Tech disruption risks differ markedly across countries and banks of the region.  Our assessment draws on four factors: technology, regulation, industry, and preferences (TRIP). In this report, we focus on banks operating in Armenia, Azerbaijan, Georgia, Kazakhstan and Uzbekistan (collectively, "Central Asia and the Caucasus"). In table 1 we summarize our views on these countries and how they compare to others.

Table 1

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The development of technologies and telecom infrastructure and more affordable mobile and internet services support the digitalization of financial services.   These developments support growing customers' preferences for digital financial services. Across the region, the number of users of mobile connection services and internet has surged over the past 20 years. Thus, the gap between the mobile and internet user numbers in Central Asia and the Caucasus and more advanced economies in Europe has narrowed.

World Bank data shows that on average people living in these five countries had about 1.26 mobile phone subscriptions in 2022 (compared with 1.21 on average for the whole Europe and Central Asia region). At the same time, on average 81% of population were internet users, compared with 88% for the total Europe and Central Asia region.

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In five countries, with the exception of Uzbekistan, the mobile internet coverage gap (the percentage of people that do not live within the footprint of a mobile broadband network) is minimal at 1%-2%, similar to Europe and Central Asia. However, there is a wide mobile internet usage gap (those who live within the footprint of a mobile broadband network but are not using mobile internet services), ranging from 33% in Armenia to 52% in Georgia. Various reasons explain the comparatively high number of people who have mobile phones but don't use mobile internet. Low income levels in particular make services unaffordable for some part of the population. This could be particularly relevant for Uzbekistan, which has the lowest level of GDP per capita in the region: around $2,500 in 2023. In contrast, Kazakhstan has the highest level of the five countries at around $13,200.

At the same time, several factors point to further potential for growth for consumers of modern technology, telecom and digital financial services in the region. These include:

• Our expectation for positive economic growth momentum over the next few years for Armenia, Azerbaijan, Georgia, Kazakhstan, and Uzbekistan;
• A long-term upward trend for disposable income;
• Continued urbanization; and
• A relatively young population (the median age is about 34 years)

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Early adopters and innovators in Central Asia and the Caucasus banking sectors gain competitive advantage in a dynamic market.   Banks need to keep up with the increasing speed and evolution of customers' demands, tightening regulation, and growing competition. Fintech and big tech companies add to traditional banking competition. At the same time, this situation provides vast growth potential for banks through the digitalization of client services and the systems that underpin them. Driving this is customers' growing preference for the convenience of digital banking, and pressure from nonbank players able to offer similar services. Digitalization enhances efficiency in emerging market banks by automating processes, optimizing branch networks, and reducing personnel costs, resulting in potential cost savings.

Currently, early adopters show limited immediate cost savings. In fact, we expect them to continue boost their IT budgets over the next few years to drive investment. However, over the long run, we anticipate they will improve their positions and become more cost efficient. At the same time, saving on IT budgets now will likely be a less than optimal choice for those banks that fail to adequately invest in digitalization and automation as they will face widening technology gaps.

Incumbent banks are well positioned to benefit from their forays into digital innovation.   All five regional banking sectors are rather concentrated and typically have few large dominant players. Many of these large players have become digital banking pioneers: they have physical and reputational prominence, brand recognition, larger IT budgets, and can hire the best talent in the market. Additional factors that help them withstand potential threats from new entrants to the sector and fintechs include:

• Banking regulation generally shields incumbent banks;
• Regulators appear to prefer stability and predictability of the existing structure and value the control they have developed over the potential uncertainty of innovating new entrants;
• Nascent capital markets mean banks can buy out competing fintechs whereas it might be tougher for non-bank institutions to raise funding for further growth.

The banking sector is a key lender in the region as there are few large corporate clients able to access domestic and external capital markets and lending by non-bank financial institutions—typically in the microloans segment--is rather small. Deposit-taking is performed by banks while domestic capital markets are embryonic and regulation favors retail depositors. At the same time, competition in some sectors--such as payments--is tight. The fintech sector is gaining market share because there is less regulation and customers are eagerly taking to digital payments.

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We doubt that the majority of banks in the region will adopt a no-branch digital model over the next three to five years. In our view, it will remain important to have a physical presence and the ability to communicate with clients in person, particularly for high-touch transactions. Branches, however, will continue to get smaller, cheaper to run, and better equipped technologically to enable clients to bank safely and quickly with a diminishing need to interact with staff. The ATM network is growing slowly, and we expect the machines will become more sophisticated in the services they offer.

