This article first appeared in Digital Edge, The Edge Malaysia Weekly on August 8, 2022 - August 14, 2022

Malaysia will see five licensed digital banks in the market within the next couple of years, putting in question the position and role of conventional banks. Local banks such as CIMB Bank and Maybank are already backed by strong digital offerings. Others, while having embarked on their digital journey, may face tougher competition, with the advent of the digital banks.

The Covid-19 pandemic accelerated digital adoption among conventional banks, and most day-to-day activities can now be performed online. According to a 2020 EY survey of banks in Asia-Pacific, 50% have already started their second wave of digital transformation.

The general consensus, however, is that the position of conventional banks will not be threatened in the next five years or so because digital banks are only allowed to provide products and services to unserved or underserved segments, which are not the target markets of the incumbent banks.

In a CGS-CIMB banking sector note, analyst Winson Ng says most incumbent banks, especially the bigger ones, have strong business franchises in Malaysia, with a long operating history (more than 20 years), extensive geographical coverage, a full suite of financial products and a huge customer base. These would help them retain most of their customers when facing competition from the new digital banks, he says.

“There is no stopping the incumbent banks from replicating any successful product offering by digital banks to neutralise the competitive threat posed by the latter,” Ng says. “Incumbent banks have much larger financial resources (capital and constant inflow of income) to compete with the nascent digital banks.”

Technology is going to play a big role, in view of Malaysia’s digital ambitions. Regulations and policies surrounding financial technology will also come under the microscope as consumers become more aware of their personal data and security.

Innov8tif Solutions Sdn Bhd CEO George Lee tells Digital Edge that, while consumers’ trust in digital banking services remains strong, they are increasingly worried about data privacy and account security, which require regulatory changes.

Lee adds that global ransomware cases are on the rise and data leaks have become more frequent, with the Philippines witnessing a 2,324% surge in hacking attacks.

“The top priority should be significant updates to our local data privacy laws and greater enforcement. As part of the MyDIGITAL blueprint, the government aims to review and amend the PDPA (Personal Data Protection Act 2010) by 2025, but our security needs are immediate and urgent,” he says.

“For instance, we could establish mandatory breach notification laws to compel companies to disclose leaks and cyber-attacks. This ensures that business partners and customers are not kept in the dark when their data has been compromised. Currently, the PDPA only requires data users to comply with its regulations, but including data processors in the list would boost accountability as well.”

Nevertheless, the entry of digital banks will raise the bar and change customer expectations, says Juan Madera, financial services sector Asean leader at IBM Consulting. As their offerings mature, Madera says, digital banks will be able to differentiate themselves in certain areas, such as small and medium enterprise (SME) banking or specific offerings to customer segments. “Traditional banks haven’t done a great job offering solutions to micro SMEs (MSMEs), which have the potential to become larger companies, as well as to specific segments such as the gig economy. Digital banks have the potential to do so.”

Shankar Kanabiran, Malaysia financial services consulting leader and partner at Ernst & Young Consulting Sdn Bhd, believes competition will be present in the market, as was seen in Hong Kong, where incumbent banks offered higher deposit rates and lower lending rates after the Hong Kong Monetary Authority issued digital bank licences.

Currently, alternative financial services such as equity crowdfunding (ECF) platforms, peer-to-peer (P2P) lending and digital personal loans are present to fill the gaps not covered by conventional banking. Madera says these parties will be the most affected by digital banks because the latter’s offerings will be more integrated.

Shankar agrees, adding that the emergence of digital banks will intensify competition with alternative financing providers. In relation to the ECF and P2P players, Shankar says that, previously, underserved or unserved segments were not fully served by traditional banks because of factors such as limited credit and financial history and low loan quantum, as well as new business models that they were unfamiliar with.

Therefore, businesses approached other players in the market, such as P2P players, as they offer short-term and flexible repayment structures, along with quicker and alternative credit assessments.

“Digital banks can alleviate such pain points through the use of innovative technology to enable a more flexible credit score assessment. Such technologies include alternative credit scoring assessments, analytics-driven operations and automated credit approval for low-value loans,” Shankar says.

“In relation to the licensed money lenders and digital personal financing, digital banks have an advantage in that they are allowed to collect deposits, which gives them access to a relatively cheaper source of funds that can be given out as loans at a lower rate.”

