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Tech Disruption In Retail Banking: Better Late Than Never For Japanese Fintech

(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.)

S&P Global Ratings considers Japan's progress on the digitization of banking and other fintech lags that of other advanced countries. However, we expect Japanese banks to catch up.

In this report, we consider fintech to be information technology (IT) that transforms the way existing financial services are provided. Here, we focus on the field of payment services. This is because, the impact and market size of fintech in the fields of banks' online lending, deposits, and asset management in Japan are limited.

There are three main hindrances to innovation in financial technology in Japan. First, small- and medium-size financial institutions have dismal fintech capability but a high combined share of the Japanese market. Second, Japan has a high cash usage ratio for payments due to the high convenience of cash in the country. Third, the elderly make up a high proportion of the population, prefer conventional service channels to fintech, and hold approximately 70% of Japan's personal financial assets.

Japanese bank investment practices are also partly to blame. IT investment in advanced infrastructure is relatively low; spending on the maintenance of existing systems accounts for about 80% of overall IT investment. Continued low profitability also curbs banks' abilities to make bold system investments.

It does not have to be this way. Japan has advanced general science and technology, so the potential for fintech to evolve is high. To realize this potential, we believe banks must make sufficient investments in new technologies, establish flexible and adaptive management suitable for fast-changing environments, and train staff to understand and introduce new technology.

TRIP Analysis Shows Relatively High Risks For Banks

We are illustrating our current views of disruption risk with our four-factor analysis of the Japan banking system's technology, regulation, industry, and preferences (TRIP; see chart 1).

Chart 1

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Industry: Disruption Risk | Very High

The weakness and inertia of Japan's banking industry is an opportunity for upstarts

The fragmentation, along geographic lines, of Japan's banking market impedes its performance and efficiency, in our view. Regional banks are relatively small in terms of assets, but their combined market share to total domestic lending is about 40% (Tier1+Tier2 regional banks; see chart 2). These banks have been hurt by the Bank of Japan's (BOJ) negative interest rate policy, because interest income from domestic operations account for about 80% of their total revenue (gross profit). Shrinking market bases as populations decline everywhere except metropolitan areas, in which major banks have strong footprint, are a further burden.

Chart 2

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We consider continued low profitability to be an obstacle to Japanese banks' making bold investments in new fields related to fintech and in existing IT systems. The majors and regional banks face declining returns on assets because of the BOJ's negative interest rate policy and severe competition (chart3). With profits in the doldrums, banks have curbed all spending on IT systems (including fintech) that are not essential. Fintech has thus been all but left aside. Expenditures on the maintenance of existing IT systems accounts for about 80% of overall IT spending (charts 4 and 5). Explicit and implicit demands for high security (on so-called zero tolerance errors) in transactions from customers and regulators are a major reason IT investment in Japan is largely maintenance-driven.

Chart 3

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Chart 4

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Chart 5

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Given the size of Japan's economy, the proliferation of technologies among various nonbanking industries, and demographic changes, we think new market entrants could eventually have a bigger impact in Japan than they have in other countries, despite the hurdles. We are focused on how mid- to long-term demographic transformation in Japan drives change in demand for fintech. Consumer preference for fintech is low at the moment because of the high ratio of people aged 60 or older to the total population. However, Japanese youth have much more enthusiasm about new technology and services. Despite the army of elderly, the nation's tech-savvy base can be glimpsed through statistics such as those on smartphone subscriptions (Chart 6).

Chart 6

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Japan's fintech development pace is slow for now. But once demand for convenient services is kindled, industry dynamism could quickly and dramatically change. This is because catering to Japan's younger generation is a huge opportunity for fintech development, in our view. However, technology majors and cutting-edge new entrants are shying away from banking services such as offering loan and deposit products to their online client bases. This is partly because of the aforementioned low profitability of retail loan/deposit operations in Japan.

For example, Japan-based internet services company Rakuten Inc. (BBB-/Negative/--) is promoting fintech, but is a minor player in the banking industry. The Japanese arm of Amazon.com Inc. is also now offering working capital loans to the customers in the country, but in very limited volume. In light of the above, we think technology majors and new entrants are likely to continue focusing on payment services, for which fees in Japan are currently high and thus uncompetitive. These technology majors and new entrants are doing so mainly in partnership with banks and other financial institutions, as they have done in other countries, in our view.

Preferences: Disruption Risk | Moderate

Consumers are graying and conservative, so banks have breathing space

Japanese consumers are more likely to use cash for transaction settlements. The cashless payment ratio in Japan was about 20% in 2016, below the 40% of Europe and the U.S. (chart 7). However, this is likely to change in tandem with Japan's demographic makeup and government promotions to encourage cashless payments.