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Governments and regulators continue making efforts to improve access to financial services and reduce the size of the informal sector.  Across the region, the proportion of transactions that occur in the informal economy is material. Access to financial services is uneven and a noticeable share of the low-income population has been underserved by banks. Digital banking services that are more cost efficient than traditional banks could help make banking services more affordable. Also, we think that in general regulators favor the expansion of digital banking because it provides them with more tools to persuade people to leave the informal economy in favor of the official sector. Banks and banking regulators have been successfully working on implementing a digital ID that allows retail clients access to financial and government services without the need to visit a bank branch.

Competition is very tight in the payment segment and is ratcheting up in others.   Across the region, rapid growth in digital payments and e-wallet activities offered by banks and nonbank fintech companies continues, making this segment one of the most advanced and most competitive. This also explains the appetite among banks for mergers and acquisitions of payments fintechs.

At the same time, competition in digital savings and investments--although growing--will likely continue to lag other segments such as digital payments or transfers. This is due to the relatively low disposable income of the population in the region, which explains higher price sensitivity of depositors compared with quality of service sensitivity. This in turn means lower saving capacity, less developed capital markets, and a lack of financial literacy and understanding about savings and investments that influence savings behavior in the region.

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At the same time, the impediments to further development of digitalization may also represent potential for growth. For example, the development of mobile and online banking--provided there is reliable telecom and internet infrastructure--enables banks to offer services to clients that live in areas where there are no branches. Governments may also seek to support the expansion of innovative banking services if it helps to diminish the informal economy. In addition, digital banking tends to change the way customers manage their money, which could spur demand for other banking products.

To fully leverage the potential benefits of technology, banks and clients will need to make substantial investments and attract top talent.   The demand for IT/banking talent among banks that develop and implement their ambitious growth plans in digitalization and innovation has accelerated over the past decade. Yet banking sectors do not always control the factors required for successful digital innovation. This includes the development of regulation to address the changing environment or the development of modern infrastructure--telecommunications, energy production and distribution, data storage and management. In the region, Georgia is closest to aligning its banking regulation with European standards. But it is the exception. Elsewhere, we see limited coordination among banks in the region in digital innovation and limited enthusiasm for the development of open banking platforms and solutions.

In Central Asia and the Caucasus, there is a noticeable disparity in infrastructure quality between urban and rural areas, and access to financial services remains uneven. This is a challenge but also an area of potential growth for banking sectors that can service underbanked populations. This will require a concerted effort by banks, governments, and providers of infrastructure such as telecommunications, energy generation, and distribution.

Despite increasing regulatory risks and oversight, regulators in the region are cautiously supportive of digital innovation in the sector, in our view.   At the same time, regulators appear to be cautious about the potential for rapid innovation and digitalization which could dilute their ability to ensure risks taken by financial sector players are viable. This is especially so outside of the banking sector, which has traditionally faced the highest degree of regulatory oversight and control. Regulators must also ensure retail clients (who may be less sophisticated than institutional clients) are treated fairly. There must also be assurances of customer data protection and transparency of innovative products. Equally important is sufficient control over compliance with money-laundering regulation and the evolving sanctions regime.

In addition, collaboration between regulators and financial sector players is important to ensure adequate actions to minimize cyber risk and attempts to exploit overall low financial literacy and awareness about social engineering fraud. In doing so, regulators must often balance the benefits of innovation against risks to financial system stability and security. This may involve taking sides in the contest between incumbent banks and fintech interlopers. While this may discourage fintechs, it better places incumbent banks to maintain their strong footing in an increasingly competitive market.

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Armenia: Digital Innovation Has A Long Way To Go To Take Space From Cash Payments

Technology: Deep penetration of mobile banking supports transformation

Digital transformation of the economy is a priority for the government. Several government bodies oversee it, including the Ministry Of High Tech Industry and the Agency For Information Technologies. There are numerous government initiatives, including the recent introduction of a single-point digital identification system, known as "Yes Em", which we see as a key step toward higher penetration of fintech and digital banking in the economy.

Armenia is relatively advanced technologically. About 66% of its population has mobile connections as of 2022, according to GSMA Intelligence, a research firm. This is perhaps the highest share in Central Asia and Southern Caucasus. Of this, 84% used smartphones, which supports digital transformation, GSMA Intelligence says.

