DIGITAL or virtual banking is a new phenomenon in banking which is rewriting the rules of traditional banking. Digital banks operate without a physical presence, so all their operations are done on mobile devices or a desktop computer.

Audrey Yap, Accenture’s finance practice lead, tells FocusM that digital banks are “branchless banks” that offer loans and credit, take deposits and sell financial products very much like conventional banks. “Digital banks differ from conventional banks mainly because of their internal systems and the technology that they adopt,” says Yap. Among the major differences are leaner backroom operations and a heavy reliance on cloud computing.

In Malaysia, digital banking took a step forward when Bank Negara Malaysia (BNM) introduced a Licencing Framework for Digital Banks at the end of 2019. It had invited public feedback on the introduction of digital banks.

“Malaysian digital bank guidelines are quite unique from the perspective of achieving a balance between innovation and a level playing field,” Shankar Kanabiran, partner of Ernst & Young says of the framework announced by BNM.

He tells FocusM that compared to Singapore and Hong Kong, Malaysia has ensured that new digital banks are able to access ATM networks and cheque infrastructure, acknowledging that some parts of the economy with unmet and unserved needs will still need access to these while using digital banks.

“Hong Kong digital banks might get access through deals with independent ATM operators, which is better than no ATM access, but (still) not ideal,” adds Shankar.

Malaysia also clearly defines that existing financial institutions are able to apply for licences in joint venture with other parties, removing any scope for ambiguity and subjectivity in interpretations.

“Regarding foreign participation, Malaysia has a clearly articulated preference for local equity control, thereby ending debate about headquarters location and subjective definitions of management, operating and board control,” says Shankar.

He adds that clarity on preference for year 5 as the breakeven mark is a welcome step to ensure applicants can develop and evaluate their plans internally.

Relaxation on stress test and disclosures in the foundation phase will ensure new banking players get time to ramp up before they graduate into full-bank players.

Would digital banking deposits be guaranteed by BNM?
Shankar tells FocusM that the central bank would guarantee deposits through digital banking but the quantum is unknown. BNM had said in its guidelines that the target for digital banks was to meet the needs of the underserved market.

He cites gig economy workers as one example of “an underserved market”.

“Many gig economy workers such as Grab drivers do not possess income verification documents and could not avail themselves of credit through conventional banking. Through digital banking which provides unsecured lending, they will be able to obtain credit,” he adds.

Will digital banks offer preferential rates?
According to Shankar, based on his experience in launching a digital bank in South Korea, initially, digital banks offered better deposit rates and lower borrowing rates compared to conventional banks but the rates drift towards equilibrium in the long run. Digital banks also had a lower cost-to-income ratio than conventional banks.

“The cost-to-income ratio of digital banks is estimated at around 10 basis points (bps) lower than conventional banks,” he adds.

Driving down costs while growing exponentially
Myles Hosford, head of Security Architecture, Asean of Amazon Web Service (AWS) tells FocusM that digital banks employ advanced technology to drive down operating costs.

“The digital bank, Monzo of UK, only employs 10 IT personnel to handle operations for its 1.7 million customers,” says Hosford. He adds that digital banks on the cloud model that is offered by AWS to its digital banking customers is also economical as it charges clients according to their usage.

Shankar of EY says that based on his experience working on a digital bank in South Korea, it took an average of seven minutes to open a savings account.

According to a joint report by Bain & Co, Google and Temasek, digital financial services in Malaysia are expected to have a compound annual growth rate of 18%, reaching US$4.7 bil by 2025.

BNM says that experiences in other markets have shown that digital banks have the potential to increase access to finance to underserved segments, for example in channelling financing towards micro and small enterprises.

“For Malaysia, the key outcomes expected from licensing digital banks are largely customer focused – catalysing new user experiences as well as enhancing access and quality of financial services for underserved segments,” says BNM.

The central bank adds that admitting diverse licensees is also expected to infuse greater competition and dynamism in the financial services sector.
How will conventional banks fare?

According to Yap of Accenture, conventional banks are rising to the challenge by improving their services and products and becoming more focused on offering digital-savvy customers with improved banking experiences. She says there will still be room for conventional banking but these establishments must up the ante on innovations and developing new business models that fit the digital ecosystem.

Aadarsh Baijlal, partner and leader of Bain & Co’s Digital practice in Southeast Asia, says despite the march of new players into the digital banking fray, it is unlikely that consumers and merchants will move away from physical banks completely. Banks have capital access and regulated deposits while funding and balance sheet management remain a potential risk to scaling the lending business for digital banks.

Cybersecurity issues
Since digital banking promotes “banking without human interaction”, issues of cybersecurity have surfaced. According to Yap, digital banks address cybersecurity issues very much like conventional banks in the sense that they protect customers’ funds, privacy and transaction data. She adds that there could be some differences, for instance, authentication can be done via biometrics instead of a six-digit Personal Identification Number (PIN). Digital banks are run on cloud computing so their security systems would differ from that of conventional banks.

