Digital Banking in Malaysia: Are incumbent banks the real winners of the COVID-19 digital revolution?

June 2020
By Paul Francis, Financial Services Strategy Director, PwC Malaysia

COVID-19 has been an important catalyst and has done more than any other event to drive digital usage in Malaysia. In the space of just a few weeks, individuals and businesses have had to replace face-to-face interaction with remote and digital channels. With the effects of the pandemic likely to continue for the foreseeable future, it is clear that things are not going back to the way they were before, at least not in the next few months.

The pandemic has shown customers and banks that not only can digital channels work, but are necessary. However, banks need to be mindful that customers may have higher expectations around the ease of use and functionality of digital banking in making the switch from face-to-face channels. This is especially so among customers who are comfortable with digital channels for online shopping, ride sharing and food delivery.

This could present a challenge for banks burdened with legacy channels and conservative cultures. And for banks that may not have invested as much in digital channels prior to the pandemic, building digital channels, capabilities and the right culture of innovation are now some of their highest priorities to remain competitive.

At first glance, it would seem that these upcoming digital banks would be ideally placed to take advantage of accelerated digital adoption among customers. These new digital banks will focus on a strong digital customer value proposition (CVP), leveraging flexible technology platforms that allow innovation and with low cost of acquisition and servicing.

But why is it that incumbent banks have a good chance of being the real winners of the COVID-19 digital revolution?

Incumbent banks are aware of the challenge, and have a bigger window to respond

COVID-19 has delayed the digital banking licensing process in Malaysia significantly, with the start of the licensing process potentially delayed until 2021. This gives incumbent banks up to 24 months to prepare for the entrance of the first digital banks in Malaysia.

During this time, incumbent banks are continuing to identify changes they need to make to their existing processes to work in a more digital world. They would have time to experiment with new CVPs, whether by developing this in-house or partnering with other companies that can bring in the right capabilities.

It’s also important to note that the start of the digital banking licensing process will likely coincide with the release of the Electronic Know Your Customer (eKYC) guidelines. Today, many key banking processes require a customer to visit a branch and sign a form with a “wet signature” i.e. marking forms physically with a pen. Replacing this wet signature with a digital proof of identity through eKYC could radically change the role of branches in banks.

While eKYC will provide the foundation for branchless digital banking models, it is also a key enabler for incumbent banks’ own digital transformation. Unlike applicants for digital banking licences who are delayed by the start of the application process, incumbent banks will be able to implement eKYC immediately.

Becoming profitable as a digital bank is more challenging than ever

Globally, digital banking models are still evolving with entrants focusing on customer acquisition and creating a compelling CVP as they seek to carve out a niche that they can monetise in the long term.

With many digital banks focusing on the more affluent customer segments, and adopting a lifestyle-based CVP, fundamental changes to customer behaviour and spending patterns will have significant implications on the continued relevance of the digital bank CVP.

In Malaysia, the challenge will be even greater. For a digital bank focused on the less affluent B40 (the bottom 40% income group in Malaysia) and the Micro, Small and Medium Enterprises (MSME) segments in line with the requirements of Bank Negara Malaysia, their attention will be diverted to those segments of society that have been the most impacted by the pandemic. Taking into account the fact that the pandemic has threatened the viability of many MSMEs, this may translate into lower income and greater risks for banks servicing them. We explore these in the next section.

Banking fundamentals: Funding and risk management have become more important

Learning from the experience of other countries, we observe that during the last financial crisis, banks in Australia with a natural funding base from deposits were able to dominate the lending market as wholesale funding sources disappeared. It follows that incumbent banks with an established deposit base are more likely to sustain their lending business even during a downturn.

With Bank Negara Malaysia’s requirement that digital banks focus on the underserved and unbanked including the B40 and the MSME segments, this means that their core customers will have lower deposits than the average Malaysian customer. Additionally, Development Financial Institutions (DFI) which are focused on similar customer segments typically augment their deposit base by offering term deposits at attractive rates which increases their cost of funds. Digital banks will need to attract deposits from customers outside of the underserved target segment to continue to grow their lending businesses.

The pandemic, and any softer economic environment that follows, may drive increased demand for credit, but economic uncertainty makes assessing risk much more difficult. For instance, a business that only a few months ago would seem viable could be facing significant risks today. With increases in non-performing loans, robust procedures will need to be in place to ensure that as much as possible is recovered. Incumbent banks with established risk procedures are likely to have greater resilience to survive the crisis.

Malaysian digital banks can still be competitive if they create a differentiated CVP

Despite the increased challenges resulting from COVID-19, there is still a place for digital banks in Malaysia.

COVID-19 has not changed the fact that a digital bank will be successful when it understands its customers’ behaviour and creates a compelling CVP that meets its customers’ needs. Access to customers, or a technology platform alone is not enough.

For players planning to apply for the digital banking licence, the delay in the application process provides the opportunity to rethink their CVP and to test whether it truly offers the customer a unique offering that the incumbent banks cannot duplicate. There are four key steps they should complete before the licence application starts in 2021:

Define a CVP for each customer segment - Be clear on how you create more value for your customers to differentiate yourself from your competitors
Build your CVP on strengths that cannot be copied by your competitors - Pricing is easily matched, but deep insight of customer behaviour and risk is much harder to duplicate
Identify the right partners to deliver on your CVP, whether it is getting access to the right customers, technology or the data required to develop a deep understanding of customer needs - If there are any gaps in capabilities, it is critical to identify partners now while they are available
Develop a clear financial plan on how the digital bank will become profitable - Understand the sensitivity of key factors around customer acquisition, cost of funds and the implications of the risk profile on your business

Winners in the digital banking landscape will be those who are able to identify a clear customer value proposition, and respond quickly to occupy and serve their niche.