Digital wallets for e-money are widespread: according to the Central Bank of Armenia (CBA) there were more than 700 thousand active accounts compared with the population of about 3 million at year-end 2023. The use of e-money is also gaining traction.

Regulation: Regulations to support digitalization do not present a direct competitive risk for bank business models

Regulation represents no material risk for the banking sector, in our view, because the authorities do not encourage non-bank intermediaries. Alternative payment systems such as e-money have advantages (e.g. wallets can't be frozen in case of bankruptcy). However, regulation has been tightening, thereby reducing regulatory arbitrage.

Authorities are gradually increasing their efforts toward digital transformation: in 2022 the government and the central bank outlined a digital transformation program for the Armenian economy, with a new agency for information systems overseeing the process. Authorities have also launched a regulatory sandbox to support new entrants. Results are yet to be seen.

No regulation for digital assets exists. However, in late 2023, the CBA announced it would seek to create a regulatory framework for the sector. Similarly, a central bank digital currency study published by the CBA research department in 2023 identified only limited use cases for digital currency in the country.

Industry: Banks dominate but digital challengers are catching up

Digital initiatives among non-bank players are unable to materially disrupt the dominant role of Armenian banks as a whole. Digital challengers such as Inecobank, Evocabank, and ID Bank are, however, gaining ground, offering a strong mobile proposition for customers. They have been the fastest-growing institutions in the market, expanding their assets base by 21% on average over the past five years compared with 12% for the rest of the banking sector. The average customer rating of the top three banking apps in Google Play and the Apple Store is only about 3.3 as opposed to 4.5-4.6 for digital challengers.

Armenia's relatively meagre population and small size of the financial sector (close to $23 billion in total assets in 2023) somewhat shield the country's financial sector from new entrants. Nor is it clear when a fully digital model will emerge, given legal requirements to sign certain documents in person and customer preferences, particularly among older people.

Preferences: Non-cash payments are gradually becoming standard

Armenia is gradually moving toward non-cash payments, but cash remains the preferred method. About 50% of all card transactions in the fourth quarter of 2023 were cash withdrawals (a noticeable change compared with 70% in the fourth quarter of 2021).

Yet at the same time an average payment for goods and services is only $20--indicating that adoption is growing fast in some segments.

In certain areas, new technologies offer material savings: e-monies currently outpace cards as a tool to pay for utilities, and almost half of all payments for goods and services are now done via virtual point-of-sale terminals. However, Armenia largely follows the pattern of most emerging markets: the use of digital services is widespread in the capital, but still emerging in the other regions, where half of the population lives.

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Azerbaijan: Fintechs Are No Threat To Incumbent Banks

Technology: The government controls internet infrastructure

The Social and Economic Development Strategy of the Republic of Azerbaijan 2022-2026 (SEDS) incorporates the creation of the country's digital economy strategy. The country ranks among the top regional performers in terms of e-commerce, thanks to the measures planned in the SEDS.

Up to 86% of the Azeri population had access to the internet in 2023, of which 90% of households in urban areas and 83% in rural areas. Connectivity outside of the capital, Baku, is much worse than in the capital, especially in remote areas. Azerbaijan had 20 fixed-line broadband internet subscriptions per 100 people and 77 mobile broadband subscriptions per 100 people in 2022, according to the International Telecommunication Union.

As of 2020, 2G and 3G mobile networks were available for virtually the entire population, 4G networks are available to about half the population, while a 5G network is in a trial phase. The government is developing a new regional fiber-optic network, the Trans-Eurasian Information Superhighway, and the ambitious broadband strategy aims to have 100% of households covered and a minimum download speed of 25 megabits per second (Mbps) by 2025. We consider this a very ambitious goal to achieve.

The government controls the internet infrastructure and can instruct companies to cut internet service under broadly defined circumstances. It also monitors and censors the internet (e.g. it has blocked access to certain social media platforms and websites in the past); however, we do not currently see this as a material impediment to digital innovation in the financial sector.

