How can RegTech optimize Public Sector Banks in India?
What is RegTech?
The regulatory environment is moving quickly with the banking sector’s rapid adoption of fintech. As a result, the regtech industry has recently experienced rapid expansion. Regtech is a subset of fintech which leverages technology to assist organizations in meeting regulatory compliance obligations more efficiently and effectively while minimizing costs. The global RegTech market is anticipated to reach $19.5 billion by 2026.
RegTech encompasses risk management, tax compliance, anti-money laundering, KYC, fraud detection and other data regulations. RegTech harnesses advanced technologies to generate reports, track transactions and regulatory changes in real time, automate manual processes, and spot potential fraud. Cloud computing and machine learning are the two most prevalent technologies in this field.
What led to the growth of RegTech recently?
The 2008 financial crisis forced the central banks to develop strict laws that would prepare financial institutions to handle any emergency crisis. Basel III regulations evolved as a result of this. Over time, most of the countries embraced these and began enforcing strict rules. Regtech industry growth was boosted by the more stringent regulations imposed by multiple regulators. Banks frequently face hefty regulatory fines, and compliance expenses are also rising. If the tasks can be automated by technology, it can save the banks a good amount. COVID-19 also played a factor in driving RegTech industry as it forced the banks to adopt the technology faster.
Current Regulatory Landscape
In India, financial institutions are regulated by the central bank — RBI, and other government entities. RBI regulates the banking industry, SEBI forms the rules and regulations for the stock market, IRDA governs the insurance industry, and PFRDA regulates pension-related funds. Since banks provide products in these domains, they are bound by all these regulators. RBI issues master regulations for all banking services ranging from their lending sector, credit and debit card services, digital payments and lending, KYC, recording and reporting.
Reserve management includes the rules and regulations on how banks can maintain their cash reserves, where they can lend, and how much they can lend. There are various essential ratios based on which the banks are regulated:
1. Cash Reserve Ratio (CRR): CRR is the portion of banks’ Net Demand and Time Liabilities (NDTL) to maintain in cash with RBI. Currently, CRR stands at 4.5%. CRR is the most common way of controlling the liquidity in the economy by RBI.
2. Statutory Liquidity Ratio (SLR): SLR requirement says that banks have to maintain a certain amount of liquid assets within themselves. The SLR is 18% of their NDTL. Banks can keep aside cash, gold, and approved securities as SLR. Any excess balance maintained with RBI is also counted under SLR.
3. Capital Adequacy Ratio (CAR): CAR is the ratio of a bank’s capital concerning its risk-weighted assets and current liabilities. Banks need to maintain a CAR of more than 11.5%. The higher the bank interacts with risky assets like loans to high-risk customers, the more capital it must keep aside under this requirement. CAR has been introduced since Basel III norms.
4. Liquidity Coverage Ratio (LCR): Introduced in Basel III norms, LCR is the portion of a bank’s high-quality liquid assets (HQLA) required to fund its net cash outflows for 30 days. The regulatory requirement is that banks maintain an LCR of more than 100%.
5. Priority Sector Lending (PSL): Domestic commercial banks must lend 40% of their total loans to the priority sector. The foremost priority sectors cover lending 18% to agriculture and 7.5% to micro-enterprises.
Another important regulation is KYC norms. These are set to combat financial terrorism and anti-money laundering. There are four key elements in KYC norms set by RBI:
1. Customer Acceptance Policy (CAP): Regulated Entities (REs) need to open the accounts of customers by verifying customers’ documents like PAN, digital signature, GST details to ensure no account is opened in an anonymous form.
2. Risk Management: This process categorizes customers as low, medium, and high-risk category based on their social, financial status, nature of business activity, location, past transactions and other factors.
3. Customer Identification Process (CIP): CIP ensures the authenticity of transactions. REs through their CIP verifies the customer information and identity whenever a transaction is initiated.
4. Customer Due Diligence (CDD): This process gathers customer information to identify and mitigate risks.
Apart from these, financial institutions must regularly provide financial reports to the regulators and abide by the changing rules and regulations.
Challenges
Banks struggle to manage their regulatory compliance due to the vast number of regulations and rising number of regulators. This article discusses three significant problems that banks face in managing regulatory compliance and offers solutions for them. First, banks need to deal with a lot of fraudulent activities and implement anti-money laundering measures. Second, banks are subject to a plethora of regulations and are required to submit regular reports to authorities. Thirdly, banks end up in huge loss of capital due to large number of NPAs.
