China, May. 14 2019 — (Editor's note: This article is part of a series of commentaries on retail banking sectors, illustrating how technology disruption forms part of S&P Global Ratings' analysis of banks. )
In China, fintech is led by Big Tech. Internet giants such as Alibaba Group Holding Ltd. and Tencent Holdings Ltd. have already turned China's consumer market into one of the world's most digitalized. Now these companies are driving disruption in retail banking with e-payments, deposit-like funds, and Big Data-assisted consumer lending. S&P Global Ratings believes banks will struggle to stay on top of tech trends.
In our view, China's bigger banks are best positioned to close the gap with Big Tech. They have large customer bases and resources, are investing heavily in digital capabilities, and have launched fintech services to rival Big Tech offerings. Many smaller banks, however, may need to rely on partnerships with companies like Alibaba's fintech arm Ant Financial, to gain access to fintech technology and stay relevant.
We illustrate with our four-factor analysis of a banking system's technology, regulation, industry, and client preferences (TRIP) what we are currently including into our ongoing bank ratings assessments. Our findings suggest that technology and customer preference are the major disruption risks to China's retail banking, and more so than for other major economies (see chart 1). Regulatory risk is declining as policymakers keep a closer watch on financial trends that could lead to systemic failures in the banking industry. At the same time, regulators are pro-innovation, in our view.
Industry: Disruption Risk--Moderate
Big Tech is taking the lead in digital adoption; megabanks still dominate
China's entrenched major banks will continue to dominate the financial sector. However, we do see some disruption risks from Big Tech. This includes increased competition for deposits and consumer loans, and missed opportunities in payments and other digital services.
The six largest state-owned commercial banks, known as the "megabanks," collectively account for 48% of the Chinese renminbi (RMB) 223.8 trillion (US$32.7 trillion) in commercial banks assets as of December 2018 (see chart 2). These banks in order of size are the Industrial and Commercial Bank of China Ltd., China Construction Bank Corp., the Agricultural Bank of China Ltd., Bank of China Ltd., the Bank of Communications Co. Ltd., and the Postal Savings Bank of China Co. Ltd.
China has granted four online banking licenses since 2014 (to WeBank, MyBank, XWBank, and aiBank). These online competitors account for a minimal portion of the banking system, although this is partly due to their "asset light" strategies. These banks often work with traditional banks as co-lenders, and also limit balance sheet size through asset-backed securitization.
Chinese tech giants offer financial services that can increase speed, convenience, and choices and, in some cases, lower costs for customers. Digital players are acquiring financial licenses that enable them to compete directly with traditional banks in some areas (see table 1). So far, Big Tech as made the biggest inroads in three major areas: e-payments, money market funds (as a savings product), and consumer lending.
Table 1 | Download Table
|What Financial Services Is Big Tech Driving Into?|
|Licenses awarded to Chinese tech companies|
|Bank||Third-party payments||Internet fund distribution||Internet microcredit||Mutual fund||Insurance||Insurance brokerage|
|Ant Financial Services Group||X||X||X||X||X||X||X|
|Tencent Holdings Ltd.||X||X||X||X||X||X|
|Du Xiaoman Financial||X||X||X||X||X|
Fintech in China has benefitted from the country's relatively less-developed financial services. The low penetration rate of credit cards, for example, triggered the birth of electronic payment services such as Ant Financial's Alipay and later Tencent's WeChat Pay. The convenience and ease of an e-payment or "QR code" payment have made such apps an indispensable part of daily life for Chinese consumers. This further increases the stickiness of such systems. Since the launch of Alipay and WeChat Pay, bank card penetration has plateaued (see chart 3).
We believe Big Tech has a substantial share of electronic retail payments. While granular data are lacking, non-bank third parties handled 530.6 billion payment transactions worth RMB208 trillion (US$30.4 trillion) in 2018. This indicates widespread usage of e-payments. Banks continue to process the lion's share in value terms because corporate customers tend to stick to established bank channels for their bigger ticket items.