Regulation: A framework for digital banking will not disrupt banks

In 2022, the Central Bank of The Republic Of Azerbaijan (CBRA) launched its Open Banking Road Map and is creating a legislative framework for it. Until 2025, Azeri banks must gradually implement an open banking approach by bringing their existing technical infrastructure in line with the requirements for open banking. The CBRA is creating centralized API (application programming interface) infrastructure to integrate startups in the banking sector. The application of regulatory sandbox and central bank digital currency by the CBRA are in initial stages: the regulation for the application of the regulatory sandbox was published in January 2024.

CBRA's Digital Payments Strategy 2023 comprises five pillars:

• Improvement in legislation to support digital payment provision;
• Expansion of coverage;
• Development of risk-based regulation;
• Increase in financial inclusion; and
• Improvement in financial literacy.

A cybersecurity strategy in financial markets for 2023-2026 aims to strengthen information security and cybersecurity at CBRA and financial institutions and more effectively manage the cybersecurity threats and cyberattacks.

Industry: Retail banks lead the development of digital products

All 23 banks operating in Azerbaijan offer internet and mobile banking. We do not foresee nonbank fintech players being able to challenge the market, and we think the country's leading banks in terms of digital solutions--Yelo Bank, Birbank, and Leobank (digital banks established by Kapital Bank and Unibank, respectively)--cater well to current clients' demands. The other medium-sized retail-oriented banks have also begun to develop digital apps.

However, Azeri banks do not yet fully use their potential to sell their products digitally. In 2023, the cost-to-income ratio in the Azeri banking system was weaker than regional peers at 59% This indicates that further progress with digitalization and automation could improve the sector's efficiency.

The Azerbaijan Fintech Association was founded in December 2020 and the fintech ecosystem currently includes 16 companies, which mostly work in the segments of online payments and e-wallets and to a lesser extent loyalty and e-commerce.

Preferences: Adoption of digital banking is slow, especially among low-income earners

People are gradually embracing digital banking products and services, especially in the capital Baku and among the younger population. The number of payment cards increased to 18.1 million at mid-2024 from 9.6 million at year-end 2020. Of the 18.1 million, 80% were contactless compared with 39% three years ago. In June 2024, about 75% of customer transfers from current accounts were initiated electronically compared with 25% in paper form. The share of non-cash payments in card transactions reached 64% in mid-2024.

Nevertheless, according to some estimates, more than half of the population work without a contract and still receive salaries in cash. The low-income group uses digital services less frequently because their overall access to financial services is poor, while some customers within the high-income group sometimes might prefer cash payments due to the low transparency of income sources. In addition, about half of the population has only basic digital skills. This is below the average of the EU and the OECD, and further limits the use of online banking.

Penetration of traditional financial infrastructure in Azerbaijan is lower than in Georgia and Armenia. As of mid-2024, Azerbaijan had about 4.7 branches and 30 ATMs per 100,000 of population. In our view, this is more reflective of the lower level of financial intermediation rather than the shift to digital banking services. Many small businesses do not offer payments by card so payments in cash are widespread. Although about 86% of the population owns a mobile phone and has internet access, only about 46% of people used them to check their bank balance and 31% to make a payment in 2021.

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Georgia: Top Two Banks Lead The Digital Transformation

Technology: A strong institutional and policy framework and government initiatives seek to accelerate the digital transformation

Georgia's primary long-term strategic Vision 2030 establishes the digital economy and information technologies as one of the 13 key aspects of the country's economic development. The strategy envisions positioning Georgia as a globally integrated digital hub.

The National Broadband Development Strategy Of Georgia and its action plan for 2020-2025 aim to maximize broadband coverage, with a target to cover 99% of the Georgian territory with 4G by 2025. In 2024, 94% of the population has access to wired or fixed wireless broadband and 58% to fiber-optic service. Affordability of fixed and mobile broadband subscriptions remains a challenge: the prices were 2.35% of per capita gross national income in 2022, above the International Telecommunication Union's target of 2%. While 79% of large businesses have high-speed internet (over 30 Mbps), only 54% of medium and 38% of small businesses do. The digital divide between urban and rural areas has narrowed over the past few years to 13% in 2021.

The government has been working on a comprehensive national digital strategy. The level of digital skills in Georgia remains below OECD and EU averages: in 2021, 36% of Georgians had only basic digital skills. The country's Digital Economy Skills Development Program aimed to train and certify 3,000 Georgian citizens in the most demanded digital skills by March 2023.