- Large number of frauds: In India, public sector banks are where most frauds occur. Banks lose thousands of crores of rupees each year to these frauds. In FY 2021–22, the amount involved in frauds was more than 40,000 crores, with more than 3,000 cases. Almost one-third (33.8%) of frauds in 2021–22 were reported in public sector banks. And these involved two-thirds (66.67%) of the total amount involved in fraud cases.
2. Manual reporting to huge number of rules and regulations: Banks must report to the regulators frequently. Regulators like RBI and SEBI can also demand reports from banks when they see some anomaly. This increases the work of the banks as they search for the required information in their database and report it to them. Most of it happens manually, and often there is a chance of error. These compliance costs are quite high. RBI had asked banks to implement proper IT systems to generate the returns for regulatory reporting; however, many banks are still not fully automated. Besides, missing out on any regulations results in heavy penalties imposed on banks.
3. Large number of NPAs: Public sector banks face many NPAs compared to other financial institutions. In 2021–22, Gross NPAs in public sector banks amounted to more than Rs. 6 Lakh Crore. The GNPA ratio of PSBs was 7.3, while private banks had a manageable GNPA of 3.8. The huge NPA results in a significant loss to these banks.
4. High LCR: Liquidity Cover Ratio (LCR) requires a bank to maintain a particular stock of High-Quality Liquid Assets (HQLA) to help it weather a stressful period, like the financial crisis 2008. It enables the bank to stay afloat during a financial crisis. LCR is a requirement under Basel III (set by the Basel Committee on Bank Supervision (BCBS)). In general, public banks have higher LCR compared to Private banks. The average LCR of top five public banks for Q3 in 2022–23 was 180%, while for the top five private banks, it was only 118%. Private banks are found to be more efficient in maintaining their LCR, while public banks are losing out on opportunities by blocking their capital. If LCR is high, then banks are holding more cash than mandated. This means fewer loans to businesses. This can impact the economy, and the lesser credit availability will lead to slower economic growth.
How RegTech can address these challenges?
The following RegTech solution is proposed for the above challenges:
- Automated Data Flow and Data-pull Approach: The manual reporting by banks can be automated using Robotic Process Automation (RPA). Be it generating reports, identifying NPA, asset classification or provision processing, RPA helps remove any human errors and fasten the process with high efficiency. This can save compliance cost, human capital and reduce the number of penalties significantly. The automation needs to be end-to-end, from source system data to report mapping and business rule automation to report generation. The data-pull system is one of the Suptech solutions that enables central banks to pull data from banks, rather than banks having to generate and submit regular reports. National Bank of Rwanda has implemented this automated data collection whereby it can access the raw data from financial service providers and then process it into useful reports. Automated data collection improves the supervisor’s ability to monitor risks.
2. Credit Risk Assessment Model: A complete credit risk assessment model to automatically check for high-risk customers to address any future NPAs and fraud cases. Machine Learning drive CRM uses neural networks to identify the most appropriate feature that needs to be checked for assessing credit risk. This neural network model gets trained on the bank’s previous data and gives a good projection of future defaults by any existing customer or credit risk for new customers. Such Artificial Intelligence tools are beneficial in identifying and analyzing any suspicious transactions.
3. Financial Dashboard: Finally, a financial dashboard providing real-time updates on such regulatory provisions will help banks take faster decisions. RBI mandates certain Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Liquidity Coverage Ratio (LCR) and many others for banks. The dashboard extracts real-time information from CBS (Core Banking Solution) and tracks these mandatory ratios. The banks’ NPA data is also covered under this, whereby industry sector-wise NPAs are calculated so banks know where not to sanction loans. The dashboard gets linked via API to external financial sources to see which sector is growing faster and analyze what per cent of loans went into it.
Conclusion
While regtech solutions offer a great solution to banks, it is important to consider an important dimension. Data security and privacy remain important issue and should always be addressed while implementing the regtech solutions. Nevertheless, with the ever-evolving technology and increasing regulations, regtech is a necessity for financial institutions. The future of regtech will be more automation with complete integration of supervisors and supervised entities. This brings more standardization and simplification across organizations.
