In-depth: making sense of digital bank policy

As Covid-19 ravages the world, ZA Bank, the first digital bank[i] to be launched in Hong Kong bravely opened its virtual doors last week; stay-at-home Hong Kong residents were intrigued by the bank’s new introductory rates and the relative ease of opening an account online.

Some parts of Asia have embarked on a multi-stage journey that will result in a host of new digital banks being unleashed on traditional banking systems, and it is all happening at one of the most difficult periods of economic and social stress in living memory. But with millions stuck at home on their devices, with more time to review (or worry about) their personal finances, this may turn out to be the most opportune time to launch an online bank.

Hong Kong was the first mover in this space, granting eight new licences last year, although the launch of many of these new businesses has been delayed. At the time of writing the MAS (Monetary Authority of Singapore) is carefully deliberating which of the 21 digital bank applicants will be successful, having limited the number of new bank licences to a maximum of five. Meanwhile in Malaysia, the process of finding dance partners and crafting business plans has been underway since the beginning of this year.

At some level of abstraction, most of us would probably agree that digital banks could be a positive influence on these banking systems even if the logic and the mechanics of that process elude us. However, a similar elusiveness permeates the statements of policymakers when it comes to the motivations and outcomes of digital bank initiatives.

Normally, when we think of financial policy we start from a baseline that the regulators are trying to fix something within their banking systems – but this is where we start to run into difficulty.

Cracking the Nut

We are of course all too familiar with the financial inclusion narrative that validates the need for digital banks in terms of reaching segments of society that are excluded from the mainstream banking system. These are the unbanked or underserved constituencies that are largely ignored by the incumbent banks.

BNM (Bank Negara Malaysia), for example, states that it has “developed a framework for digital banks to offer banking products and services to underserved or unserved market primarily through digital or electronic means”.

According to the most recent World Bank financial inclusion dataset (Findex), 15% of the adult population in Malaysia do not have an account with a bank or any other financial institution, and have not used a mobile-based payment service within the last year. This statistic is based on data collected in 2017, and it is likely that today the proportion of unbanked would be much lower due to increasing mobile and digital access, and the proliferation of non-bank payment services.

Statements regarding financial inclusion have also been made by authorities in Hong Kong and Singapore, but the same dataset indicates a much smaller proportion of the adult population lacks a bank account – only 5% in both of these jurisdictions (and, again, likely to be overstated by 2020 standards).

There are of course many countries in Asia which have a far more serious problem with the unbanked. As a point of comparison, the same dataset indicates that Indonesia and Vietnam have unbanked populations of 51% and 69% respectively.

Reaching the underserved in Malaysia, Singapore or Hong Kong is a noble aim, but are policymakers overstating the case? Are we about to witness a wild swing of the sledgehammer to crack a nut? And will this nut be able to feed the hungry herd of digital banks that is about to come out to graze?

Crossing Borders

A commonly-held view suggests that this is merely a launching-point, and that these digital banks will extend their reach beyond their headquarters in Hong Kong, Singapore or Kuala Lumpur to other emerging markets in Asia (including the Greater Bay Area in the case of Hong Kong digital banks).

However, the stark reality is that a bank licence in Vietnam or Indonesia cannot be conjured out of thin air. And if those regulators require a local partner or joint venture arrangement (the emerging regulatory standard in Asia) the economics will have to be shared with local partners and the commercial case for such a project needs to be sufficiently robust.

The incentive to expand across borders is nevertheless implicit in the high capital bar set for newcomers. Last year, the co-founder and CEO of the UK fintech phenomenon, Revolut, stated that his company would not be applying for a digital bank licence in Singapore due to the capital requirements imposed by MAS. But, for those that have the money and the self-belief, the horns of capital deployment and asset origination will need to be grasped firmly.