Regulation: Support for innovation and digitalization

The National Bank of Georgia (NBG) has taken an open and proactive approach to the development of new technologies and innovation in the financial sector to increase financial stability and inclusion. The NBG's supervisory approach to risk is technologically neutral. Over the past few years, the NBG has created the policy environment and the infrastructure to increase use of digital financial services and fintech, including:

• 2019--Created the Financial Innovation Office to communicate with innovators of fintech and to help fintechs understand the NBG's supervisory approach.
• 2020--Introduced the Regulatory Laboratory (sandbox) allowing financial market participants to test innovative services and products while complying with supervisory requirements (mainly on testing new ways of customer verification).
• 2021--Launched Open Banking in Georgia, involving immediate exchange of information between financial institutions using electronic technologies, at the initiative of customers. In 2023 regulations included non-banks into open banking. Banks and non-banks have data-sharing obligations and must follow rules of data standardization;
• Started to explore a central bank digital currency;
• Amended the Law on Payment Systems and Payment Services in alignment with the EU Payment Services Directive 2;
• Applied to join the Single Europe Payment Area.
• 2023--Drafted a fintech development strategy.

Industry: Top banks are progressing in digital innovation whereas fintechs are entering the market

The two largest banks, TBC Bank and Bank of Georgia, which represent about 70%-80% in key market segments in the banking system of 15 banks, lead the way in digital innovation. They have made early investments in in-house IT systems and talent as well as marketing and education campaigns to spread awareness and benefits of digital banking. They have developed their own digital brands, Tnet and mBank. For example, for the Bank of Georgia at mid-2024, 57% of retail products and 80% of loans were sold digitally.

For TBS at mid-2024, 70% of retail transaction and 68% of loans were through internet and mobile banking. The banks have developed so-called financial super apps to fulfill a variety of customer needs. They are strongly positioned to continue their digital transformation, which has already reduced branch networks, delivered competitive client servicing, and improved efficiency. The cost-to-income ratio of Bank of Georgia was 33% and for TBC 38% in the first half 2024--this is stronger than the system average of about 45% and the regional peers' levels.

At the same time, small Georgian banks are only starting to develop digital products and services, which require considerable investment. Cost benefits will be realized only in the medium-term.

In 2020, the NBG implemented the licensing framework for digital banking. In 2023, the NBG granted banking licenses based on the principles of digital bank licensing to Space, Pave Bank Georgia KSC, and Hash JSC, which will operate in test mode for seven months, and a digital banking license to Paysera. We do not expect these players to disrupt the competitive landscape given the well-developed digitalization of the market leaders.

Preferences: Customers are gradually embracing digital products but still prefer cash.

Georgia has long sought to boost financial inclusion. According to the World Bank's Global Findex, 70% of Georgia's adult population had a transaction account in 2021. However, poorer households and small merchants, especially in rural areas, still have limited access to financial products.

We consider the average Georgian retail customer to prefer more traditional services compared with the EU, but more digitally savvy than in Central Asia. Card and mobile payments have climbed in recent years: 62% of the population made or received a digital payment in 2021. At mid-2024, there were about 8.5 million debit and credit cards issued in Georgia. Yet most of the Georgian population still uses cash in daily transactions. With about 31 branches and 95 ATMs per 100,000 people, traditional financial infrastructure in Georgia is comparable with Southern European countries.

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Kazakhstan: Major Banks Are Spearheading Financial Innovation

Technology: Banks are establishing fintech infrastructure within their own ecosystems

Banks in Kazakhstan are quick to adapt to new technologies, having a clear first-mover advantage and potential to strengthen their market positions. We believe that affordable access to the internet, high connection speeds, high and increasing internet penetration, and a highly skilled IT workforce support digital transformation. This has prompted banks to enhance their payment infrastructure and find ways to develop their own tech-driven ecosystems. In contrast, fintechs have only a moderate presence.

According to the Global Enabling Sustainability Initiatives' Digital Access Index, out of 157 countries, Kazakhstan ranks 10th in terms of affordability; and 62nd in terms of access and use of new information and communication technology. This places Kazakhstan on par with Mexico, Argentina, and South Africa.

Over the past decade, the Kazakhstani banking industry, and especially the largest players, have been investing heavily in digitalization. Key drivers of this are customer preferences, a strong IT sector, and intense competition. This supports the underwriting process, enhances the customer offering, and improves the user experience. However, business transformation comes at a cost. The risk of technology or infrastructure malfunctions has increased, requiring further greater investments in IT, data protection, and infrastructure. We estimate the average share of IT-related costs for banks is likely to climb to around 15% of their operating expenses over the next three years from 8%-10% currently.

