This article first appeared in The Edge Malaysia Weekly on January 13, 2020 - January 19, 2020

BANK Negara Malaysia’s proposed licensing framework for digital banks makes it clear that such banks — meaning, those with no physical presence — are to come up with products and services only for the “underserved and unserved” segments.

In its exposure draft on Dec 27 last year, the central bank said digital banks would have to address market gaps in the underserved and unserved segments. This implies that digital banks are not likely to be a major threat to incumbent banks as their products will be quite different.

But it raises the question as to whether it is worth it for companies to pursue a digital banking licence in Malaysia. After all, there are reasons why incumbent banks do not already focus on these segments. Banks often incur high servicing costs for the underserved and there is typically low revenue potential, particularly when it comes to the B40 segment.

But who exactly are the underserved and unserved? In Malaysia, these are generally understood to be the small and medium enterprise (SME), micro-SME and B40 segments, according to Kelvin Lee, financial services assurance partner at PwC Malaysia.

He notes that Bank Negara specifically uses the terms “unserved” and “underserved” instead of “unbanked”. This indicates that while the unbanked population is small in Malaysia, banks are not adequately serving the needs of certain segments in terms of products, services and pricing.

“We are seeing challenger digital banks in other territories targeting segments that, although ‘banked’ in the conventional sense, traditional banking products and services are not tailored to them. For example, traditional banks may not be inclined to give credit to workers in the gig economy. However, challengers like ride-sharing service providers in the US are developing micro-lending products specifically for their drivers in a time of need,” Lee tells The Edge in an email interview.

Hence, it is up to the challengers who intend to apply for the digital banking licence to demonstrate to Bank Negara which target segments of the underserved and unserved they are looking at, he adds.

Asked whether it is worthwhile for companies to invest heavily in a digital banking licence when they may not make strong returns from such segments and could take a really long time to make profits, Lee says: “For traditional banks, it might not appear to be lucrative to serve these segments. More often than not, they do not have the insights that challenger digital banks have of their target segments.

“Taking the example of the ride-sharing service providers, they would have amassed data from the drivers within their ecosystem — for example, the amount of time they are driving and their earnings. Therefore, the challenger is in a much better position to make an informed pricing decision based on its data analytics in serving these segments.”

Indeed, one of Bank Negara’s requirements is that applicants must submit a detailed five-year business plan, which must include the applicant’s market study of the underserved and unserved segments and an analysis of the market gap.

“From our understanding, there is a lot of interest [among potential applicants] to serve SMEs and micro-SMEs,” Lee remarks.

Based on Bank Negara’s proposed requirements so far, some of the incumbent banks that had expressed interest in a digital banking licence last year may fall by the wayside.

“At the moment, we are inclined to believe the incumbent banks are adopting a wait-and-see approach. This is because there is no regulatory arbitrage in the Bank Negara requirements that would entice an incumbent bank to apply,” says Lee.

He adds, however, that there may be exceptions.

“For example, banks that already have e-wallets may have ambitions to scale up the e-wallets to a full-fledged digital bank. When Singapore began its digital banking journey, we also observed that Singaporean banks such as DBS, OCBC and UOB did not participate in the licensing process. This is an indication that the incumbent banks are focused on their own internal digital transformation process, rather than applying for a separate licence,” Lee says.

Last year, technology firm Grab, telco Axiata Group Bhd (which owns e-wallet “Boost”) and at least five banks — CIMB Group Holdings Bhd, Affin Bank Bhd, Hong Leong Bank Bhd, AMMB Holdings Bhd and Standard Chartered Bank Malaysia Bhd — had signalled their interest in pursuing a digital banking licence in Malaysia.

Over in Singapore, Grab and telco Singtel teamed up to apply for a digital full bank licence. Singapore had received 21 applications for five digital bank licences as at the end of last year, and expects to announce the successful applicants in June.

In Malaysia, the central bank expects to finalise its policy documents by the first half of this year, after which it will open applications for up to five licences. Hong Kong, which issued eight such licences last year, will see the first digital bank — owned by Standard Chartered Bank and its non-bank partners — commence operations early this year.

According to Lee, conceptually, Bank Negara’s guidelines for digital banks are not significantly different from those in Hong Kong and Singapore. However, there are a few differences. For instance, its guidelines stipulate substantially lower capital requirements of RM300 million (post-foundational phase, that is after five years), in comparison with Singapore at S$1.5 billion.

“What was also encouraging for challengers was that Bank Negara did not specifically dictate a timeline for the digital bank to break even. However, it expects digital banks to demonstrate a path to profitability,” he notes.

Is five years enough time for digital banks to prove that their business model is viable? “We believe that five years will be sufficient for [them] to prove that they have a compelling business case to serve their specific target segments. Bank Negara acknowledges that digital banks may not be able to break even within five years. This may be due to various reasons — for instance, continued technology investment costs, high customer acquisition costs in the initial years of operations and compliance costs. Therefore, it is imperative for digital banks to demonstrate that their shareholders have the necessary financial firepower to continually invest in digital banks, to push through the initial years, and to turn the path to profitability,” Lee says.

Applicants are required to develop an exit plan in the event their business model is not sustainable and a wind-down of the business is required. This is consistent with regulations in Singapore and Hong Kong.

Bank Negara has referred applicants to its Recovery Planning (RP) exposure draft guidelines — which were issued late last year — as a starting point to develop such a plan. Recovery and resolution planning is something that investors will be hearing more of this year as it will have implications for all banks, including digital banks.

RP is essentially an extension of an existing bank’s risk management practices in which the bank needs to have a comprehensive recovery plan to recover from a near default event.

“Digital banks will need to prepare their Resolution Plan to wind down their business in an orderly fashion, without causing disruption to customers and to the wider financial system. As this area is new to the banking industry, we foresee that many digital bank licence applicants may struggle to develop a comprehensive RP document,” says Lee.

Meanwhile, unlike Singapore, digital banks in Malaysia will be allowed to participate in the ATM network. This indicates that Bank Negara is cognisant that it would be unreasonable for Malaysian customers who are banking with digital banks to go totally cashless, says Lee.

In a Jan 10 strategy report, CSG-CIMB Research opines that digital banks will not have a substantial near-term impact on incumbent banks. “[Digital banks and their innovative products] could pose competitive threats to banks but the near-term impact would not be significant as they are focusing on the lower end of the segments, that is, small-ticket retail customer transactions and micro loans.”  

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