Money market funds
Tighter regulations have stemmed the growth in Big Tech-managed money-market funds (MMF), but, in our view, these deposit-like vehicles will continue to challenge banks' funding models. China's biggest and most famous online MMF, Yu'e Bao, was launched by the Alibaba group in 2013. Yu'e Bao's flagship product, Tianhong Yu'e Bao, quickly grew to become known as the world's biggest MMF. With no minimum deposit, investors can buy in or withdraw their money anytime with the ease of a few clicks on the Alipay app. Such funds offer higher yields than bank deposits by taking advantage of higher rates on interbank loans and bonds, as well as interest rate caps imposed on bank deposits (see chart 4). Other Big Tech firms offer similar products.
Bank deposits as a percentage of total liabilities have declined since the launch of Yu'e Bao. In our view, this demonstrates the Big Tech effect. That said, tightening regulations and increased competition from bank-launched MMF may be relieving some of the pressure on banks. Yu'e Bao's asset sized declined by 33% to RMB1.13 trillion (US$165.0 billion) at end of 2018, from a peak of RMB1.68 trillion (US$245.3 billion) at end of March 2018 (see chart 5). Ant Financial began imposing investment limits on Tianhong Yu'e Bao as regulatory scrutiny intensified (though later it removed the limits as such pressure lessened). New regulations on money market funds have also begun to crimp (see table 2).
China's evolving regulatory framework should also begin to slow inroads that Big Tech has made into consumer lending. Many factors combined to trigger explosive growth in the peer-to-peer (P2P) consumer fintech market between 2015 and 2017. These include fast-expanding e-commerce, the availability of Big Data, a relatively low awareness of data privacy, and a loose set of regulations on fintech. Momentum slowed after new regulations hit the industry (see table 2).
Consumer fintech will continue to shape the banking industry. Two implications stand out. One is that quick and easy access to digital credit platforms has reduced the need for credit cards. This constitutes increased competition for banks. Second, small-to-midsized banks that do not possess the relevant technology will depend on fintech partnerships to expand their exposure to consumer finance loans. Apart from P2P consumer fintech companies, online banks are also active in consumer lending. WeBank, for example, is pursuing a platform, asset-light strategy, using its fintech capabilities to acquire customers and co-lend with other banks for a fee.
Preference: Disruption Risk--Very High
Customer culture and preferences and rapid growth of e-commerce accelerate adoption
China's fintech industry will continue to take flight, in our view, supported by several tailwinds: the high smartphone penetration rate and extremely high 4G mobile network coverage, the popularity of social-networking apps, and the underdevelopment of the banking industry, especially in remote areas. Then there is the "millennials factor," given China's younger consumers like to spend and have a taste for virtual wallets over physical ones.
Big Data is another tailwind. China's high rates of digitalization and its outsized e-commerce market have produced a vast amount of data that can facilitate development of the consumer fintech industry. For example, data analytics or artificial intelligence (AI) programs could allow for borrowers' financial status to be gauged in a few seconds, making instant credit approval possible.
That said, traditional commercial banks hold on to many advantages, including, crucially, a low cost of funding, as is apparent on the pricing of mortgage, personal, and other types of consumer loans. Moreover, commercial banks can also adopt AI and other technologies to improve their services. Finally, banks benefit from a confidence factor. In the first half of 2018, an "investor run" on P2P lending platforms underlined the many unknowns on the fintech frontier.
Regulations: Disruption Risk--Low
Traditionally reactive, to boost innovation, but now tightening to ensure system stability
China's regulators, while pro-innovation, have begun to more closely monitor fintech-related disruptions to prevent systemic failures to the banking system. The combined regulatory effect of promoting innovation and financial stability should support the largest banks' resilience, limiting their disruption risk. Smaller banks, on the other hand, may be less sheltered.
The sector's regulators are the People's Bank of China (PBOC) and the China Banking and Insurance Regulatory Commission (CBIRC). Banks are subject to substantial requirements on capital, provision coverage, reserve ratio, deposit interest rates, and must regularly report to the PBOC and CBIRC.