I like to think of the balance sheet building challenge in simple leverage ratio terms. Using Singapore as an example, a 6% leverage ratio applied to the SGD 100 million minimum paid-up capital required for a digital wholesale licence translates into a balance sheet size of roughly SGD 1.7 billion, whereas the new full bank license with its SGD 1.5 billion capital requirement would imply total assets of SGD 25 billion.

This starts to look like a rather large nut to crack, notwithstanding all the superior technology of the digital banks, and for the weaker players, it may become a choice between stealing someone else’s lunch or suffering some form of credit quality indigestion.

In Tech We Trust

The HKMA (Hong Kong Monetary Authority) states that its policy is motivated not only by financial inclusion but also by a desire “to promote fintech and innovation in Hong Kong and offer a new kind of customer experience.”

This is a vague statement and has to mean more than just improving the UI/UX of banking apps. Mischievous observers might argue that what the policymakers were really trying to say is that digital banks will reduce the cost of financial services for customers. This is never expressly stated as a policy motivation, but costs are clearly in mind in many pronouncements regarding the new banks.

For example, the Chairman of the MAS, while introducing the new licensing regime, referred to technology’s potential for “reducing costs and improving convenience for consumers”. However, we are left to ponder the reasons why these costs have not already been reduced, how they will be reduced, or which parties will benefit from any cost reduction.

The stronger argument is based on technology and the need to keep current with rapid developments in this area. That the incumbent banks have clunky and expensive legacy IT systems and that new technology could provide insights into clients’ needs and financial position is difficult to dispute. But without much of a track record, to claim that digital banks are the best solution strikes me as a policymaker’s leap of logic, and possibly a leap of faith.

The implication of this position, however, is that the incumbent banks have failed to adapt or proven to be unwilling to adapt. This is rather embarrassing given these banks’ gigantic IT budgets, online and mobile initiatives, and plethora of digital banking awards, and would constitute an indictment of the regressive nature of the status quo. Is this the market failure that policymakers are too shy to mention?

Policy Tension

A large part of the challenge to understand what is going on is that this policy area is fraught with difficulty, not least because some of the prudential regulation that is imposed on banks in order to safeguard financial stability tends towards the creation of barriers to entry and the privatisation of economic benefits. In plainer language, it’s much easier for central banks to supervise a concentrated and profitable banking sector than a fragmented and more competitive banking system.

The other challenge is that in Asia the central banks often perform multiple roles that include policy elements that are strictly non-financial, for example, elements of industrial policy (financial sector development) and manpower policy (employment and skills).

Of more relevance to digital banks are the areas of competition policy and data privacy – two important considerations that are subsumed within the in-house central bank discussion. This could be for very practical reasons, if there are no appointed independent agents of government tasked with those roles, or if those agents exist but lack the resources and expertise to pursue their mandate for the financial services industry.

Contrast this situation in Asia with the leading role played by competition authorities in the UK in identifying the deficiencies in the retail and SME banking segments, or the role of the competition authority in Australia in pursuing open banking and implementing the Royal Commission recommendations.

I am not advocating for a right or wrong way to do things. It may indeed be more practical for the digital bank discussion in some parts of Asia to be led entirely by the central bank, as long as all interests in this policy-making process are given due consideration. But whatever is gained in terms of efficiency and practicality will likely come at the cost of transparency; we will never really know who had the loudest voice in this discussion.

There are of course essential tensions that cannot be glossed over and these reflect different approaches to policy. Most prudential policymakers are trained to think in terms of economic trade-offs, whereas competition policy also incorporates elements of fairness and justice in their approach; data protection is often concerned with fundamental rights and ethics. The BIS’ economic research team has done some excellent work in this field (cf. the ‘regulatory compass’ that I referenced in a previous article), and it is apparent that this will become a major coordination challenge going forward.

Singapore Sling

Much of the above applies to Singapore, but the slice of pineapple garnishing the MAS’ policy cocktail is that the digital bank initiative should properly be understood as part of the government’s ongoing liberalisation of the banking sector.

