What they all have in common, however, are the innovative ways they deliver banking services without physical branches. 

According to McKinsey[1], a digital bank has the following characteristics:

• a digital front-end and operations
• a digital-native back-end core
•  structure and culture like those of a technology company

The first two points are technical and easy to verify, yet a business culture is something intangible. However, it goes to the heart of the issue. McKinsey offers a definition: “the characteristics of a digital operating model include a horizontal structure, minimal bureaucracy, a nonhierarchical environment with high levels of staff empowerment and ownership, and a test-and-learn culture enabling continuous development of systems, products, and channels.”

Levels of bureaucracy vary significantly between digital and established banks. In traditional established and well-resourced banks, the regulatory and compliance “bureaucracy” has notably expanded over recent years to tackle the increasing demands placed on them by regulators in various national and supra-national jurisdictions.

While regulators in jurisdictions such as Singapore and Malaysia have shown some flexibility or have sought to build a parallel regulatory environment better adapted to digital banks, the vast majority of jurisdictions still apply existing banking laws and regulations to digital banks. Even in the few jurisdictions that have set specific regulatory frameworks for digital banks, the main licensing and ongoing requirements are similar to those for traditional banks.

The situation continues to evolve. The Financial Stability Institute (FSI) recognised that the sector offers significant benefits compared with traditional banking. It concluded that: “the overall challenge for authorities is to maximize the benefits of fintech innovations while mitigating potential risks for the financial system”.[2]

The pandemic pushed the issue up the agenda

However, the pandemic accelerated the expansion of digital banking and fintech, setting off alarm bells at the FSI. In January 2022 FSI chair Fernando Restoy remarked that “The current regulatory setup, consisting of a series of diverse activity-based requirements accompanied by specific rules only for traditional financial institutions, is simply not fit for purpose”.

Restoy also warned of various sources of risk. This included systemic stress due to excessive indebtedness, liquidity mismatches, third-party dependencies and operational vulnerabilities (such as technology outages), the issuance of new forms of payment such as stablecoins, and various concentration risks.

Regulators around the world are taking note, and it is highly likely that there will be an overhaul of the regulatory framework. Restoy thinks this could mean the creation of new regulatory categories and supervisory models. Digital banks and fintechs, with their slimmed-down bureaucracies and flat hierarchies, will not be well-placed to deal with this shock to their business models.

Focus on what you do best

All of this is likely to be a distraction from what digital banks and fintechs do best: serving customers, identifying opportunities among underserved market segments and growing the business. What we have learned over the years is that the regulatory burden never goes away – it gets more complex over time and requires constant maintenance. This also applies to traditional banks, and it will apply increasingly to financial institutions following the new business models too.

However, we have also learned that meeting regulatory requirements is not simply a business overhead. The work done to satisfy the regulator is also extremely valuable for internal management of the bank, providing insights that enable the optimum trade-offs between risk and growth. Such as leveraging the European Central Bank (ECB)’s Internal Capital Adequacy Assessment Process (ICAAP) to establish more effective and profitable risk-based pricing.