In this article which is part of our 'Restricted ADI Pathway Series', our Banking and Financial Services Team highlights some of the factors to be considered by potential applicants for a Restricted ADI Licence such as Neo-Banks, Digital Banks, Commercial Banks and Payment Services Providers. In light of current market conditions including a deterioration in capital markets, increasing interest rates and diminishing valuations in the fintech sector, we examine the increasing regulatory emphasis on banking business 'sustainability' in the context of our analysis of the recent exits of Volt Bank and Xinja Bank which are discussed in our previous article in the series. 

We are regularly asked to advise potential applicant neo banks, digital banks and commercial banks and payment providers on the utility of the Restricted ADI licence pathway as opposed to a direct route to a full ADI licence.

In our view, to meet the expected quick trajectory to transition to a full ADI licence within the two-year restricted licence period, there needs to be a well thought out business plan that:

• addresses compliance with the regulatory guidance such as capital accumulation and capital quality, risk and governance infrastructure, prudential targets and an exit strategy
• is supported by the momentum of investor capital, a viable capital management and fundraising plan, a substantive customer pool, an achievable strategy to launch asset and deposit products as well as a sustainable banking business model to generate sufficient revenue to sustain its operation and achieve profitability and offset establishment and operating costs.

In this respect, the Restricted ADI licence pathway is not without its difficulties for new incumbents for the following reasons:

A Restricted ADI is not expected by APRA to grow significantly beyond a $100 million balance sheet during the restricted phase which may also encompass a pre-existing prepaid card product. However, against this background, an applicant must achieve full ADI capitalisation in two years.

A restricted ADI is subject to a deposit limit of $2 million on the aggregate balance of all protected accounts and a deposit limit of $250,000 on the aggregate balance of all protected accounts held by an individual account holder. 

APRA has indicated that the restriction applies to deposits only (not income-producing asset products) and APRA will agree to an alternative approach for deposit products that are not for individual persons (such as an SME) and a Restricted ADI can continue to offer to the general public these existing (non-deposit) products (for example, pre-paid cards or personal loans) that were established before the entity became a Restricted ADI. 

However, a Restricted ADI must also achieve a limited launch of at least one income-generating asset product and one deposit product during the restricted phase before it can progress to an ADI licence.

Under the regulatory framework there are limitations on who may be offered a new deposit product during the restricted phase, the expectation being that it will be confined to the staff of the Restricted ADI and their families and friends. This limits the depth of the customer portfolio in the context of a largely fixed cost base. However, APRA will permit a Restricted ADI to create a waitlist of customers during the restricted phase for a full public launch even though other members of the general public are not able to apply for a new release deposit product from a Restricted ADI.

Implicit assumption of risk and an exit scenario 

Restricted ADI applicants must have a credible exit plan identifying the avenues it would take to cease their banking business and exit the banking industry. There is thus a built-in limitation on the product model as the primary focus of:

• the exit plan is the timely return of deposits to customers without reliance on the FCS, and without impacting the financial stability or necessitating the use of APRA’s crisis management powers
• the deposit limitations are predicated on APRA’s underlying policy intent that an orderly and successful return of deposits will be easier to achieve if all depositors have some personal connection to the Restricted ADI and thus there are inherent limits on customer and product expansion during the restricted licence period. 

Rapid escalation of capital 

There is increased complexity of capital required in moving from the simpler Restricted ADI capital requirements relating to initial capital and Prudential Regulatory Capital (PCR) and then to new ADI status which necessitates a more onerous and articulated capital management plan and capital raising strategy by the end of the two year restricted licence period. For example, some of the capital pressures include the accumulation of surplus capital over PCR and a heavy reliance on additional capital raising or organic capital generation to fulfil the business plan.

The chequered history of the Restricted ADI pathway described in our previous article in the 'Restricted ADI Pathway Series including notable exits by Volt Bank and Xinja Bank have resulted in APRA articulating its emphasis on the sustainability of a Restricted ADI's banking business and associated capital model as a pre-requisite for the transition to a full ADI licence.

In this regard,

• during the restricted licence phase, Restricted ADIs are expected to be focused on developing their resources and capabilities to meet the full prudential requirements for their intended business as a new ADI - see APRA Information Paper - ADIs: New entrants – a pathway to sustainability
• a determination by APRA as to whether an applicant can move to new ADI status will be based primarily on an assessment of whether ADI has established itself as a sustainable enterprise.

By way of example, the viability or sustainability factor has resulted in an additional regulatory requirement that a Restricted ADI must achieve a limited launch of at least one income-generating asset product and one deposit product before it can progress to a full ADI licence.

Against the background of the regulatory limitations imposed on a Restricted ADI to conduct limited, low risk or traditional banking business during its start-up phase, some of the sustainability risks include:

• the pressure to fully capitalise the ADI to avoid breaching prudential capital requirements in a period in which there will be quick capital exhaustion and substantial operating costs to achieve and complete development and accommodate planned growth
• the difficulty in assessing a break-even point and achieving profitability noting that a new ADI's business plan is likely to forecast an initial period of loss-making
• the pressure of meeting planned product launch dates
• the pressure to acquire customers quickly and in sufficient numbers to meet financial projections.

In planning for a potential application for a Restricted ADI licence, applicant neo banks, digital banks, commercial banks and payment services providers will need to appreciate the tensions and risks created by the inherent limitations imposed on their banking business during the restricted licence phase to conduct limited, low risk or traditional banking business and the trajectory required to progress to a full ADI licence within two years against the background of an 'up or out' deadline. If a Restricted ADI is not in a position demonstrate a sustainable enterprise within two years, it must wind up its banking business and exit the banking industry. 

In light of current market conditions including a deterioration in capital markets, increasing interest rates and diminishing valuations in the fintech sector, the risks of not 'making the jump' are substantially increased.