Chart 7

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We think two main factors drive the low ratio of cashless payments and adoption of online services in retail banking in Japan. First, in Japan, cash is often more convenient. Second, a high proportion of the population is 60 or older, and these people hold a high percentage of the nation's financial assets.

People's high preference for cash settlements is a factor keeping the ratio of cashless payments down. However, there has been meaningful movement on this recently, with the government aggressively promoting cashless payments through incentives and other means.

We see two key factors behind the scenes that help facilitate Japan's high cash settlement ratio. First, small- and medium-size retailers prefer cash transactions. This is because of high transaction charges levied by, for example, credit card companies in Japan. Card companies charge 2%-3% fees against settlement amounts. In addition, installation costs for cashless settlement machines can be burdensome for small retailers. It is no wonder Japanese small retailers accept only cash. Second, there are more ATMs in Japan than elsewhere. With about 150,000 ATMs nationwide in Japan (about 1.2 per 1,000 people) deployment density is higher than in most developed nations; they are the primary means by which people obtain cash. In addition, the risk of holding cash is generally low, because Japan is, in some respects, one of the safest countries in the world. However, it is susceptible to natural disasters, and many prefer to hold cash because cashless payment technology may fail in during a catastrophe.

Another factor behind the low ratio of cashless payments and slow adoption of online services in retail banking is demographics. The population is aging and there are fewer children around. Generally, people aged 60 or older, who tend to be less tech-savvy, account for about 35% of the total population. They prefer traditional channels such as cash transactions and face-to-face trading to cashless payments and online services, in our view. Even those aged 40-60, who together have hefty spending power, hesitate to use cashless payment services because of privacy concerns. In addition, people aged 60 or older hold 65% of total personal financial assets (chart 8). However, this will gradually change over time amid demographic change and a transfer of financial assets (through inheritance, for example).

Chart 8

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On the other hand, some factors are likely to drive cashless payment growth and the adoption of fintech in Japan. One is the government's recent aggressive promotion of cashless payments. Recognizing Japan's low cashless payment rate, the government aims to double the ratio to around 40% by June 2027. To do so, it has implemented refund schemes for people settling transactions cashlessly, for example through cards. This policy expiring in June 2020, was implemented to offset the effects of an October 2019 2 percentage point consumption tax hike to 10%. However, it is a good chance for retailers to start offering, or promote existing, cashless payment services. In fact, Japan's cashless payment ratio has increased significantly since the government drive began. For example, statistics released in December by marketing, consumer, and retail tracking company Intage showed the percentage of cashless payments for groceries over a week in October increased by 8.3 percentage points to 53.4%, compared with a week in July-August.

E-commerce trading in Japan also promises to boost cashless payments and fintech. More e-commerce means more transactions where the use of hard cash is not a choice. The size of Japan's business-to-consumer e-commerce market has been increasing; it stood at ¥18 trillion in 2018 and has seen annual growth of close to 10%. The ratio of e-commerce to all commerce transactions was 6.2% in 2018, up from 5.8% the previous year (chart 9).

Chart 9

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Technology: Disruption Risk | Moderate

Technology is ready; banks are not

We do not see technology as a constraint on Japanese banks digitalizing their business models. The challenges are related to low profitability and management. Low profitability prevents banks from making sufficient investments in fintech. Meanwhile, banks lack the flexible and adaptive management needed for a fast-changing environment and staff that can understand and introduce new technology.

In our view, Japanese banks cannot switch from their mostly outdated IT systems quickly, simply because they cannot afford to. In addition, most Japanese banks are struggling to maintain their existing core IT systems and being saddled with maintenance costs on their tightly-knit networks of brick-and-mortar bank branches. Because of this, Japanese banks are behind emerging fintech companies, which have cloud-native and open application programing interface (API)-native technology.

In countries where fintech is evolving faster, such as China and Singapore, well-designed open API systems are key for retail banks. In a nod to this, Japan's Financial Services Agency partially revised the Banking Act in 2018, imposing a duty on banks to improve open API systems. However, in our view, the development of open API as a whole has been slow. This is because regional banks, with 40% market share in Japan, do not have the investment capacity to pursue necessary changes. Some critics also say many banks are cautious about opening up their systems, because it will allow fintech upstarts to acquire the necessary information from banks and leave them as legacy conduits of information.

The lack of dynamism in Japanese bank management and operations pose a further challenge, in our view. It is important to introduce new technologies and mechanisms that improve customer convenience and user experience (UX), to implement it quickly, and to assign staff who understand new technologies. This is because Japanese banks up until now have had hierarchical structures and rigid reporting lines that stifle innovation. At the same time, we recognize that Japan's fintech-related technology is on par with that of other countries. Japan's knowledge of digital technologies, such as robotics, communication technology, and AI (artificial intelligence), is top-tier. The banking industry also has a record of providing safe and secure services that have evolved in line with customer needs and business practice. For example, Japanese ATMs incorporate biometric authentication and mobile payment systems.

