- In the near term, Canadian banks' dominant market position will likely help them to fend off fintech challengers, although the regulatory environment continues to evolve and become more accommodative to new market players.
- Fintech adoption is largely bank-driven, as Canadian banks are steadily adapting to the new digital environment by implementing digital offerings and adhering to updated regulations, although at a slower pace than international peers.
- We believe the COVID-19 pandemic--and associated containment measures--will increase consumer adoption of financial tech, accelerating Canada's transition to a technology-based financial system with a smaller physical footprint.
S&P Global Ratings believes that Canada's major banks are moderately placed to deal with tech disruption risks, in part thanks to their dominant market positions. That said, the country's banking sector is entering a period of significant change as market participants respond to new technologies and increasing customer demand for tech-driven convenience, in part fueled by the COVID-19 pandemic. The pace of adoption, previously rather slow but steady, has significantly increased during the pandemic although some international peers, especially Nordic and Asian countries, seem more advanced.
Applying our four-factor TRIP (technology, regulation, industry, preferences) analysis reveals that Canada's stable banking industry will ultimately set the pace of digital adoption among retail banks. We expect customer preferences will increasingly shift toward fast and convenient, mobile and affordable, banking services, making Canadians more receptive to new digital products and services offered through banks. Security and privacy concerns will likely make Canadian customers more wary of services from stand-alone fintechs and Big Tech like Alphabet, Amazon, Apple, and Facebook. Nevertheless, even larger, established retail banks in Canada have reported data breaches in the past, thereby mitigating their competitive edge in this area. In our view, the risk posed by tech disruption is going to increase, as Canada's regulatory environment becomes more favorable to fintech innovation. For now, we see partnerships between fintechs and retail banks as more likely than an all-out disruption, given the niche focus of many fintech market entrants (particularly in offerings like mortgages and payments) and the high barriers to entry. Fierce pricing competition between the large banks and thin profit margins, particularly on mortgages, also make disruption more difficult and less lucrative.
Canadian Banks Face A Moderate Risk From Tech Disruption
Chart 1 illustrates our current views of disruption risk with our four-factor analysis of the Canadian banking systems' TRIP.
Industry: Disruption Risk | Low
We consider the technological disruption risk for Canada's banking industry low. The country has a resilient and well-established banking sector with a long history, established clientele, and a high degree of financial inclusion (99% of Canadians above the age of 15 have a bank account, and Canada has the largest rate of credit card ownership among peer countries, according to the World Bank). Canadian retail banks face limited competition from fintech players in their core activities of deposit taking and lending. Therefore, for now, they can set the pace of adaptation of innovative fintech products but risk losing market share to emerging fintechs if they cannot adapt to changes in consumer preferences and new tech.
Canada's banking industry is highly concentrated, with its six largest banks (listed in order of total assets): Royal Bank of Canada [RBC], The Toronto-Dominion Bank [TD], The Bank of Nova Scotia [Scotiabank], Bank of Montreal [BMO], Canadian Imperial Bank of Commerce, and National Bank of Canada) accounting for almost 90% of assets. Co-operatives (credit unions and caisses populaires) have a sizable local presence in British Columbia, Ontario, and Quebec, but bank-based financial intermediation is the norm in Canada for household credit. We believe that with increasing competition and declining traditional revenue streams, digital product offerings can open new revenue channels for traditional Canadian banks.
Canada's major banks operate under a universal banking model with a centrally regulated network providing a wide variety of comprehensive and tailored financial services to customers. The Canadian banking system remains among the most highly assessed banking systems globally, according to our Banking Industry Country Risk Assessment (BICRA). Canada's BICRA is classified in Group 2 (Group '1' to '10', from lowest to highest risk; for more information, see: "Banking Industry Country Risk Assessment: Canada," published Jan. 27, 2021).
During the pandemic, trust in Canada's financial services industry has increased significantly and continues to rank favorably among international peers, according to the 2020 Edelman Trust Barometer. The quality, breadth, and sophistication of the country's financial institutions and their history of withstanding tumultuous credit cycles underpin this trust. Lending practices are generally conservative, product types more limited, and pay practices more circumscribed than in the U.S. and other peer countries. Leading up to the 2008 financial crisis, Canadian banks did not aggressively adopt lending to targeted high-risk segments, such as subprime, instead maintaining lower loan-to-value ratios. In part because of their positive track record, consumers are less motivated to seek out alternative solutions and providers.