Identity (ID) assurance technology would be at the forefront for digital banks. Innov8tif’s Lee says process automation and digitalised financial services had existed in incumbent banks long before digital bank licences were issued. However, digital banks are not dependent on physical branches nor teams of staff members to verify and authenticate their users firsthand.

As such, digital banks are forced to operate under the assumption that the customer data they receive from web portals or mobile applications are legitimate and authentic, says Lee. Loan applications, account openings or free giveaways rely heavily on the integrity of this customer database.

“ID assurance technology helps protect said sanctity. One good example would be e-KYC (electronic know-your-consumer), where users are required to perform a selfie and capture their ID card using their mobile phones to register a user account,” he says.

“This helps digital banks automate data collection and, hopefully, dissuade amateur fraudsters from creating fake accounts. However, ID assurance can go beyond e-KYC, such as binding unique devices to user accounts or comparing registration attempts against criminal and bankruptcy databases.”

Lee adds that the existing e-KYC requirements should be expanded as recent data leaks have been a goldmine for fraudsters, enabling them to impersonate unsuspecting victims for account openings and transactions.

More robust anti-spoofing requirements are needed to combat these tactics, he says, and the government should also consider extending such requirements beyond the financial industry, considering that e-commerce scams made up about a third of all cybersecurity cases over the past five years.

Although the rise of digital banks translates into more demand for e-KYC products, only five Malaysian digital bank licences were issued this year, with hopefully more to come, says Lee. He says Innov8tif’s business mainly involves tackling the regional market and expanding the scope of where e-KYC can be applied, such as telecommunications, start-ups and utility companies.

“e-KYC involves establishing proof of the user’s identity, but we have since expanded the scope to proof of address and income. We have also increased our localisation support, where our technology is able to scan Thai and Khmer languages and support the majority of identity documents in Asean, passport included,” he says.

Over the last few years, the country shifted its priorities to manage the economic fallout of the pandemic, Lee says, but digital banking will now play a much more direct role. The issuance of digital bank licences will address an immediate priority rather than fuel the nation’s ambitions.

“Digital banks also offer faster transfers and payment distribution, easy loan applications and better visibility over financial transactions. This benefits both consumers and businesses, large and small, local and foreign. It reduces friction and promotes trade and business activities, all of which are crucial at this point in time,” says Lee. “Its ability to oil the wheels needed to drive the economy makes it a core pillar in furthering our national digital agenda.”

Digital banking will also serve as a benchmark for other sectors to follow when it comes to delivering a well-crafted online user experience, setting up digital platforms and higher cybersecurity standards. It also boosts our international standing as well, says Lee. “Many foreign investors and corporate leaders are already impressed with our widespread QR code adoption. An impressive digital banking ecosystem will further cement that reputation,” he adds.

“The keywords here are ease and accessibility. The push towards digital banking is highly welcomed and anticipated. It may not be our nation’s highest priority, but it certainly is a cornerstone of our digital ambitions. Its ability to cause positive rippling effects should not be underestimated.”

The focus of conventional banks will be on its existing customer base, which is already reasonably well served by the incumbents, says Shankar. Bank Negara Malaysia has said that digital banks are expected to focus on the underserved and unserved population.

Based on research done by Bain & Company and Temasek, 15% of the total adult population in Malaysia remain unbanked in 2019, while 40% were underbanked. MSMEs also faced a finance gap of US$21.5 billion, owing to credit constraints. The gap represented around 7% of the Malaysian economy.

Thus, Shankar says, the digital banks’ primary target market would be the “middle segment”, as well as MSMEs, especially in the areas unaddressed by the incumbents. Most of the market value is held by the “middle segment” as 42% of the value pools are with individuals earning between RM2,000 and RM4,000 per month.

“The ‘middle segment’ includes individuals who lack credit history or a consistent source of income, such as gig workers, first-time borrowers, young middle class, retirees and those who have recently joined the workforce. It may also include individuals who possess a low level of financial literacy and individuals from the rural areas,” he says.

“There are promising prospects for digital banks in Malaysia as they are expected to offer a differentiated and compelling proposition, especially to the younger generation, digital natives and the underserved and unserved segments, which are often overlooked by banks because of their weak conventional credit scores.”

There are concerns about the ability of digital banks to tap these market segments, says Shankar, as the majority of the unbanked have minimal to no income, which suggests that they are highly unlikely to engage with digital banks merely because of the digitalisation of banking services.