Therefore, we believe that Japan's technology capability is high and not an issue. However, banks need to apply this technology, and are struggling to do so because of the aforementioned constraints. As a result, Japanese banks lag technology majors in countries such as China, specifically in areas such as client data use and efficient business execution. In our view, if Japanese banks can make sufficient new investments in fintech, realizing its potential, its development would catch up with peers in other countries.

Regulation: Disruption Risk | Moderate

Japan's regulators emphasize stability over innovation.

We don't see much difference between Japan's regulatory framework and those of peers. However, Japan has in the past been slow to deregulate: Historically, system stability beats incubating innovation. We consider Japan's regulatory framework to be neutral for promoting innovation or disrupting retail banking. We see the attitude and willingness of banks to respond to changes as more critical.

Japan's regulator has established a sandbox system for companies with new business models. Under the system, fintech companies are afforded the opportunity to field test their ideas with regulatory supervision before fully rolling out products. In our view, this shows regulators are balancing consumer protection and the need to safeguard the financial system from disruption caused by unregulated entities, new market players, and technology majors.

Expectations for the changes brought about by challenger banks and fintech-driven progress are increasing in Japan. These extend to social fields, with many looking for the provision of a new financial social infrastructure and more competitive nonfinancial corporations. With this in mind, the government introduced a Regulatory Sandbox system to lead innovation in Fintech in 2018, following the lead of the U.K. and Singapore. However, thus far the system has not had much of an impact in Japan. The FSA had approved only two of the applications made for sandbox benefits by the end December 2019. This compares unfavorably with other countries that have similar sandbox systems. While the environment is there, big burdens for new entrants seem to have led to hesitation.

Recent key legislative changes related to fintech include changes to Banking Act in 2016 and 2017 (applied in 2017 and 2018, respectively). The revisions relaxed restrictions on investment in fintech companies by banking groups, which had been basically prohibited. Also, revisions to acts related to payment service and sales of financial instruments are being proposed. These regulatory initiatives are to reduce cumbersome licensing and regulatory requirements and to promote digital financial services.

Fintech promises medium- and long-term benefits, despite short-term turbulence risk

We expect Japan's major banking groups, such as the three biggest, to work through fintech challenges. They have enough capacity to invest in new technology. New entrants that pursue fintech goals efficiently and effectively through different approaches to traditional banks are also likely to do well. Regional banks, shinkin cooperative banks, and credit unions, which lack financial strength and fintech know-how, have gloomier prospects. As a result, a proportion of the consumers at these weaker banks may shift to the majors or others that offer better services. This would accelerate the deterioration of business positions for small- and medium-size financial institutions that do not possess specialized strengths.

In the medium to long term, we expect fintech to have a positive effect on Japan's macroeconomy and banking industry. This is because we expect a resolution of corporate and banking industry stagnation in Japan. Fintech, with the promise of lower marginal costs for financial transactions, can help facilitate the resolution by putting over-banking to bed. However, a survival of the fittest process is likely to lead to pain for weaker financial institutions in the short term.

Finally, for Japan to realize the high potential of fintech, it is essential that banks invest in new technology and get management and staff up to speed.

Related Research

  • The Future Of Banking: Research By S&P Global Ratings, Aug. 30, 2019
  • Tech Disruption In Retail Banking: Austrian Banks' Bricks And Clicks Model Still Does The Trick, Jan. 29, 2020
  • Tech Disruption In Retail Banking: U.K. Banks Embrace The Tech Race, Nov. 14, 2019
  • Tech Disruption In Retail Banking: GCC Banks Are Catching Up As Clients Become More Demanding, Sept. 8, 2019
  • The Future Of Banking: Will Retail Banks Trip Over Tech Disruption? May 14, 2019
  • Tech Disruption In Retail Banking: German Banks Have Little Time For Digital Catch-Up, May 14, 2019
  • Tech Disruption In Retail Banking: China's Banks Are Playing Catch-Up To Big Tech, May 14, 2019
  • Tech Disruption In Retail Banking: Swedish Consumers Dig Digital--And Banks Deliver, May 14, 2019
  • Tech Disruption In Retail Banking: France's Universal Banking Model Presents A Risk, May 14, 2019
  • The Future Of Banking: Will Fintech Have An Outsize Impact In Japan? Feb. 20, 2018

This report does not constitute a rating action.

Primary Credit Analyst:Shoki Nagano, Tokyo (81) 3-4550-8340;
shoki.nagano@spglobal.com
Secondary Contact:Ryoji Yoshizawa, Tokyo (81) 3-4550-8453;
ryoji.yoshizawa@spglobal.com

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