Digital banking is on the rise worldwide, thanks in large part to regulators welcoming these new entrants as a much-needed injection of competition and innovation in the banking sector. In an effort to encourage digital banking, some regulators have decided to create custom licensing regimes. At the same time, we see markets where digital banks are thriving without a special license. So, what are the new digital banking licenses, and do they help to harness innovation in the banking sector?
To begin with, it’s a good thing that regulators are looking for ways to shake up the banking sector. In markets as diverse as Hong Kong, Singapore, Germany, South Africa and Mexico, fewer than five banks dominate the market. The lack of competition and the oligopolistic structure of the sector makes incumbents slow to innovate, which means customers miss out on lower prices along with greater choice and quality of services that meet their needs.
Digital banks have new technological capabilities and lower operational costs and capital expenditures per customer, positioning them to offer more affordable, user-friendly services to underserved customers than their brick-and-mortar counterparts. In this way, digital banking could advance financial inclusion. Digital banks also stimulate the modernization of the sector, moving it toward a modern digital architecture that improves the overall quality of banking services.
To lure new entrants — including to markets that haven’t seen new entrants for decades — some regulators have adopted a bespoke digital banking license. Hong Kong, Korea, Malaysia, Singapore, Taiwan and the Philippines are all examples of this approach.
Bespoke digital banking licenses go by different names: “virtual banks” in Hong Kong, “internet-only banks” in Korea and Taiwan, “digital banks” in Singapore. But they share a few characteristics:
- Restrictions on bank’s physical presence. By limiting physical touch points, regulators encourage innovation in digital distribution. Digital banks in Taiwan and Singapore are not allowed to establish branches. Bank Negara Malaysia proposes a similar measure. However, banks may participate in a shared ATM network and offer services through agents to ensure access by the underserved.
- Unaltered fundamental requirements for banking. New digital banks still must comply with basic regulatory requirements such as AML/CFT and consumer protection rules, risk management and prudential requirements like minimum capital.
- A focus on financial inclusion. Regulators expect new entrants to target unserved and underserved customer segments, including micro, small and medium enterprises.
Another common feature concerns ownership and controlling requirements. To attract (or yield to) big tech companies and other types of investors in digital banking, regulators are relaxing ownership limits where they exist. For instance, Korea allows non-financial companies to own up to 34 percent of digital banks. The Financial Supervisory Commission in Taiwan allows a non-financial company with financial technology, e-commerce or telecommunication capabilities to found a digital bank and own more than 10 percent of the capital. This is not the case for traditional bank ownership.
Creating a bespoke license is certainly not the only approach regulators have used to bring new players to the market. Australia, the United Kingdom, Singapore and Switzerland are testing a phased licensing process whereby new entrants commence operations with limited activities before becoming fully licensed banks.
Since 2013, bank license applicants in the United Kingdom have been able to choose between the regular licensing process and a sequenced or phased one. The sequenced licensing allows applicants to launch their business at a small scale, subject to restrictions (for example, limits placed on the total amount of deposits the start-up bank can collect from the public at the initial stage). As they build their capabilities and capital readiness over a determined timeframe, regulatory approvals are expanded to a full-fledged license.
However, some jurisdictions simply treat digital banks for what they are: banks with cutting-edge technology under the hood.
Without creating any specific licensing procedures and often by relying on risk-based regulation, regulators in Brazil, Germany and South Africa have licensed digital banks under their existing licensing regimes. It may attract less attention in news, but this approach seems to yield satisfactory results. These countries and their start-up digital banks are evidence that a special licensing category for digital banks often is not needed to create a digital banking industry. What is often more important than a bespoke license is the ability of regulators to accommodate innovation, applying a risk-based approach driven by activity-oriented risk assessment; openness to new solutions, such as cloud computing (including a cloud-based core banking system); and open communication channels, such as innovation offices (or a regulatory sandbox).
This is not to say that the countries that have implemented special licenses did not have good reasons to do so. We believe that many of them had reasons stemming from their specific context and pre-existing regulatory requirements. That’s why we believe regulators should carefully consider whether following this approach makes sense in their own context before announcing their own digital banking license.
Technological innovation has been changing the banking landscape around the world. The COVID-19 pandemic will further push banking onto digital channels. Eventually, the distinction between "traditional" and "digital" banking will most likely fade away. The question is whether the regulatory framework will need to undergo significant changes on the way.