Madera points out that most universal banks, such as Maybank and CIMB Bank, cater for 80% of the population, which means there is always an opportunity to better serve the remaining 20%. The problem with the 20% is perhaps that it is more difficult to assess their risk, but that does not mean that is not a good proposition, says Madera.

“It is very important that digital banks become purpose-built organisations, particularly when targeting the unbanked population. The purpose has to be very clear and it has to have an ethos associated with banking,” he says.

“So, digital banks need to gain the trust of customers and be purpose-built while building their brand and image to create a long-term relationship with clients, whether they are individuals or MSMEs. That’s something that traditional banks haven’t done that well and there is an opportunity for digital banks to focus on that.”

In addition, there will still be segments such as those serviced by the silver economy, many of whom are not digital-savvy, or those who prefer to transact conventionally, owing to reasons such as a fear of data breach and fraud, says Shankar.

Despite these concerns, there has also been increasing acceptance of digital banking services across the banking landscape. According to the 2022 EY NextWave Global Consumer Banking Survey for Malaysia, respondents showed much interest in the one-stop shop concept, with 68% rating seamless integration as being either extremely or very important, while 61% were either extremely or very interested in super apps.

“The survey also found that the seamless integration of banking activities and stronger personalised offerings is one of the key factors for banks to retain and engage in more customer relationships. While there is still a long way to go, especially in gaining consumer trust, digital banks will be the future,” says Shankar.

As with any industry, the weaker, non-profitable players will be removed from the market over the long run — either by having to cease their business, merge with another entity, consolidate to grow their size or be acquired by stronger players.

CGS-CIMB’s Ng points out that RHB Bank is the only Malaysian bank that secured a new digital banking licence (through its joint venture with Boost) that would be negative for the bank in the short term because of the potential operating losses, over the next two to three years, from the new digital bank.

He says, however, that the potential annual net loss would be small. “We expect the venture to be positive for RHB Bank in the longer term when its digital bank turns profitable. Furthermore, it can learn the ropes of running a pure digital bank, which could help it to improve its existing operations.”

There have been cases of digital banks dropping off the market in Australia and Europe, which means that the possibility of something similar happening here cannot be discounted. Ng expects new digital banks to be loss-making — or record minimal profit, at best — in the first two to three years after they commence operations as it takes time to acquire new customers, and because of the limited size of the focus market.

“Within this period, any aggressive price competition undertaken by the new digital banks could deplete their capital positions, which will not be viewed positively by the regulator,” he says.

“So, if a new digital bank embarks on aggressive price competition that leads to a swift expansion in its loans or deposits but a decline in its total capital, its shareholders may have to top up its equity capital to support the higher risks it is undertaking. This would not be a desired outcome for the shareholders of the new bank as the move would dilute its return on investment (ROI).

“The new digital banks cannot afford to launch any large-scale price competition against the incumbent banks for a long period of time. Comparatively, the incumbent banks have much stronger financial muscle and higher profitability from their existing businesses to fend off any price competition from the new digital banks.”

Madera says some of the strategies undertaken by digital banks are Asean-wide strategies, therefore the investments can be shared and leveraged among the region’s 700 million population.

“Banks that are specific to one country, whether it’s in Singapore or Malaysia, will find it more challenging because of the high competition and high degree of bank population as well,” he says.

It is also important to note that each consortium that was awarded the licence would have a sound business plan in place, one that forecasts the projected growth, ROI and payback period, says Shankar.

As determined by Bank Negara, the licensees would need to be able to maintain capital funds of at least RM100 million, unimpaired by losses, during its foundational phase (the first three to five years of operations). Thereafter, the amount increases to RM300 million.

“It is important to note that there will be a shift in the measure of success for digital banks, in which the market will not only rely on the traditional banking metrics but also digital business and digital economy metrics, such as the percentage of digital sales and the net promoter score for the purpose of assessing digital business metrics, and the share of trust, the share of mind and the ecosystem value to assess the digital economy metrics. These metrics will be taken into consideration in evaluating the success of the digital banks,” says Shankar.

So, who will ultimately win in Malaysia’s financial services game? The customers, say Shankar. “Based on what we have seen with successful digital banks regionally, their success can be attributed to the scaling of customer base quickly to achieve profitability, delivering ‘brilliant basics’ as table stakes and being laser-focused on specific segments and a targeted value proposition.”

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