A Step-by-Step Guide to Building the Essential Components of a Digital Bank
The first part of this series looked at the authorisation process. Now, let’s look at some of the components of digital banking that you need to build a successful bank. As previously noted, understanding the needs of banking is crucial to developing a sustainable digital bank with a competitive advantage. There is a multitude of financial technology (fintech) and regulatory technology (regtech) products and services available. These provide customer identification, credit scoring, fraud prevention and payments, to name a few. This fintech and regtech ecosystem gives new banks access to components that could be too costly or time-consuming to deliver in house.
New banks can focus on their core capability and the fintech and regtech to provide the necessary components of digital banking. Non-financial services firms may want to leverage fintech and regtech services to embed financial services into their products and extract value from it, thus meeting the needs of banking.
Flexible partnerships coupled with modular-based products that scale quickly and are easily integrated with your business model. API’s (Application Programming interfaces) provide seamless integration between components. An API is a standard way in which applications are addressed, and it’s how they communicate with each other. We will cover this technology in part 3 of this series.
In the early stages of building a digital bank, it's essential to embrace small-scale innovation for big results. To learn more about the benefits and potential of micro-experiments in streamlining operations, achieving better compliance, and enhancing cybersecurity, check out our blog post on The Power of Micro-Experiments: Embracing Small-Scale Innovation for Big Results.
Who are the UK payments Schemes?
In part 1, we looked at capital as a barrier to entry. Another barrier to entry is payments. Payments flow through one of the many UK payments schemes. For example, faster payments (real-time payments up to GBP250k), BACS (Direct Debits) or CHAPS (high-value payments). The Payment Systems Regulator (PSR) governs the schemes.
Access to the payments schemes is either through direct access, i.e. you become a member of the scheme and connect to them, which incurs additional complexity in technology and operations. Or by indirect access, i.e. you connect through a traditional bank that already has access to the schemes. The latter is called sponsored access, and it’s the most common approach for new challenger banks, and this is where a sponsor bank comes in.
What is a Sponsor Bank?
The sponsor bank is an existing authorised bank with direct connections to the payment schemes. They facilitate the sending and receiving of payments and provide other services such as electronic statements. Sponsor banks also provide settlement services. For example, when you send a faster payment, your digital bank sends payment messages to the receiving firm. The actual money is exchanged via the bank of England’s real-time gross settlement (RTGS) system three times daily.
It’s worth looking at some of the considerations when selecting a sponsor bank because they will impact your business plan, your products and your technology. If you’re offering real-time payments check your sponsor bank can too. Will you use their sort code or request your own? What are the transaction costs? Will you provide mobile direct debit signups? Finally, as your digital bank remains accountable for compliance, customer identification and money laundering checks, what requirements does the sponsor bank make of you? In some cases, sponsor banks are opening up API’s. Still, these can be limited, so you may want to look at a payment’s aggregator or gateway.
What is a Payment Gateway?
We already covered some of the components of payments, sending, receiving and settlements. Also, there is transaction monitoring for anti-money laundering (AML) and sanctions screening for overseas payments. Connection to the international payments messaging network (SWIFT) or conversion of payment messages to the new message standard ISO20022, to name a few. As a new =digital bank, that’s a lot of technology to build and operate, and this where a payments gateway can help.
All those components can be provided by the gateway. This does require integration with your technology, digital banking operations, finance and compliance. However using a payment gateway in your early stages removes development costs, operational overhead, you can achieve a better level of compliance and cybersecurity.
As a side point, if your business model is only payments, instead of applying to be a digital bank, you can apply for an authorised payment institution. Or a small payment institution if your monthly turnover is less than EUR3m. You can benefit from fewer capital requirements and a shorter authorisation process.
Finally, if we bring together your digital bank, the payments gateway, the sponsor bank and the schemes, this is an overview of a possible payment’s ecosystem.
How can regtech and AI streamline AML and KYC processes?
Banks are required to perform anti-money laundering (AML) and know-your-customer (KYC) regulatory checks. These traditionally have been paper-based, but with the expansion of regtech, many digital options coupled with artificial intelligence, machine learning and biometrics seamlessly integrate into the customer onboarding workflow.
Real-time identity verification though a smartphone ‘selfie’ matched to a passport or driving license, can validate new customers at the start of the customer journey. Real-time data feeds for automating AML checks and risk monitoring, enable customers to onboarded or rejected within minutes.
To delve deeper into how these technologies can enhance the machine learning pipeline and optimise AML and KYC procedures, we recommend reading our blog post titled Enhancing the Machine Learning Pipeline with Design Thinking.
How do banks build credit scoring capabilities for lending?
When you apply for some form of lending your credit score is checked, this is relatively simple from a customer perspective but how does a digital bank build a credit scoring capability?
At a high level, the credit scoring process has three parts, first is the credit risk policy this outlines the policies (e.g salary, rent, court judgements) and the fraud checks required, second is the credit reference agency where a person’s credit history is obtained and finally, this is compared against a credit scorecard.
As a new digital bank, you won’t have your own customer base on which to create your scorecard. You can use an off the shelf scorecard or you could buy some additional analysis. The latter may increase your lending potential, but it is more expensive. An off the shelf scorecard that may prevent customisation of products, may lack flexibility which in turn may lead to manual underwriting.
The credit checks and scorecards can be as complex or as simple as you need, and a lot of work goes into defining them so it’s advisable to bring in external expertise to help tailor them to your needs.
What is Core Banking?
Core banking sits at the heart of digital banking technology. Components include loans, deposits, current accounts and more. Core banking deals with creating new accounts, calculating interest, processing deposits, withdrawals, payments and reporting.
Existing core banking systems have come under much criticism, mainly due to their monolithic architecture. A monolithic application is where all the components are tightly woven together and housed in a single system. As opposed to modular systems where each component is separate, and you only use what you need.
In the overview below the modular approach allows components to operate independently and replaced independently. It’s worth noting that each of these modules often operates at a far granular approach than is shown here.
Whist monolithic application are fully capable in their own right they often lack flexibility. It is not easy to integrate with new systems and the skills and expertise to build and maintain these are slowly dwindling. This is leading to higher maintenance costs and a lack of agility.
There are many fintech’s delivering new modular solutions. They are, in essence, breaking down the monolith, splitting these into modular components and building them with microservices. They can leverage the latest technology to create cloud native systems within cloud managed services. More on this in part 3.
How do card platforms enable secure and configurable transactions?
Card platforms deal with the processing of debit and credit card transactions. They provide card issuing, card authorisation, settlement and statements. Similar to core banking, new modular services provide endless configuration options. These options might be a virtual debit card that can be created instantly for mobile payments or card locking or transaction freezing via mobile apps.
All aspects of the card platform can be accessed via API’s and are fully compliant with the Payment Card Industry Data Security Standards. PCI DSS is a set of security standards. The standards maintain a secure environment, ensuring that all companies accept, process, store or transmit debit or credit card information in the same way. Note that even if you are using a card provider, you will need to achieve a level of PCI DSS compliance.
In the next and final part of this series, we will look at how technology and the way it’s delivered can enable the success of your business. Until then enjoy some tasty Danish Cardamom Buns and a cup of coffee for getting this far.
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Further reading (All sources checked June 2020)
bank of England’s Real-Time Gross Settlement
PCI Security Standards Council
Payment Systems Regulator
FCA Apply to become a payment Institution
FCA Financial crime guide
FCA Handbook
We are Pay UK
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