Regulation: Balancing innovation and resilience

In general, financial services remain heavily regulated, with the key focus being on traditional financial business models and standard banking risks. This will largely limit market access for new entrants with radically innovative business models. Given the increasing risk of data breaches, we anticipate that the regulation will continue to focus on the privacy and safety of data.

Regulation and practices have supported banks' investments in new technologies and have hindered innovation in the financial sector. Financial regulators in Kazakhstan have implemented several major projects that support further technological advances in the banking sector and are working on additional initiatives. The National Bank of Kazakhstan continues to investigate the idea of overhauling the monetary system by launching a central bank digital currency (digital tenge), a pilot of which began in early 2024. We understand this initiative is unlikely to overlay the banking system.

Industry: Barriers to entry are high given large banks' dominance

In our view, it is unlikely that digital innovation in banking will materially challenge the positions of the dominant players, as they were early adopters of digitalization and innovation. The top 10 banks' share of total assets is about 88%, while two leading banks, Halyk Bank and Kaspi Bank, together account for about a half of total customers' funds. Market leaders also spearhead banking innovation and investments in digital transformation, having deep pockets to invest and having defined cost optimization and digital transformation as key priorities. Kazakhstani banks have demonstrated solid earnings capacity, with return on average equity (ROAE) of about 25% over the past five years and one of the best in industry cost-to-income ratio at 25%-30%. This helps them swiftly respond to emerging technologies and evolving customer needs. This dominant position is underpinned by a long history of operations and solid customer relationships.

We consider this high degree of concentration an advantage for the incumbent retail banks as it represents a big challenge for digital disruptors trying to enter the market. Also, banks are in an excellent position to invest in and benefit from the digital transformation, thanks to the relatively undeveloped venture capital market in Kazakhstan in the absence of potential external competitors.

Preferences: Increasing demand from tech-savvy population

The bank customer loyalty model is set to shift. Instead of preferring one particular bank, customers will use several preferred banks for different operations and services, switching between them easily. Evolving client preferences are forcing banks to digitalize quickly and continuously improve their products and services. Urbanization, geographic distribution, and age are key influences on customer preferences and prompt them to demand more digital innovation.

The majority of Kazakhstan's urban population is willing to adopt new financial technologies tailored to their everyday financial needs. About 88% of the total population is tech-savvy, uses cards over cash payments, and internet and mobile banking services. This segment of the population is also highly correlated with the core retail banking cohort. While the pandemic accelerated the adoption of mobile banking, demographics have also been crucial. So-called digital natives generations are accustomed to transacting remotely, often using their phones, and typically have little attachment to traditional banking brands, services, branches, or products. This makes them more open than previous generations to new solutions, such as buy-now-pay-later loans, and to switching banks easily.

We believe the geographic distribution and age of the population play a role in the pace of the digital banking transformation. For example, about 64% of countrywide transactions with cards occur in three largest cities (Almaty, Astana, Shymkent), where only 24% of country's labor force live. Big cities appear to have the highest concentration of tech-savvy customers and wealth, banks that offer innovative products, and IT talent and infrastructure to support them.

Uneven income distribution and a notable share of the population on relatively low incomes constrain the overall penetration of banking services and, to some extent, the demand for digital innovation. According to Kazakhstan statistics provider Qazstat, about 75% of the population earn on average equal or less than KZT237,000 (about $500) per month, limiting the bankable population and the client segment that would be interested in advanced banking products.

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Uzbekistan: Digital Innovation Can Improve Uneven Access To Financial Services

Technology: Banks and fintechs are innovating and investments in infrastructure will boost growth

Over the past five years, digital innovation and transformation have supported the government's strategic focus on major transformation and modernization of the Uzbekistan economy. The key initiatives are outlined in Digital Uzbekistan 2030, launched in 2020, and in The Development Strategy Of New Uzbekistan For 2022-2026. The government's digital transformation strategy aims to develop "e-government", improve the quality of public services through digitalization, promote the use of digital ID for financial and non-financial services and payments, encourage investments in the telecom sector to improve mobile and internet coverage and affordability. To achieve this, the government supports educational programs in IT and has created IT-Park, an environment with preferential tax and business operations conditions for IT businesses and startups.

