Digital banks want Hong Kong, but does Hong Kong want them? This is the question facing the virtual institutions entering this market, which are set for losses for the next two years at least. S&P Global Ratings believes online lenders' Hong Kong opportunities are largely niche, that incumbent banks are already highly digitally competitive, and that several internet-based lenders will likely fail.

Despite the inevitable cash burn and high potential for failure, eight virtual banks have already landed in Hong Kong. Big incumbent banks are backing several online lenders. The incumbents want to test the business model and spread their bets across regions, should digital banking break out as a major service.

Large technology companies are also backing virtual institutions on the view it's the easiest way into Hong Kong's lucrative banking market. The regulator has essentially stopped granting licenses to traditional lenders. Even if one were for sale, it would be prohibitively expensive.

Does The Virtual Business Model Make Sense In Hong Kong?

The typical story about virtual banks is that they are cheaper to operate. Indeed, Hong Kong's digital lenders have significant cost advantages over traditional banks in terms of overhead and infrastructure. But they face major hurdles in turning those advantages into profits.

Chart 1

For example, banking professionals are well paid in Hong Kong. The digital banks have to spend as much--or more--as traditional banks on their employees but have a much thinner base of revenues to support this cost.

The digital players also lack brand recognition. They must spend heavily to acquire customers. Their marketing costs are significant, and many are offering loss-making interest rates to draw in customers.

At the beginning of its operation, in August 2021, the digital-only lender livi Bank Ltd. offered new clients a 3% interest rate for the first HK$50,000 they deposited with the bank. This was much higher than the essentially interest-free (0.001%) deposits offered by the big incumbents: Hongkong and Shanghai Banking Corp. Ltd. (The), Standard Chartered Bank (Hong Kong) Ltd., and Bank of China (Hong Kong) Ltd.

Hong Kong's digital lenders are also offering rates on personal loans that are significantly below market. The terms may include attractive cash rebates. Some have already dialed back these offers, cutting their deposit rates and raising lending rates.

Chart 2

The virtual banks will need to keep spending heavily for years to achieve a critical mass of clients. Only then will they be able to establish the range of products and services they need to be fully competitive.

Meanwhile, the large incumbent banks are ramping up their online offerings. They have deep technology budgets and armies of IT specialists. This will make it difficult for virtual institutions to match, let alone beat, the incumbents' products and services.

We expect the digital-only banks to remain niche players for the next two to three years at least, and that some of these institutions will not survive. All were making a loss as of the end of 2020 (see chart 3).

Shareholders' financial support will be vital to keep the entities going in the meantime, to replenish lost capital and pay for the heavy cost of expansion. Mox Bank Ltd. shareholders have injected HK$469.2 million into the institution so far in 2021, according to the bank's financial reports. Shareholders in WeLab Bank Ltd. have invested HK$65 million into the bank this year. Mox and WeLab Bank are two of Hong Kong's eight online lenders.

Chart 3

Mindful of their risks, the Hong Kong Monetary Authority (HKMA) required the virtual banks to provide an exit plan at their initial application. This was to ensure that these institutions could cleanly exit the market with minimal disruption, should one fail.

Incumbents Are Catching Up

To become viable, the virtual institutions will need to offer more than loss-inducing interest levels. On top of providing a seamless online experience, the digital banks may utilize their more nimble structure compared with traditional banks, and offer more innovative, customized products.

For example, many virtual banks let customers choose the period on their fixed deposits, which is completely out of the norm for the industry. Some virtual banks have started to offer seven-day payday loans to customers, a new concept for Hong Kong.

The traditional banks are responding. For example, all the major players in Hong Kong--Standard Chartered, HSBC, Hang Seng Bank Ltd., Citibank (Hong Kong) Ltd., and Bank of China offer virtual account opening.

Regulators are pushing for greater financial inclusion in Hong Kong, prompting large banks to match some of the digital banks' measures. For example, many incumbents are removing their service fees for basic banking accounts, even if the funds on deposit are minimal.

Meanwhile, the traditional banks have a wide range of instruments--from basic credit cards to wealth management--that outmatch the digital players. Virtual banks so far only provide very simple savings, credit card, and loan products.

Given the difficulty in cracking this ultra-competitive market, we view as notable that eight digital-only players have already ventured into Hong Kong (see table 2). We see four broad reasons for wanting to launch a digital-only bank.

Reason No. 1: It's a cheap way into Hong Kong

A digital bank is the cheapest way into Hong Kong's lucrative banking market. The only real alternative would be to buy an existing bank network. This would be expensive, typically involving a huge premium to the existing share price.

The regulator rarely approves new locally registered licenses. The last one was granted in 2015 to Bank of Communications (Hong Kong) Ltd., which is a subsidiary of one of the six largest banks in China. Excluding the virtual banks, there are a total of 23 locally registered license banks in Hong Kong. Very few of these banks are independently run (and thus could conceivably come up for sale).

With the virtual licenses, Hong Kong regulators have offered a cheap and rare opportunity to get into the Hong Kong banking industry. The competition for the license was strong with around 30 applicants. The approved entities sailed through the process (see chart 4).

Chart 4

While regulators require the same initial capital for a virtual bank as they would for a traditional lender (HK$300 million), the digital entities require less upfront investment. Hong Kong's real estate costs are notoriously high. Digital banks get to skip the step of setting up a network of physical branches, which would be dauntingly expensive.