Pre-COVID-19, Canadian banks enjoyed strong profitability, enabling them to invest in required technology to maintain their long-term business viability. We expect they will return to strong profitability as the effects of the pandemic and recession subside. This will provide banks with the financial flexibility to continue upgrading their systems and digital products. According to the Canadian Bankers Association, Canada's six largest banks invested about C$90 billion in technology enhancements from 2009 to 2018. We understand most of this was ploughed into new tech rather than maintaining legacy systems. RBC, for instance, announced in 2018 that technology spending had increased by a compound annual growth rate of 7.5% to an estimated C$3.2 billion, following its earlier announcement that it would spend 40% of its overall technology budget on innovation while reducing money spent on maintaining its legacy IT system.
Most Canadian banks have also launched so-called innovation labs, dedicated facilities in which they can partner with fintechs, offer seed funding and other resources, and foster relationships that help them develop their own digital offerings. In these labs, bank staff often works alongside or in partnership with external parties, providing a useful place for cooperation and knowledge exchange. Some Canadian banks also benefit from their foreign operations. RBC and Scotiabank have a significant presence in emerging markets that are often more advanced in their digitization of products. Competition from fintech challengers and more digitized banks in these markets can spur Canadian banks to similarly innovate at home. Foreign markets also serve as a useful test environment for innovations that can subsequently be implemented in the Canadian market.
However, Canadian banks' revenue structure makes them somewhat vulnerable to disruption risks from fintechs. Non-interest income, some of which is fee income that fintechs could attempt to capture, accounts for about 40% of the major banks' operating revenue. We believe that fintechs will initially focus on inefficiencies in the financial system, potentially eroding fees and commissions by providing low-cost alternatives, particularly in wealth management and payments. However, we believe that Canadian banks' dominant market share, and a longstanding and well-established network of clients across products over the past several decades, gives them an edge in defending their fee income.
In general, fintechs face significant entry barriers in the Canadian market. Opportunity and real costs of changing banks are often non-negotiable and banks continuously expand product offerings, making switching less attractive. High name recognition and reputational advantages also shield existing banks. Lastly, but of most importance, obtaining a banking charter is a lengthy and complex process. In addition, Canadian ownership rules effectively prevent any foreign bank's subsidiary from achieving significant scale. For instance, HSBC Bank Canada, despite having operated in Canada for almost 40 years, accounts for only about 2% of total assets of banks in Canada at Sept. 30, 2020.
Access to finance can also be a barrier for fintechs. Traditionally, Canadian banks provided steady dividend income for investors, although the pandemic has led to temporary restrictions on dividend payments. Nevertheless, Canadian bank stocks should remain an important part of large investors' portfolios, somewhat reducing available capital for fintechs. Innovate Finance estimates that capital invested in Canadian fintechs was US$384 million in 2018--substantially lower in absolute and per capita terms than that in other countries, including China (US$19.0 billion), the U.K. (US$1.7 billion), and the U.S. (US$10.6 billion).
Canada's fintech sector, therefore, remains relatively small and is unlikely to threaten major banks' core lending operations in the near term. Hence, Canadian banks don't see fintechs as direct competitors but instead have forged partnerships or have acquired some fintech startups to replicate the required service offerings in-house. By contrast, we understand Canadian banks generally consider U.S. Big Tech as a threat, given its large network of users.
Digital Innovation Among Canadian Banks
Several successful "in-house" fintech developments by Canadian banks do exist. RBC's Express Track Wire Payment leverages global payments innovation technology and in late 2019, the bank filed patents aimed at using artificial intelligence to help predict consumer purchases. BMO uses machine learning to help customers pay their bills via the its QuickPay tool. In addition, Scotiabank and TD have digitized the entire mortgage process in real time. Using a mobile app, Canadian Imperial Bank of Commerce helps small businesses manage banking, accounting, and payroll on one digital platform.
Big data is another area where Canadian banks have progressed with digital innovation. TD pooled all its data in a data lake, which it then used, among other things, to develop its MySpend app, helping it to analyze and predict customer behavior. Canadian banks are also using big data in their research departments to help internal and external clients in their capital markets activities.