Singapore has displayed some remarkably clear thinking over last three decades on this subject. There have been a few stages in this process, but the main ingredients have involved a wave of domestic bank consolidation, the introduction of foreign banks with a gradual easing of the restrictions imposed on them, and more recently the recognition of some foreign banks as systemically important and rooted in the local system.

The digital bank policy therefore is presented in the language of ideology. But as a unilateral initiative, is liberalisation an end in itself or a means to a particular end? Is there something unsatisfactory with the post-crisis market structure of the banking industry that is being indirectly addressed by the digital bank policy?

My own view is that some components of post-crisis regulatory reform (think G-SIBs and LCR) radically redefined the dynamic between local banks and international banks in many markets, and that the new regulation contributed to:

  1. the weakening of the international banks’ overseas business;
  2. the strengthening of the domestic banks’ market position (the corollary of (1)); and
  3. the market conditions for the rise of new competitors – or Fintech.

Within this context, the role of new digital players in places like Hong Kong, Singapore and Malaysia takes on a different significance. But the viability of these new business models is dependent on regulators’ willingness to create a small breach in the barriers to entry that protect the local incumbents.

Whether the new banks have any real impact on the profits and profitability of the incumbents remains to be seen. While COVID-19 is likely to have an impact on the incumbents’ results for some time to come, it will still be an uphill battle for the new banks to win market share – although the gradient of that hill will perhaps be a little less steep than three months ago.

The Future We Deserve

The French academic, Thomas Philippon, who is known for his work on the stubborn cost of financial services intermediation, attempts to comprehend the dynamic between new entrants and the incumbent banks in his classic paper published in 2017, The Fintech Opportunity, in which he states:

“If one steps back, it is difficult not to see finance as an industry with excessive rents and poor overall efficiency. The puzzle is why this has persisted for so long.”

A recent post from the well-known commentator in Asia, Emmanuel Daniel, expands on this problem in an eviscerating article entitled Why DBS Is Not The Best Bank In The World. In this long but thoughtful piece, Daniel argues that currently financial regulators are doing a disservice to other industries and other market processes by seeking to define and to promote digital economies that are bank-centric (i.e. by placing regulated banks in a place of primacy within digital ecosystem):

“…banking regulators in general and not just Singapore, appear to be taking the approach that digital finance has to reach a desired state that they will define before the rest of society can function. This slows down everybody else, including other agencies tasked with regulating and promoting a whole range of social infrastructure, supply chain, distribution, healthcare and government services.”

Within this view of the world, the new digital banks will become part of a regulated order alongside the incumbent banks, and will be carefully moulded to fit a role within the system where their technology can be harnessed but their disruptive impact minimised.

There is much else in Daniel’s commentary that is refreshingly provocative in its unorthodoxy, but I would argue that his comments on “hubris” within the Asian banking industry require more unpacking; specifically, how we arrived at this “Great Gatsby” moment so soon after the 2008 financial crisis, and the fact that European and American experiences have differed considerably from Asia.

I would also suggest that Daniel’s references to the Fintech successes of China are a little disproportionate when we compare Chinese accomplishments against the potential of much smaller economies and banking systems, where the ability to scale enormously and rapidly simply doesn’t exist. Clearly there are differences in approach to the digital economy and regulation, but that is something of an orphan statement unless we also include a political dimension to the discussion – and that is another debate entirely, to be pursued over cognac and a copy of Fragile By Design.

We have almost come full-circle – to the bold move of a Chinese-backed digital bank launching a new business in Hong Kong, a main artery of global finance. It may be the first but will certainly not be the last digital bank in Asia to attempt to reach an ever-growing online community and marketplace. This would not be possible without the enabling policy support of regulators in Asia – policy that in many respects defies conventions and categories.

When ideas and behaviour become viral they are called ‘memes’, and if, hypothetically, a digital banking meme were to exist I wonder which policymakers would prove to be immune.

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