Reason No. 2: Participants see it as a bet worth taking

Hong Kong's virtual banks also have strong backers that can afford to take a bet on a business that may pay off in unexpected ways.

China's big technology firms know the potential of online finance and they are invested in almost all of Hong Kong's virtual lenders. For example, Xiaomi Corp., Ant Group (affiliated with Alibaba Group Holding Ltd.), and Tencent Holdings Ltd. are all backing existing digital banks in Hong Kong. Alibaba and Tencent have extensive experience with digital finance in mainland China. These big groups can afford many years of losses in Hong Kong, if necessary.

The entities may also benefit from tie-ups with the parent. For example, both livi and Mox offer rebates and discounts for shopping in their parents' retail stores or websites. Jardine Matheson Holdings Ltd., which is invested in livi, owns a pan-Asian pharmacy chain, and the Mandarin Oriental hotel chain. Mox shareholders include Trip.com, which owns travel sites, and PCCW Ltd., which operates telecom companies.

Table 1

We believe such arrangements will help the virtual banks and their merchant backers. It incentivizes users to sign up for services at the bank and the merchants. Meanwhile, the banks collect data on spending habits, which they can use for targeted marketing (see appendix for shareholder details).

Several big incumbent banks are backing virtual banks. Industrial and Commercial Bank of China (Asia) Ltd. backs an entity called Fusion Bank. Standard Chartered is invested in Mox, and Bank of China backs livi Bank.

We believe this is a way for established banks to place a bet on online lenders. If the pure-play digital model takes off, then these incumbent banks can leverage an existing business. They could also cheaply replicate the operation in other markets, spreading out their initial investment costs.

The other big incumbents in Hong Kong--particularly HSBC and Citibank--are not investing in virtual-only banks. These entities are still betting on virtual banking, they just believe they can develop the service within their current infrastructure. They are spending heavily on digital services. This gives them some protection should a particularly powerful piece of financial technology disrupt their traditional model.

We see more opportunity for cross-selling as the virtual banks obtain licenses from the Securities and Futures Commission, and the Insurance Authority, to offer brokerage, insurance, asset management, and other financial management products.

That is exactly what Mox is aiming for. Mox has announced that the firm wants to double its customers to 200,000 by the end of this year. Mox has also said that the firm aims to launch insurance and wealth management products after it obtains relevant licenses. This could help the bank to generate more revenue and, perhaps, to eventually break even.

Reason No. 3: Niche opportunities are available

We believe the virtual banks have niche opportunities that the large banks may be overlooking. This may include a more focused coverage of small and midsize enterprises (SMEs), and of poorer clients typically underserved by traditional banks.

Given their small capital base, virtual banks can only do small-ticket loans. This makes the institutions the natural lenders to SMEs. Virtual banks may improve their revenue base and profitability by bundling financing and technology solutions to SMEs.

This gives the digital players a toehold in Hong Kong's competitive banking industry. It also lets them forge ties with enterprises that may grow much larger in the years ahead.

Virtual banks may also attract a young, tech-savvy clientele. While their initial income level or revenue contribution to these virtual banks could be low, as their wealth grows, so would their banking needs.

Digital banks' low operating costs also make them a natural fit with poorer clients with minimal cash. The institutions may be able to offer basic products at a low cost to this segment. Hong Kong regulators are likely to look favorably on virtual banks' ability to cater to this underserved market.

Reason No. 4: Virtual banks are eying the Greater Bay Area

Then there is an opportunity that is, for now, pure potential but could be huge. By setting up a virtual bank in Hong Kong, backers may be positioning themselves for the chance to sell financial products into mainland China.

Mainland Chinese regulators want greater financial integration in the Greater Bay Area. The region encompasses the prosperous cities of Hong Kong, Shenzhen, Macau, and Guangzhou. The area has a combined GDP of US$1.67 trillion with a total population of around 86 million as of end-2020.

Hong Kong institutions are not yet permitted to sell their products in mainland China, and virtual banks are restricted to serve only with Hong Kong residents. However, they will likely gain access to this giant market as integration rolls out.

We also see significant growth opportunities for the cross-border selling of financial products once governments finalize "Wealth Management Connect" and "Insurance Connect." The initiatives would allow cross-selling of financial instruments between Hong Kong and other cities in the Greater Bay Area.

We think Hong Kong's virtual banks will eventually have the same access to the Greater Bay Area as any other financial institution in the city. Furthermore, if the goal is to serve this region, an institution may prefer not to carry the cost of a branch network in Hong Kong.

The size of that opportunity may justify the start-up costs and any losses incurred over the next several years. That broadly is the story of digital banks in Hong Kong: losses now, but the possibility of a breakthrough in the years ahead.

Table 2

Related Research

• The Future Of Banking: Can Digital-Only Banks Crack Malaysia?, April 13, 2021
• The Future Of Banking: The Incumbents Strike Back, March 16, 2021
• The Future Of Banking: China's Digital Renminbi Could Hit Payment Platforms, Nov. 11, 2020
• The Future Of Banking: One Year On, Hong Kong's Open Banking Initiative Hits A Roadblock, Oct. 3, 2019

Writing: Jasper Moiseiwitsch

Digital design: Evy Cheung