Hosford says AWS minimises the risk of a cyber-attack in digital banking by using AI and machine learning. “AWS ensures cyber threats are handled in real time,” he says. Its fraud detection system facilitates the requirements of KYC (Know Your Client) and the Anti-Money Laundering Act (AMLA).

According to a report by consulting firm, Bain & Co, the underbanked consumer who does not have access to traditional financial services will be the engine of growth for digital banking. It adds that technology enabled business models offer a more effective way to serve the underbanked segment thus creating new market opportunities.

The report also says that SMEs remain a largely underbanked segment in most markets. Eighty per cent of surveyed SMEs say they need to borrow but lack access to affordable credit. Digital banking will be in the forefront of serving the banking needs of SMEs.

The Monetary Authority of Singapore (MAS) has also opened applications for digital banking licences. E-wallet players and other digital financial providers will be allowed to apply for the licences and there will be five digital banking licenses to be awarded.

It was reported that around three dozen firms, including ride-hailer Grab, Standard Chartered and Singapore Telecommunications are in talks to form consortiums that can meet tough entry norms to bid for the licences.

Singapore’s MAS has imposed stiff requirements for licensing, including requiring S$1.5 bil in paid-up capital for retail banks, and local control. This has made it necessary for bidders to team up to combine banking know-how with technology.

Singapore’s central bank will issue up to two retail and three wholesale bank licences. Retail banks can accept deposits from and offer services to both retail and non-retail customers but must be led by a Singapore-based company. Wholesale banks will mostly serve SMEs.

Some of the applicants are hoping that their customer data combined with new technology will help them grow their business in Singapore’s banking market that has over 150 deposit-taking institutions, with total assets of about US$2 tril.

Singapore’s initiative follows moves elsewhere including in Hong Kong, which issued eight online-only banking licences, four to consortiums. The island-state is set to announce the winners in mid-2020 and the digital banks are expected to start operations from mid-2021.

How will digital banks be regulated?
According to Yap of Accenture, digital banks have to adhere to rules akin to traditional banks. They will have to meet the minimum paid-up capital requirement and the same supervisory standards of regular banks. They will also have to observe corporate governance standards, risk management practices and information systems resilience.

McKinsey in a report says that in a digital banking environment, the compliance department has to play a more active role. It has to shift from a mere advisory role to directly participating in risk management. The governance of risk management with regulations is achieved by a risk management framework that is fully integrated to work with a bank’s operational-risk protocols and procedures.

Digital banking has a heightened money-laundering risk because of the opportunity for banking transactions to occur without ever having seen the person who owns or controls the account. Billions of dollars move through the international banking system in a day.

The real ownership of an account and the source of funds can be masked from the bank. False identification documents and shell corporations are frequently used to open bank accounts for illicit transactions.

When banks fail to file suspicious activity reports and fail to take appropriate actions to stop money laundering, they are subject to severe prosecution and enormous fines. That is the reason why banks are spending billions of dollars to ensure that their banking compliance systems are water-tight.

Banks typically have many cross- border issues. Even if there are no branches in a country, the use of a bank card by a customer, to buy something or withdraw cash from an ATM, can trigger local compliance issues.

Reuters reports that there were more than 56,000 regulatory changes related to banking in 2017. Compliance with regulations is made more challenging with the innovations happening in digital banking. It makes it more difficult when regulations have not yet caught up with the technological advancements.

Trust in digital banking will be enhanced through a robust compliance framework to operate safely and effectively.

Shaking up the market in niche segments
The future of digital banking will depend on its practicality and ease of usage. Some quarters assert that what we have now is simply digitised banking where traditional banking products are adapted to the digital era using smartphones and the internet.

There is also a school of thought that says the real innovation will begin when legacy banks move away from modernising the digital experience and focus on launching new digital capabilities.

Shankar of EY says digital banking would “shake up” the market in niche segments. The digital banking environment is expected to have a huge influence on the banking sector in Malaysia.
Given BNM’s focus on addressing the needs of the underserved market, digital banking could take off in a big way here.

However, people need to be convinced on the merits of digital banking before they opt for it. BNM has been successful in providing a sound landscape for conventional banking and in all probability it will do the same for digital banking.

The trust issue is the cornerstone of banking and with adequate safeguards, the central bank must ensure that the integrity of digital banking in Malaysia would not be compromised.

It would also be interesting to see if the conventional banking groups in Malaysia apply for the digital banking licence. Some have upped their digital offerings and opting for a digital banking licence may result in some duplication. However, some conventional banks in Singapore had applied for the digital banking licence there by teaming up with e-wallet players to take advantage of the latter’s database.