Who Bears the Risk in Fintech?

The excitement around fintech in India is palpable. This enthusiasm can be attributed to fintech’s potential as a market-led solution to the policy objective of financial inclusion. Fintech can expand the reach of formal finance by offering users personalized financial products in an economically viable manner. Unsurprisingly then, regulation of fintech is central to financial inclusion.

Fintech regulation must prevent and mitigate risks while also preserving the potential for financial inclusion. To understand if the regulation of fintech in India meets these objectives, it is important to analyze the existing regulatory regime. Our recent research, Financial regulation of consumer-facing fintech in India, aims to do just that, answering the question of how fintech is regulated in India.

How do we define and categorize fintech?

There is no universally accepted definition of fintech yet, but it is important to note that fintech is not defined simply by the use of technology, since proliferation of technology in finance predates fintech. But a defining feature of fintech is the use of technology to increase the reach of finance. Our research uses this intuition and draws from the Financial Stability Board’s definition of fintech to qualify fintech as:

Business applications, products or services that make a previously inaccessible financial function/ instrument available to a consumer, benefitting in large part from the underlying technology.

Using this definition, our research creates a typology of consumer-facing fintech in India. We identified 14 key fintech activities and grouped them into five well-recognized functions of finance: (i) insurance, (ii) payments, (iii) deposit, lending and raising capital, (iv) investments management, (v) market support and a sixth category, miscellaneous.

The Typology of Consumer-facing Fintech in India

This categorization shows that a lot of innovation in India is clustered around providing credit and lending solutions to consumers. Many of the fintech categories highlighted above are not exclusive to India and are found in other countries as well, but the business models differ across countries because of the difference in regulatory regime. This is true within countries as well. In fact, our research shows that in India, the four sectoral financial regulators approach regulation of fintech differently.

How is fintech regulated in India?

Since it is not yet possible to assess an overarching regulatory stance towards fintech in India, our research traces the broad contours of the regulatory framework by creating an index that measures regulatory oversight. This index scores and compares financial regulation across three parameters: (i) existence of a regulator, (ii) existence of active regulation and (iii) the intensity of applicable regulation. Higher scores reflect greater regulatory oversight extended to an activity, as depicted below.

From this regulatory landscape, we can see that different financial supervisory bodies regulate entities performing similar functions differently. For example, insurance web aggregators and credit product comparators perform the same functions for insurance and credit instruments, respectively. Yet, the former is tightly regulated as reflected in a score of five, and the latter is completely unregulated, corresponding to a score of zero.

Such differences in regulation are also visible within the same financial function. The Reserve Bank of India (RBI) tightly regulates peer-to-peer (P2P) lending platforms but does not regulate alternative credit risk modelers, despite the two performing similar functions and generating similar risks.

Implications for future regulation

These variations in regulatory approaches point to some early principles for regulating fintech. Like traditional financial regulation, fintech regulation should focus on the size and nature of the financial risk created by the financial activity. But fintech regulation also needs to look at who is bearing the financial risk.

Fintech solutions can substitute physical, regulated entities like banks or traditional insurance providers with technology. But when they do this, the financial risks which were previously absorbed by regulated entities may get passed on to end-users or other non-financial providers, such as those who provide technology support. Therefore, it is important that regulators consider the nature of the entity that bears the risk when designing regulation.

For instance, both P2P lending platforms and alternative credit risk modelers assess creditworthiness of borrowers and generate credit risk. However, the credit risk generated by a P2P Platform is borne by an individual lending his or her money, while the credit risk generated by an alternative credit risk modeler is faced by a financial institution. Despite the same nature of financial risk, these two fintech models will qualify for different regulatory approaches due to the difference in the types of entities which bear the risk. In the case of P2P lending platforms, regulators could consider recommending that platforms assess if the lending decision is appropriate for the lenders’ portfolio and if the lenders understand all risks associated with it clearly. In the case of alternative credit risk modelers, revising loan provisioning guidelines could be considered. 

Seminal scholarship suggests that financial regulation should be functions-based, focusing on the financial functions being performed and risks being generated, instead of focusing on the underlying institutions. Our analysis suggests that effective regulation of fintech will have to consider both the nature of the financial risk and the nature of the entity bearing the financial risk. Understanding who bears the financial risk is instrumental in developing appropriate and effective regulatory tools.