We consider Uzbekistan will need to do more to improve mobile and internet coverage if it is to catch up with some regional peers. Much of the population lives in rural areas and areas that are difficult to access. As of 2022, an estimated 10% of the population lived in areas without mobile broadband networks; at the same time, whereas 91% of people used cellular mobile services only about 77% of the population had access to internet. To achieve further progress in the development of digital financial services will require a concerted effort by banks, the government, the banking regulator, and providers of infrastructure such as telecommunications, energy generation, and distribution.

Regulation: Balancing growth with caution

In general, banking regulation is cautiously supportive of further innovation and digitalization and presents no material risk for the banking sector's transformation, in our view. We think the regulator is aware of the rather low financial literacy of the population and still dominant position of the state banks in the sector; these banks have about 70% of market share in total assets. This cautious approach allows the government to modernize at a gradual pace and ensure the stable functioning of state banks and the sector in general.

Notable developments over the past years will encourage digital innovation while controlling the risks involved. These include the implementation of MyID to access government and financial services; updated legislation on payments and payment systems; and regulation of crypto exchanges.

Industry: Digital payments and loans are soaring and face tough competition; digital savings face less competitive pressure

The financial sector has been rapidly transforming over the past decade. However, it is still in the early stages and primarily offers simple financial products. There is a need for the sector to incorporate best banking practices, including better governance standards, more efficient business models, and more advanced risk management and underwriting practices.

At the same time, the sector benefits from digital innovation in the global financial sector and the sharing of international best practices and talent.

Financial services penetration in Uzbekistan is still well below that of regional peers. According to WB Global Findex data, between 2011 and 2021 the share of the population with a bank account almost doubled to hit 44%. Low-income levels, especially in rural areas, and out-of-reach bank branches are among the most common factors explaining poor access to financial services for 15%-30% of population. A significant informal economy still exists, and cash transactions are widespread.

These obstacles represent a unique opportunity for the Uzbekistan banking sector. Digital innovation could allow banks to address the problem of physical access to bank branches and help reduce the cost of financial services, thereby making them more affordable. Some of the most pronounced digital innovation trends in the past decade include:

Strong growth in digital payments and e-wallet activities continues.   The volume of transactions through POS terminals quadrupled in 2023 alone, and continues to grow. Banks are eager to benefit from these activities. Indicative of this is the consolidation of Payme by TBC Bank, and interest from Kazakhstan fintech Kaspi.kz to the privatization of Humo, one of the country's leading payment systems. We expect to see further cross-sector and cross-border acquisitions over the next few years.

Banks continue to develop their ecosystem.   They are integrating financial services and aiming to capture what they see as vast potential in the e-commerce segment, which has been growing strongly but still has rather low penetration.

Retail lending has been growing strongly.   Incumbent banks are developing online and mobile lending products, including buy-now-pay-later loans and see this as potential source of growth. The 2023 acquisition of Ipoteka Bank by Hungarian OTP Group will, in our view, allow Ipoteka to leverage the vast retail experience and knowledge OTP has gained from its operations in Eastern and Central Europe. This could potentially intensify competition in the Uzbek market.

State-owned and private banks alike aim to grow the services they offer to micro, small and medium-sized enterprises.   This will require them to offer a full range of services that customers are able to access remotely and at low cost.

We think Uzbekistan's established banks will maintain their positions in the banking sector, and fintech companies are yet to represent a threat to incumbent banks, in our view. Banks that actively develop and invest in digital innovation today will be better positioned in the market over the next few years. Improvements in the banks' cost base will not be immediate, however, as they will likely continue to make significant investments.

Preferences: Young tech-savvy population welcomes financial innovation

There is a big disparity in the use of digital financial services among the population, primarily due to variations in age, income, and access to financial services. However, we believe the structure of the population and continued urbanization will spur demand for digital innovation. This includes the adoption of mobile and internet banking, a preference for digital payments over cash, and a willingness to use new banking products.

The population is young and growing strongly. Since 2000, it has increased by about 47%. About 30% of population comprises people younger than 14, and the median age is about 30. At the same time, the overall income level is low, with GDP per capita about the lowest in the region, which has been a major impediment to the growth in the use of traditional and innovative banking services. Incomes among the rural population are well below average levels.

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