In brief - In the final article in our 'Restricted ADI Pathway Series', we examine the history of Restricted ADIs and New ADIs, particularly arising from the fintech sector and the impact on new ADI enterprises of current market conditions, regulatory limitations and other factors affecting the feasibility, such as raising continuing capital and sustainability of the banking business model in the context of interest rate increases.
We ask - is there likely to be a trend of contraction in the neo banking and digital banking sector in the immediate future post-pandemic?
In examining the experience of new entrants in the banking sector and the transition to a new ADI via the indirect pathway of a Restricted ADI licence, it is apparent that there are inherent risks of failure to achieve full ADI status thus leading to an exit. The regulatory requirement that a Restricted ADI is required in its application to have a credible exit plan identifying the avenues it would take to cease its banking business and to exit the banking industry is testament to the reality of that risk.
We make the following observations about the market experience involving potential banking entrants seeking to utilise the Restricted ADI licence pathway and the complexities and risk in endeavouring to transition to a full ADI licence and achieving a sustainable banking business in the context of the prudential regulatory framework.
Transitioning to a new ADI - observations on the risk, complexities and difficulties
The history of utilising the Restricted ADI pathway has had varying outcomes for potential applicants seeking to move to full ADI status.
There are notable market examples in Volt Bank and Xinja Bank where:
a restricted ADI has failed to 'make the jump' to a new ADI licence; or
having secured a new ADI licence, the licensee has failed to attain compliance with the prudential requirements nor a sustainable banking enterprise which can comply with the prudential framework, and thus has undertaken a planned exit consistent with its regulatory business plan.
A number of successful Restricted ADI start-ups or neo banks have been acquired by existing ADIs, for example, 86 400 which was acquired by NAB and then absorbed into UBank.
Some neo banks have by-passed the Restricted ADI phase entirely and proceeded via the direct route to full ADI licence, for example, Judo Bank.
Some neo banks, digital banks or payment providers have operated under a related ADI's full licence, for example, Up Bank.
There are a small number of successful applicants who have successfully transitioned through the restricted ADI phase to or directly attained a new ADI licence, for example, Judo Bank (formerly Judo Capital).
Observations about the immediate future
Whilst there was increased activity during the pandemic by neo banks, digital banks and payment service providers contemplating expansion and growth via a Restricted ADI licence pathway, the passing of the pandemic appears to have signalled the start of a neo bank contraction in Australia.
It is apparent that banking is a capital-intensive proposition and a Restricted ADI applicant is unlikely to 'make the jump' and scale up unless, amongst other things:
it has a feasible capital management plan to raise successive tranches of capital (noting that new ADIs are expected to meet their prudential capital requirements with capital that consists entirely of Common Equity Tier 1);
it can develop a sustainable customer, and banking and financial product portfolio strategy to achieve and maintain growth, profit and an overall sustainable banking enterprise.
Xinja Bank and Volt Bank are examples of the inherent regulatory tension and market risk which forced an early exit in circumstances where there was an inability to raise capital through additional funding rounds, or a continuing struggle to develop sustainable revenue flow via new product and customer portfolio growth.
The current capital market downturn and its impact on capital raising in the fintech sector consequent on declining fintech valuations, its impact on profit forecasts and more expensive borrowing resulting from rising interest rates suggests that the operational, prudential and business sustainability risks will increase in the immediate future for neo banks and digital banks.
Further competition from the large fintechs, whose extensive platform business models provide them with scale and revenue diversity to provide banking and payment alternatives to customers, and acquisition opportunities initiated by the existing banks to absorb fintechs will be equally problematic.
Other hurdles that Restricted ADI applicants and new ADI applicants in digital banking and the fintech sector are likely to experience, and which could signal the drying-up of neo banks, are:
overcoming the hurdle of the cost of customer acquisition;
consumer trends currently favouring the acquisition of financial services from non-financial brands;
increasing interest rates, which have resulted in a retraction of home loan demand;
the loss of a digital competitive edge as existing banks have embraced digital strategies in response to the pandemic;
the 20 per cent shareholding ceiling imposed on ADI investors, which may potentially impact on the ability to raise future capital via capital allocations to existing shareholders and thus necessitate access to a broader shareholder or investor capital pool in a declining capital market.
Neo bank and digital bank trends, and ADI status
In summary, the combination of factors described will present significant hurdles and make it increasingly difficult for neo bank and digital bank ADI entrants and others to make the jump to a new ADI Licence.
In our view, the following material factors will drive this outcome:
current banking and fintech market trends which reflect increasing financial services competition in the banking sector and point to consolidation;
current market conditions, including a deterioration in capital markets, increasing interest rates and diminishing valuations in the fintech sector which negatively impact capital raising, sustaining and growing customer pools, and growth in lending and related financial products;
the inherent regulatory pressures to achieve prudential compliance, as well as banking business 'sustainability' which assumes a viable business model to generate sufficient revenue to sustain its operation and achieve profitability and offset establishment and operating costs;
in the case of Restricted ADIs, their propensity to have novel and untested business models and thus less flexibility in timing and resources available to address these issues.
Future of fintech amid more complex barriers to achieving ADI status
Overall, whilst the period of the pandemic provided an impetus for digitalisation and an appetite for investment in fintech as capital markets appeared more buoyant, the tide is likely to turn post-pandemic evidencing a trend of contraction in the neo banking and digital banking sector in the immediate future, particularly in a deteriorating capital market and an economic environment of increasing interest rates.
This is not to say that innovative fintech in the banking sector will retract but the barriers to a new entrant achieving ADI status (whether indirectly via a Restricted ADI licence pathway or directly by application for a full ADI licence) have clearly increased in complexity and may drive the banking market toward alternative product development, customer engagement and strategies focussed on innovated banking services (including banking as a service).
However, only time will tell!
Read the other two articles in our 3-part series:
Part 1 - Restricted ADI Pathway - APRA Clarifies Policy on Restricted Licence Period and transition to new ADI
Part 2 - Restricted ADI Pathway - Feasibility and sustainability considerations for new applicant digital banks, commercial banks and payment services providers
This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2023.