usage of fintech, India's adoption rate was 87% for 2019, which is one of the highest (along with its regional peer, China) and is considerably higher than the global average of 64%. Digital payments have been at the forefront of India's fintech sector. We have seen new entrants in this sector, but we expect the position of incumbent banks to remain strong and strengthen further as they are also adopting technology at a rapid pace.

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