This article first appeared in The Edge Malaysia Weekly on March 22, 2021 - March 28, 2021

COVID-19 has hit digital-only banks hard, putting them in a more vulnerable position than traditional banks that have been expanding their digital offerings during the pandemic, says S&P Global Ratings.

The US-based credit rating agency notes that the pandemic has been a strain on the nascent business models of digital-only — or virtual — banks. “What was shaping up pre-Covid-19 as a moment of glory for virtual banks is turning into an ordeal for some,” it says in a March 16 report on the future of banking.

It notes that virtual banks have a low market share relative to traditional banks. In many cases, they have highly concentrated business profiles, often need to rely on higher interest rates to attract deposits and have small, unseasoned lending books. Many virtual banks in Asia-Pacific have never even been through a full credit cycle.

“The outbreak has exposed gaps in the business model of some virtual banks. Many will need to revamp their strategies or find a stronger partner with which to merge. Some may not survive. Some have already conceded,” it says.

Some of the virtual banks that have relied on high deposit rates to attract customers are finding it hard to sustain this business model amid the current ultra-low interest rate environment. “In the absence of a meaningful core value proposition, we wonder how sticky deposits will be if above-market deposit rates are not maintained,” S&P remarks.

In Hong Kong, for example, where seven virtual banks started operations last year, some of the deposit rates were almost three times as high as those offered by traditional banks. This, and cash rebates on card spending, helped the virtual banks attract 300,000 accounts and over US$1 billion (RM4.1 billion) in deposits in just a few months, Hong Kong’s finance secretary Paul Chan said last November.

In Australia, virtual banks such as Xinja Holdings Ltd, Volt Bank Ltd and 86 400 Ltd were forced to cut deposit rates after the central bank announced a series of rate cuts starting early 2020. Xinja ended up having to stop accepting new savings accounts to keep costs under control and, in December 2020, made a decision to hand back its banking licence. It cited Covid-19 as a major factor for its shocking exit.

Elsewhere, UK-based global virtual bank Monzo Bank Ltd saw losses increase significantly to US$145 million for the financial year ended Feb 28, 2020, from US$62 million in the previous year.

Meanwhile, S&P says the economic fallout from the pandemic may also limit virtual banks’ access to capital, putting them in a difficult position. “We expect [that] the traditional lenders may start buying the virtual banks, or other merger and acquisition activity may occur. While often happening under distressed circumstances, such mergers can make good strategic sense,” it says, citing National Australia Bank Ltd (NAB) as an example.

In late January, NAB said it would acquire 86 400, in which it already had an 18.3% stake, for A$220 million (RM703.8 million), giving it access to the latter’s 85,000 customers and A$375 million in deposits.

To be fair, not all virtual banks have crumbled under the weight of Covid-19. Two weeks ago, Russia’s TCS Group Holding plc, which runs the country’s largest virtual lender Tinkoff Bank, announced a record net profit for the year ended Dec 31, 2020.

Its net profit rose 22% to 44.2 billion roubles (RM2.45 billion), even as revenue increased 21% to 195.8 billion roubles. According to TCS, it was the first time in its history that the number of non-credit product customers exceeded that of credit product customers.

China’s WeBank Co Ltd, which benefits from the strong sponsor backing of Tencent Holdings Ltd, has also held up decently amid the pandemic, having maintained generally stable asset quality ratios. “We believe that virtual banks embedded into larger groups will likely maintain the benefits of strong financial investment power and focus on client experience,” says S&P.

Despite the tough times digital banks are facing, S&P is of the view that the concept of such banks is here to stay. “In emerging markets, the case for virtual banks is compelling. Longer term, they may yet be an effective means of reaching vast unbanked populations, particularly on the back of increasingly wide smartphone use and access to higher-speed internet,” it says.

It notes that the pandemic has revealed an essential need for credit for all during crisis periods. “For many millions of people, virtual banks may be the solution. Through financial inclusion, virtual banks may eventually achieve wider penetration of the banking market and greater revenue. The virtual banking trend may also reduce shadow banking, which we view as a positive.”

Meanwhile, traditional banks have been upping their digital game even as Covid-19 turns more customers towards digital offerings. For example, Singapore’s United Overseas Bank Ltd started its first mobile-only digital bank, TMRW, in Indonesia last year following its Thailand launch in 2019.

A recent survey by global analytics software firm FICO revealed that 61% of Malaysian consumers prefer to use digital channels to engage with their bank during financial hardship. The poll, conducted in December 2020, demonstrates the willingness of consumers to embrace digital banking and the opportunities that lie for banks to further develop their offerings.

“I think there is a real opportunity in Malaysia around serving, particularly, micro-SMEs and small businesses,” Raphael Bick, a partner at McKinsey & Co’s Shanghai office, tells The Edge.

“There is still a mass consumer and lower mass consumer segment, and that is not fully digitally served by existing banks. Even though many of the incumbents are working on their digital propositions, their mobile apps and their digitised offerings, relative to other markets, you would still see quite an opportunity there for enhancing the proposition for [this segment],” he adds.

He believes there is also a “huge opportunity” in serving the self-employed, and this would probably be the primary medium-term focus of digital banks.

Bank Negara Malaysia, which plans to award up to five digital bank licences, has set a June 30 deadline for those interested to apply, and will announce the winners by the first quarter of 2022.

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