To promote innovation, China has taken a light-handed approach toward the fintech industry, only stepping in when problems emerged. But this is changing, given the large size of some tech-driven initiatives. A core example is the Tianhong Yu'e Bao fund, the world's largest MMF. A run on the fund could potentially cause settlement, liquidity, and systematic risk to the banking system. Recognition of this type of threat led regulators to draw up rules to enhance protections on money market funds (see table 2).
We expect more proactive regulation on fintech to encourage collaboration between fintech companies and banks. Regulators tightened their grip on all aspects of fintech starting 2017, including placing limits on asset-backed securitization and leverage, implementing a centralized payment clearing system (NetUnion), and cracking down on the use of proprietary credit scores. Third-party payment services such as Alipay and WeChat Pay now have to deposit 100% of clients' reserve funds with PBOC, no longer enjoying the advantage of earning interest on those deposits. Regulators also reined in the unfettered growth in the P2P consumer fintech industry. As a result, more fintech companies are positioning themselves as enablers to traditional banks, rather than trying to go solo.
Table 2 | Download Table
|China's Fintech Frontier Stage Is Ending As Regulations Catch Up With Market Trends|
|Sector||Major regulations over the past two years|
|Payments||Reserve ratio on client deposits began increasing monthly from July 2018, reaching 100% client deposit reserve ratio in January 2019. The accounts should get settled through UnionPay or NetsUnion.|
|Money market funds||Sets a same-day (t+0) redemption cap of single investor's single money-market fund through a single channel at RMB10,000. Payment companies are banned from paying with their own cash for same-day redemption to investors.|
|Consumer fintech||Tightens regulations on micro-loans including on their funding sources, pricing caps, and maximum financial leverage. This includes online micro-loans, often for consumer purposes.|
China's regulators have also begun to address issues relating to data privacy. The Personal Information Security Specification took effect on May 1, 2018. While implementation is still unclear, given the standard is non-binding, the comprehensive language represents a convergence between Europe and China's data protection regimes.
Technology: Disruption Risk--Very High
Playing catch-up in an economy where Big Data, AI analytics, and cloud computing are widely applied
China is one of the most advanced digital economies in the world. A report from consulting firm Accenture indicates that US$25.5 billion was invested in China's fintech companies in 2018, almost half of the US$55.3 billion global investment. Big Data, AI analytics, and cloud computing have been widely applied in China's fintech development.
We expect the investment rate to stay high, subjecting banks to high disruption risk. Big Tech has hoarded a substantial amount of data from their e-commerce, search engines, and e-payment businesses. The sector invests heavily in AI analytics for cross-selling opportunities like consumer finance and other services. While "open banking" is still taking shape in the banking industry, some technology firms already have open platforms. For example, Alipay started offering its application programming interfaces (APIs) to third party developers as early as 2014, a necessary step to allow merchants to create storefronts at Alipay.
Fintech services are sophisticated and work well in China; providers have also, at the same time, had to satisfy the requirements of authorities on security, accuracy, scalability, and a short response time to market. Much of this is made possible by cloud computing. During Alibaba's "Singles Day" sales promotion on November 11 ("11/11") in 2018, the value of sales reached more than RMB213.5 billion (US$31.2 billion). To support this 24-hour shopping event, Alibaba's payment system has be able to handle more than 1.7 billion transactions per second during peak orders.
In our view, China's bigger banks can narrow the gap with Big Tech. In 2018, the megabanks invested 1%-2% of their operating income to fintech, a proportion that is likely to keep increasing. Fintech adds multiple client touch-points, including proprietary banking apps, enhanced online banking, websites, and social media. AI robots can answer general customer enquiries at network branches, where customers can also reduce wait time by using "smart terminals" to open accounts, update personal information, get foreign exchange, or make local and overseas payments.
Big Data and AI analytics, as well as voice and facial recognitions tools, have enabled more effective and cost-efficient customer profiling, precision marketing, anti-fraud, risk management, and customer onboarding. The bigger banks are also expanding strategic partnerships with technology companies.
Smaller banks will find it harder to catch up, in our view. They lack in scale and resources, and may have to rely more heavily on partnerships with Big Tech to gain access to the technology and stay relevant. Given their size, they would have less bargaining power in their negotiations with the Big Tech.