COVID Narrowed the Gap Between Traditional and Digital Banks
When the Monetary Authority of Singapore (MAS) decided to join the global party for digital banking by opening up applications for digital banking licences, many people (myself included) wondered how the new digital banks would compete for customers with the traditional banks.
Yes, we are aware that the younger and more tech-savvy crowd would be the main group that the digital banks target. But, within the five licences that MAS will be awarding, three are for wholesale banks (i.e. targeting mainly corporates and SMEs). How will the digital banks operate if the main on-boarding channel is digital?
After all, the logic goes, banking is a relationship business, especially for the high net worth individuals (HNWIs) and corporates. These were (supposedly) the ‘high-touch’ group, and (supposedly) the more profitable group. You needed your team of relationship managers to, well, manage the relationship (as the name implies).
However, COVID changed all that. Digital banks had expected an uphill battle to convince customers to transacting digitally and with as little contact as possible.
Now?
Everyone wants to transact digitally.
Additionally, other government ministries, not just the banking regulator, have enforced ‘social distancing’ measures and required banks to actually scale down their branch operations, which is a boon for a digital bank that can only operate one branch.
So, it seems that the gulf between the traditional banks and the digital banks has narrowed considerably, particularly in this important front. However, this is just the customer-facing front. Even though the gulf in this area has narrowed, there are two other major areas which can still remain competitive between the traditional banks and the digital banks — the regulatory capital requirements, and the credit model.
1. Regulatory capital requirements
One key area that stands out is the regulatory capital requirements. MAS allows a digital bank to scale up its regulatory capital slowly for the first five years, instead of having to meet the full capital requirements upfront.
Prima facie, this looks to be an advantage for the new digital bank since capital management is of utmost importance for a bank, and having a lower capital could potentially translate into a higher return on equity.
However, COVID has changed the narrative. Now, having a robust balance sheet is more important than optimising for efficiency.
This can be seen in multiple industries now, not just in banking.
Previously, where efficiency and skeleton crews were valued, now backups and contingency plans shine. For example, thinly-capitalised Fintechs were all the rage back when liquidity was cheap and plentiful, but now, investors (and customers) are looking for a robust balance sheet, even if that means that the capital usage is not optimal.
After all, having money that’s doing nothing is better than having no money!
In times like these, cash is KING.
So, now the reduced regulatory capital requirements don’t seem all that safe. Is having a reduced regulatory capital requirement a true advantage in this environment?
Would MAS now look more favourably at digital banks that can stump up MORE than the minimum regulatory capital ? Will having a heavier balance sheet be the anchor necessary to ride out this storm?
2. Credit model
The other big area is the credit model. Traditional banks have relied heavily on the financial metrics of a company (or person) to grant a loan and to compute the probability of default, while the digital banks are supposed to use more non-conventional metrics to evaluate the borrower’s credit worthiness.
Now, this is not to cast shade on any model — no model is perfect, which is why we have Non-Performing Loan (NPL) ratios. However, when times were good, all the non-financial metrics seem to paint an accurate picture of the borrowers’ credit worthiness, because they can still repay their loans.
COVID is now the ultimate stress test for these new credit models. Will the data points drawn from alternate sources e.g. your smartphone have a high enough correlation (spurious or not) to help the digital banks price their loans and manage their NPLs well, compared to more conventional financial metrics?
One good example for discussion is Grab’s Upfront Cash Programme. They claimed that one input to compute the loan is the driver’s future incentive earnings, and this looks like it is based on forecasted past earnings data.
However, COVID has decimated the incomes of many of these drivers. Will the drivers be able to repay the loan now?
Again, this is not to say that the model is bad, because no model is perfect. This model is a very novel and innovative one, based on the data they can obtain from their drivers that a bank cannot.
But, the dataset for the driver’s past earnings is not complete, since it has not accounted for a shock like COVID (or even the past recessions). Is Grab’s credit model robust enough to withstand this kind of shock? Are their debt recovery processes and write-off provisions sufficient to handle the NPLs?
One thing leads to another…
A bad combination of the above two factors could lead to a worst-case scenario — the closure of the digital bank due to a spike in NPLs that their thinner capital cannot withstand.
Meanwhile, even though we are going through COVID, the timeline for the issuance of the digital bank licences is still ticking, with the announcement for the licensees due in June 2020.
But, there is still a silver lining.
After all, tough times breed resilience. Digital banks that are born and built during these times should have a solid footing going into the eventual recovery.
And the digital banks will have the golden opportunity to prove that.