Lastly, most of Canada's large banks have either formed partnerships with fintechs or launched fintechs through their start-up venture arms. RBC launched its own fintech with a bank offering for children and teenagers called Mydoh and has partnered with an Israeli fintech, Personetics, to help with its digital banking assistant. Other banks, such as National Bank, have partnered with fintechs to target specific segments: Montreal-based Thinking Capital has worked with the bank on streamlining small business loan applications. BMO partners with fintech platform Blend to enhance its overall digital strategy, in particular with its digital mortgage process.
Technology: Disruption Risk | Moderate
Canadian banks have begun transitioning from legacy IT systems to newer digital processes for their operations, although legacy systems still play an important role. As a result, these systems, not fintech challengers, appear to be bigger threats to the country's banks for the time being. This is underpinned by the Office of the Superintendent of Financial Institutions', the Canadian bank regulator, findings (OSFI; "Developing Financial Sector Resilience In A Digital World: Selected Themes In Technology And Related Risks," September 2020) on technology risks, as over a third of cyber and technology incidents were caused by technology outages. See chart 5 for the share of major reported incidents that occurred from Oct. 31, 2018 to June 30, 2020, based on incident type (root cause).
In terms of the broader conditions needed for greater digital adoption, it's a mixed picture. The underlying technology required for fintech innovation, such as fiber optic broadband and 5G, is now widely available throughout Canada. However, the country still lacks a real-time payment system--where transmissions of payments occur in real time--which Australia, China, EU countries, Japan, the U.K., and the U.S. currently use.
We believe Canada's adoption of new financial technologies is gradually increasing to match that of its peers. According to Ernst & Young's Global FinTech Adoption Index, the country's fintech market adoption rate increased from 18% in 2017 to 50% in 2019, not insignificant but still far behind China and India at 87% and peers such as Australia, Germany, and the U.K. at 58%, 64%, and 71%, respectively, in 2019. Nevertheless, we expect growth will continue, as the pandemic accelerated a shift in consumer preferences for tech-enhanced products while regulations become more favorable for fintech innovation.
Canada's network infrastructure is comprehensive and sufficient to meet the data needs of imminent technological developments: The country is 11th in the IMD World Digital Competitiveness ranking, and by 2021, about 90% of households will have access to high-speed internet. Canadians have become more accustomed to mobile payment or digital wallet services, and according to the Canadian Internet Registration Authority, their comfort with using them increased to 32% in 2019, from 23% in 2016. Approximately 92% of Canadians had access to long-term evolution (LTE)-advanced services in 2017, and LTE mobile networks cover 99% of inhabited regions and over 86% of major roads and highways.
The Bank of Canada has prioritized modernizing the retail payments system and intends to make real-time, peer-to-peer transactions possible in the next two to three years. Payments Canada has made some progress on this front and aims to launch its first real-time payments platform called Real-Time Rail by 2022.
As the pandemic has shown, cloud computing offers important benefits, both for customers and employees, and banks will increasingly move their data and systems to cloud-based solutions. We believe this will enable them to better process vast amounts of data and use the information to tailor new products and services to customers. To that end, some Canadian banks have undergone at least partial cloud transformations in recent years, although increased regulatory scrutiny on their operations and outsourcing arrangements has hampered the transition somewhat.
Preferences: Disruption Risk | Moderate
The Canadian payment network is poised for increasing disruption from consumers, as preference for technology-driven, convenience-focused banking is on the rise. We believe, that Canadian banks will adapt to these changing inclinations and deliver the services customers prefer. Cash and check transactions are quickly waning in popularity and faster, more convenient electronic channels such as POS card transactions (credit, debit, and contactless) are expanding. In fact, over half of the transaction volumes of both debit cards and credit cards is contactless, according to Payments Canada, mirroring the level in other developed economies. In our view, the popular use of contactless payments in retail transactions--particularly since the onset of the pandemic--should aid fintech adoption, as they facilitate smartphone-based digital wallets.
We believe online transfers will also play an important role in the future of bank transactions between clients. Online transfers are the fastest growing payment segment, increasing by almost 50% by volume in the past 10 years. As per a Canadian Bankers Association's survey in 2019, 88% of Canadians banked online in 2018, and 53% say it is their most common method of banking, a trend that will likely continue, given the rising number of digital products and services available.
