Asia’s Emerging Virtual Banks

Asia boasts one of the world’s most active financial technology (fintech) sectors, as technology conglomerates take advantage of increasing internet connectivity to provide digital financial services like online lending and mobile payments. Branchless, virtual banks have been in existence long prior to the recent rise of new financial technology giants.1 Today, several Asian regulators are amending existing rules to allow technology firms to own and run virtual banks, which will likely result in a number of new digital lenders. This has triggered debate and discussion about licensing requirements, risk management, and consumer protection.

Not New but Gaining Traction

The virtual bank is not a new phenomenon in Asia. Japan opened the door for branchless banks in the late 1990s in a wave of financial deregulation and the nation’s first internet bank, Japan Net Bank, has operated since 2000. Over time, Japan Net Bank and other internet banks such as Seven Bank and SBI Sumishin have gained popularity with convenient online banking options and low costs, even though they remain small, niche players. Like Japan, Hong Kong was an early mover, issuing guidelines on the authorization of virtual banks in 2000. Still, the concept of virtual banks only started to take off in Asia recently as booming fintech and an increasingly tech-savvy customer base led authorities to easing ownership requirements for virtual banks.

Allowing Non-Financial Companies to Own Virtual Banks

Participants interested in opening virtual banks include not only traditional banks but also non-financial companies, especially telecom and technology firms. But traditionally, bank ownership by non-financial companies has been capped in most of Asia to prevent spillover of commercial risks to the banking sector and to ensure the public bank safety net does not expand to non-financial owners. In those jurisdictions, before nonfinancial companies can get involved in banking in a meaningful way, authorities often must first take steps to revise existing ownership rules.

In May 2018, the Hong Kong Monetary Authority (HKMA) revised existing guidelines to allow non-financial firms, including technology companies, to own and operate virtual banks via a locally incorporated holding company, a departure from the previous rules that non-financial corporations cannot own more than 50 percent of a bank. Elsewhere, South Korea’s National Assembly passed a bill to raise the non-financial corporations’ maximum stake in banks to 34 percent from the current 4 percent in September. Meanwhile, Taiwan’s Financial Supervisory Commission (FSC) is amending regulations to permit non-financial corporations to take up to a 60 percent stake in virtual banks.

Asia’s Virtual Banks Open for Business

China has some of the highest profile virtual banks—WeBank and MyBank, which are sponsored and controlled by technology conglomerates Tencent and Alibaba, respectively. They were both among the first five privately owned banks to receive a license from the China Banking Regulatory Commission (CBRC) in 2015. Both turned a profit one year into operation and continued to report impressive earning figures in 2017. Beyond financial performance, WeBank and MyBank highlight the recurring theme of how large tech conglomerates have expanded their business models by leveraging online commerce, social network platforms, and big data to convert existing users into potential banking customers.

South Korea approved a plan that would grant preliminary banking licenses to two internet banks in 2015. K-bank received its license in 2016 and began operations in 2017—the first time a new bank had been licensed in Korea in 25 years; Kakao Bank followed shortly after. Within a year, the two banks have attracted more than 7 million customers and extended some 8 trillion won (US$ 7.5 billion) worth of consumer credit loans, according to the Korean Financial Services Commission (FSC).

More virtual banks are on the way. By August 31, more than 50 companies from across the world have expressed interest in applying for virtual bank licenses in Hong Kong after the HKMA welcomed the establishment of virtual banks in Hong Kong. After finalizing rules for virtual banks in August this year, Taiwan’s FSC is currently planning to issue two virtual bank licenses. Korea’s FSC has also recently announced the intention to grant two more preliminary virtual bank licenses by early next year.

The Allure: Financial Inclusion

For regulators, a top potential benefit of virtual banks is financial inclusion. Unsurprisingly, virtual banks can be run more efficiently than conventional banks. By definition they can avoid the overhead costs that come with maintaining a physical branch network, such as real estate and bank personnel. Virtual banks also tend to offer less complex products, with simpler processes, and can host nonessential services at third party vendors to control costs. Such cost savings can be passed on to customers in the form of lower fees for services and higher rates on deposits. Virtual banks also benefit from scalability, which appeals to regulatory agencies in countries looking to expand financial inclusion.

Regulators have articulated their anticipation for virtual banks to help improve financial inclusion. For instance, the amended HKMA guidelines stated “To bring value to the industry, virtual banks must… play an active role in promoting financial inclusion.” Chinese regulators have similar expectation for privately-owned banks, including the two virtual banks. Both WeBank and MyBank have established the strategy of becoming market leaders in extending small- and micro- loans to households, small businesses and rural borrowers, a substantial demand that conventional banks were not able to meet in the past.

The Challenges: Risk Management and Consumer Protection

Also unsurprisingly, there are plenty of regulatory challenges. Money-laundering and fraud are key risks in the banking industry, and traditional banks have established strict Know-Your-Customer (KYC) processes to ensure the identity of customers and curtail risks. Virtual banks, however, encounter a fundamental dilemma in trying to identify customers that it may never see. Regulatory approaches to addressing KYC requirements are different. Korea’s FSC decided to allow customers to open a bank account remotely with a virtual bank. In contrast, Chinese regulators insist on restricting the type of accounts a virtual bank can offer and only allow opening full-service accounts in person, which effectively put restrictions on virtual banks’ business scope and source of funding.

Moreover, the use of technology in lieu of physical branches has opened the door for potential fraud, and raised the issue of how banks should use and treat customer data. Asian regulators appear to be mindful of these issues, and some have written specific rules regarding consumer protection. For example, the HKMA requires each virtual bank to have at least one physical location in order to handle customer complaints. Nonetheless, consumer protection will likely remain a top concern and the challenge will evolve with fintech’s increased participation in providing financial services, calling for more regulatory responses.

Last but not least, virtual lenders typically often focus on the underserved population, which benefits financial inclusion but implies more challenges for risk management. Safety and soundness concerns are especially acute when the banks in question are owned and run by non-financial firms with no prior experience in banking. To address the concern, Asian regulators have stressed that virtual banks are subject to the same minimum licensing criteria and supervisory requirements as traditional firms. Although virtual banks are relatively small in size and arguably not (yet) systemically important, some of them need to create an exit plan as a prerequisite for a banking license in order to minimize potential risks to the public financial safety net.

Traditional Banks Brace for Challenges

It is still too early to tell whether Asia’s new virtual banks will be able to thrive and achieve long-term growth. After all, internet-only banks have existed for more than a decade in advanced economies like Japan and the United States, but none have become an industry leader despite high levels of internet penetration in both countries. Nonetheless, the emergence of virtual banks has opened the door for non-financial companies to enter the banking industry in several jurisdictions, and traditional banks are feeling the pressure for future competition from niche lenders backed by technology firms and often without physical footprints.

Some are taking a page from virtual banks’ playbooks—MUFG and Mizuho have recently announced their plan to convert retail branches into automated branches, and some Japanese regional banks are taking the same approach. Elsewhere, Singapore’s DBS Group has launched the mobile-based digibank in India and Indonesia. Others are considering partnering with technology firms. In that sense, the challenge posed by virtual banks can also prompt traditional banks to embrace financial technology.

1. In this blog, the term virtual bank is used to describe banking institutions that are primarily hosted online, including online, branchless, internet, and mobile banks.