Neo banks, or startups ‘aiming to disrupt banking for millions of Indians’, have been a sort of holy grail investment in the fintech VC world. We are talking consumer neo banks, and at my last count, there are more than 20 of them that have raised nearly a billion dollars over the past five years.
That’s a lot of money, but then startups in India raised a lot of money in general over this period. The critique here, though, is that there really hasn’t been a business model other than credit that seems to be sticking.
With that said, I have somewhat of a traditionalist view of credit. It’s not a growth business but rather a risk business. I also think that millions of Indians do not need a disruptive bank. They just need a functional one. This has several cascading implications:
- Disruption typically means feature-rich. While many customers are keen to experience these features, they are unwilling to pay for them.
- Disruption as a value prop is an expensive one when it comes to acquiring customers. Two things create customer pull in financial services — being there at the time of a need and brand. Disruption as a brand value prop takes years to establish and a much shorter period to become a commodity. And being there at the time of a need means running a ton of ads and suffering a low click-through rate. In a nutshell, in financial services, disruption means high CAC.
- Unlike in the case of other startup categories, I want to bank with my mother’s bank. Banking is a serious business, and parents often significantly impact how young millennials bank. Neo banks often don’t get to play a role in this conversation.
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As a result, the NuBank of India will take a few more years (decades?) to build. In the meantime, the competition in the consumer credit space will continue to increase as well-funded neo-banks start to issue transaction credit instruments such as credit cards or as credit on UPI instruments.
Core tenets of transaction credit
As you read through this section, note that there is a central assumption I make. It is that for credit on UPI to succeed, most transactions need to be MDR-free. I will revisit this assumption and write a follow-up in a few months, but this is my strongly held-point of view for now.
Zero or near-zero MDR
I think the credit on UPI revolution lives and dies by this tenet, and I will try to describe it.
If a small merchant — think the small electrical shop behind my dad’s house — receives a payment on UPI, he expects to receive 100 per cent of the money in his account. If the issuer starts levying a 1.1 per cent MDR on this transaction (assuming it settles using a credit on UPI loop), the merchant starts turning off credit transactions in a heartbeat.
I actually think the RBI will start asking merchant acquirers to turn off credit on UPI acceptance on all merchant QR codes by default. And if that happens, Credit on UPI is dead on arrival.
So, how does credit on UPI work? I think for credit on UPI to succeed, the interest rate needs to be high enough so that issuers can offer an MDR-free transaction. This is not simple — an MDR-free transaction means a significant negative carry for the issuer. In the case of a credit card, the issuer is paid by the merchant in the form of an MDR for the credit-free period offered to the user.
There is a second-order effect — in the case of Credit on UPI, the revolvers must pay for the credit-free period enjoyed by the transactors. Therefore, assuming a current split of transactors and revolvers (see SBI Card; the ratio is 35–65), the interest rate on revolving needs to go up by as much as 18–24 per cent to get to credit card equivalent economics, which means an APR of 50 per cent + for the revolving user.
Rewards need to be re-thought
This brings me to the user segmentation. I believe Credit on UPI needs to be offered only to revolving customers. Adding transacting customers to bump up card spending and earn MDR does not work in this world.
Which means rewards need to be rethought. In the world of credit cards, the ground reality is that revolvers pay enough interest for some of it to be farmed back into rewards that are mostly used by the transactors. In the world of revolver-only instruments, similar rewards don’t really work. The user segment changes and rewards need to be rethought from the ground up.
This has a significant impact on user retention and on spending prioritisation for customers.
Customer engagement takes place on payment platforms
In the world of credit on UPI, user acquisition happens at two levels. First, fintechs acquire users and issue them credit instruments. Second, the payment platforms acquire users and enable them to pay at the point of purchase.
In my view, users will not use the issuer platform as their payment platform. To illustrate, I have never seen anyone open their HDFC bank app to pay at the neighbourhood store. We (predominantly) use Google Pay, PhonePe, or Paytm. In the world of Credit on UPI, the user will simply add her credit instrument to her payment app of choice and just continue her merry way.
Now, you may say that the fintechs issuing these credits on UPI instruments are not HDFC banks, but I submit that they are not PhonePe either, and I bet that winning a user from PhonePe is just not going to be easy.
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I contend that the battle is lost, and it’s best not to invest in trying to ensure that the user uses your app as a payment platform. Gamification and rewards tend to be very effective, but I wouldn’t count on the user opening the issuer app a few times a day.
CAC is crucial
Yes. Fintechs that cannot solve for CAC don’t make it. We saw this in BNPL, and we will see this kill many credits on UPI platforms over the next few years.
Collection muscle unclear
Yes. Fintechs that are built with collections as an afterthought don’t make it. We saw this with a host of personal loan platforms. We will see this kill many credits on UPI platforms over the next few years.
A word of caution: Debt trap
Household financial assets in India are at their lowest ever. The gross savings rate (Savings to GDP ratio) has declined at a rapid clip — from 37 per cent in 2011 to 30 per cent in 2022. Now, sure, part of this is linked to an increase in the value of real assets and investments, but it’s easy to see that spending has increased at a rapid clip, as has credit.
This shows up in household credit, which nearly doubled last year. Again, some of this goes into real estate, but I would contend that a fairly significant proportion goes towards other personal expenses, a sign of increasing aspiration for a large spending consumer segment.
Now, this rapid increase in indebtedness is not unique to India. There is an increase in leverage across the world, most notably in the US. To be fair, an increase in indebtedness is, in some ways, necessary to improve the standard of living in India.
India has always been a consumption juggernaut, and credit allows consumption to grow even faster. Simplistically, if tomorrow is going to be better, we can always grow into paying off the debt, and that remains the most likely scenario.
However, contagion across markets works in funny ways. The Indian consumption economy has been one of the most resilient across the world — not been dramatically impacted by global macroeconomic fluctuations for over a decade now. Importantly, the consumption economy looks at its best — people are spending more all around us.
However, there is a note of caution that I need to point out — a lot of this consumption is credit-fueled. How domestic credit behaves in the wake of a global credit meltdown — which looks more likely every passing day — is anybody’s guess, and we could see a temporary cycle in small-value personal loans and transaction credit.
However, the long-term story is clear as day. Retail credit penetration in India will continue to go up, and there remains a tremendous opportunity to create new, disruptive models in transaction credit.
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