Not all banking is immediately moving online, however, and at least in the pre-pandemic era 67% of Canadians used in-branch banking (as of 2018), somewhat limiting the scope for branch-cutting. Compared with some peers, Canada still has a slightly larger rural share of the population (18.5% of total population) compared with the U.S. (17.5%), the U.K.(16.3%), Australia (13.9%), Sweden (12.3%), and Japan (8.3%), according to World Bank data, perhaps explaining the still-high branch usage. However, as a result of the pandemic and with mobile and online channels rising in popularity for bank transactions, the design of branches and scope of in-branch services are changing. Having previously mostly centered on banking transactions such as account openings, cash withdrawals, and wire transfers, bank branches now increasingly include face-to-face advisory services for personal banking, while other services move online. We believe that this transformation, accelerated by COVID-19, will allow banks to expand consumer adoption of online and mobile channels while still maintaining the face-to-face interactions that Canadians traditionally value.
Although mobile banking and other tech-enabled banking experiences are slowly becoming the new normal for Canadians, security and data privacy concerns remain front and center for a significant portion of the population, lowering the disruption risk posed by the arrival of open banking, where third-party providers get access to consumer's financial data, including transactions. The Canadian Bankers Association detailed that almost three-quarters of Canadians were reportedly not interested in open banking at an early stage of these products being offered, and 90% were concerned with data privacy issues arising out of sharing information with tech companies. Given the level of trust in the Canadian banking system, we believe the vast majority of Canadians will continue to rely on their banks to offer secure digital banking services and are willing to share their financial data with them. This will enable Canadian banks to leverage their existing customer base and loyalty to encourage customers' adoption of open banking products.
Despite Canada's aging population, we believe the consumer mindset is likely to change in the coming years, as three-quarters of respondents believed that implementation of robust security measures will sufficiently address their concerns. Furthermore, the younger population, i.e. millennials and following generations, is likelier to use open banking, as they are likely more willing to share financial information with third-party providers in return for better services.
We believe that fintechs and open banking are unlikely to radically change the Canadian banking industry owing to security and data privacy concerns. However, their disruptive influence cannot be ignored, as technology evolves and customer preference shifts gradually, especially with the natural increase in a digitally native millennial population.
Regulation: Disruption Risk | Moderate
We believe Canada's regulatory environment has a moderately disruptive influence over the banking industry, as regulators try to balance the demand for technology-led innovation with the responsibility to maintain a stable and robust financial system. Although Canadian regulators have yet to adopt conclusive digital goals that would prompt banks to accelerate their digital efforts, policymakers have become cautiously receptive to fintech innovation.
Canada's regulatory framework has become more welcoming to fintech innovation since 2018 and regulators have taken steps to advance the digital agenda. For instance, collaboration between banks and fintechs has been made easier by a 2018 amendment to the Bank Act. Under the amendment, approval for bank-fintech cooperation by the Finance Minister is no longer required and banks have permission to design and sell technology related to their core business, and the process for investing in fintechs has been streamlined. In addition, the Ontario Securities Commission's 2018 "regulatory super sandbox" provides certain regulatory exemptions to fintechs and enables them to experiment with business models, products, and services.
Moreover, the federal government provides incentives, financial assistance, and advisory services to small and midsize enterprises (SMEs) and start-ups, including fintechs, through various programs. We believe that such measures will ultimately reduce fintechs' barriers to enter the Canadian market, intensifying pressure on domestic retail banks. However, banks are highly regulated, with constant supervision and high levels of coordination with regulators. Canada has a high threshold for granting banking licenses, making it very difficult for smaller fintechs to enter the market. We believe that the country's existing structures regulating new industry players will delay the threat posed to retail banks and will give banks ample time to adapt to new technological demands. Overall, Canada still lacks many key fintech credit policy frameworks when compared with certain peers.
According to information compiled by the Bank for International Settlement from early 2020, Canada's policy responses to enabling technologies are still somewhat lacking. While the country has made and is making regulatory progress on application programming interfaces and cloud computing, it is still missing adequate regulation for biometric-based identification and authentication, distributed ledger technology, and machine learning/artificial intelligence. A strength, however, is that Canada's regulatory framework includes several innovation facilitators such as innovation hubs, regulatory sandboxes, and accelerators, i.e. partnership arrangements between fintechs and supervisory agencies.
Open banking is becoming increasingly important in a regulatory context. In September 2018, the Department of Finance established an advisory committee that, in January 2019, released a consultation document based on which regulatory action would be taken in the future. However, there has been no meaningful progress to date and regulatory action on open banking likely hinges on further updates to Canada's data privacy law, the Personal Information Protection and Electronic Documents Act.
Although the Canadian regulators' actions are a step in the right direction to promote innovation, we have yet to see the actual ground-level impact in the banking sector. The exact nature and extent of the impact of regulatory changes on the sector will likely become clearer as policymakers take concrete steps to remove barriers for the impending arrival of open banking and to strengthen data privacy laws.
COVID-19: An Accelerator Of Tech Adoption
We believe the COVID-19 pandemic will boost Canada's adoption of financial technology. Efforts to limit COVID-19 transmission have accelerated the use of contactless payment, e-transfers, and check-image capturing globally. Similarly, social distancing and branch closures have significantly decreased foot traffic in physical branches, accelerating the use of online and app-based banking. Mastercard reported that globally, in the first quarter of 2020, contactless payment volumes grew at 2.5x the rate of noncontactless payments. We believe that although banks will face pressure on earnings under current conditions, which could lead to temporary delays to technology-based initiatives, they will continue prioritizing technology investments for changing consumer practices.
The pandemic has accelerated Canadians' previously steady move toward digital payments and automated financial services. As social distancing measures were introduced almost overnight, many banking services such as mortgage renewals moved online while government support programs, especially SME loans and grants, were intermediated by banks through online channels. Canadian banks across the board reported a surge in online transactions, with BMO reporting its weekly rate of customers signing up for digital banking jumped as much as 300%. Interac, Canada's premier interbank system, reported a surge in first-time e-transfer users following pandemic-related lockdown measures and a record-setting 61.3 million e-transfers in April 2020 alone. Therefore, we believe the pandemic's accelerating effect on technology adoption will trump temporary delays in development initiatives, hastening retail banks' expansion of new alternatives.
Large Canadian Bank Ratings Face A Moderate Risk From Technological Disruption
Overall, we believe Canada's domestic banks are moderately positioned to adapt to technological disruption and we do not expect technological disruption to cause downward rating pressure in the near term. Canadian banks are widely trusted and well-regarded thanks to prudent risk management and a traditionally cautious mindset. With stable client bases and favorable regulation, domestic banks are determining the pace of fintech adoption: slow but steady. We see partnerships between fintechs and retail banks as more likely than an all-out disruption. Major banks have been investing significantly to upgrade their systems through in-house tech developments and partnerships with start-ups, increasing their digital offerings with TapToPay technologies, mobile banking apps, and online transfers, to name a few.
Canadians are increasingly adapting to a mobile and online world, reflecting a growing preference for technology-driven, convenience-focused banking, especially among younger consumers. However, Canadians' increased digital appetite is offset by a lower level of trust in unsecured financial technologies to handle their financial information and a sustained value in relationship-based banking experiences. Moreover, Canadian regulators have been slow to develop the regulatory requirements to accommodate these new technological options, including for open banking and cloud sourcing. We believe the pace of retail banks' adoption of more diverse digital products will also depend on the updating of data security privacy laws by Canadian regulators.
In the long term, though, we believe technology's disruptive influence on the Canadian banking sector will grow, following the trends of Canadian regulations becoming more favorable to fintech innovation and customer services being completed more heavily through digital and online banking channels, accelerated by the pandemic.
Emily Markowitz contributed research to this report.
- Banking Industry Country Risk Assessment Update: December 2020, Dec. 15, 2020
- The Future Of Banking: Research By S&P Global Ratings, Sept. 14, 2020
This report does not constitute a rating action.
|Primary Credit Analyst:||Felix Winnekens, New York + 1 (212) 438 0313;|
|Secondary Contacts:||Shameer M Bandeally, Toronto + 1 (416) 507 3230;|
|Lidia Parfeniuk, Toronto + 1 (416) 507 2517;|
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