Virtual Banking: The Hong Kong Experience

Motivations for Hong Kong to encourage virtual banking include promoting financial inclusion, provides better customer experience and promotes fintech innovation, explains Hong Kong Monetary Authority. This was an article features in In Focus magazine issue 5.

The convergence of banking and technology is a global trend. More and more tech companies, riding on technological innovations, have ventured into finance to provide more personalised and integrated financial services to customers. In some jurisdictions, it has proven to be technically feasible and commercially viable for virtual or branchless banks to operate.

Hong Kong’s motivation to encourage virtual banking runs into fintech development and innovation of solutions to the banking industry – this includes use of innovative technology solutions for remote customer on-boarding, big data and AI in risk management, and provision of personalised products and services.

These solutions will motivate incumbent banks to enhance business operations and services, thereby raising the overall quality of banking services. In addition, as virtual banks will engage primarily in retail banking business and aren’t allowed to impose any minimum account balance requirement or low-balance fees, they’re expected to help promote financial inclusion.

Hong Kong’s Journey of Virtual Banking
Hong Kong is the premier international financial centre in Asia and has been at the forefront of smart banking in terms of digital banking. By and large, banks in Hong Kong are offering safe and efficient banking services to customers, both through the conventional branches and through digital banking.

In view of the explosive advancement in technology in the last few years, and rising aspirations of customers for more personalised and integrated services, Hong Kong aims to proactively embrace the trend and seize the opportunity to upgrade its banking system.

Therefore, the Hong Kong Monetary Authority (HKMA) took the lead and helped the banking sector to rise to a higher level as well as embrace the enormous opportunities brought about by the convergence of banking and technology by rolling out virtual banking in 2018, which is one of its Smart Banking Initiatives unveiled in 2017.

The introduction of virtual banking is one of the HKMA’ s key initiatives for spearheading Hong Kong into a ‘New Era of Smart Banking’. A major milestone was achieved when the HKMA granted banking licences to eight virtual banks in the first half of 2019.

Criteria of a Virtual Banking License
As of September 2019, there are eight virtual banking license holders in Hong Kong. A statutory objective of HKMA, which is the currency board of Hong Kong and de facto central bank, is to maintain the stability of the banking system in Hong Kong.

Based on the business plans of the eight virtual bank license holders, the total amount of capital deployed and the human resources required in their first three years of operation will only represent a small portion of the banking industry. Thus, it’s expected that the impact of the introduction of virtual banks to the banking system in Hong Kong should be acceptable.

Same as conventional bank licences, when assessing the applications for virtual banking licences, HKMA has to be satisfied that the applicant can meet all of the licensing criteria set out in the Seventh Schedule to the Banking Ordinance, including adequate financial resources and adequate systems of control.

HKMA also considers whether the business plan is in line with its three policy objectives of introducing virtual banks to Hong Kong:
1. Promote fintech development and innovation in Hong Kong
2. Offer better customer experience
3. Promote financial inclusion

Going forward, HKMA aims to observe the operations of virtual banks after they commence business, the response of customers, market acceptance and the impact of virtual banks on the stability of the local banking system before considering whether to further process virtual bank applications. HKMA expects to be able to conduct a comprehensive assessment of the situation about one year after the first virtual bank has launched its service in Hong Kong.

Challenges and Solutions
The eight virtual banks are currently completing the build-out of their systems and processes, with the aim to begin rolling out virtual banking services before the end of the year. Before commencing business, a virtual bank must put in place adequate systems and controls to manage the risks to which it is exposed, and demonstrate to the HKMA’s satisfaction that these systems and controls will operate effectively.

Like conventional banks, virtual banks must have an effective risk management framework for monitoring and controlling different types of risks including credit, interest rate, market, liquidity, operational, reputation, legal and strategic risks.

This notwithstanding, HKMA has identified three key risk areas that are more pertinent to virtual banks and will devote greater resources to supervising the virtual banks’ management of these risks:

1. Technology risk management is of vital importance to virtual banks given their tech-driven business models and sole use of digital channels to deliver banking services. HKMA requires virtual banks’ security and tech-related controls and arrangements to be ‘fit for purpose’, regularly reviewed to ensure that they remain appropriate in light of latest technological developments, and subject to a detailed independent assessment before business commencement.
2. Customer data privacy and protection since virtual banks face the possibility of higher data privacy risks, which arise from their use of big data and behavioural data analytics in the design and marketing of their products and services, as well as in risk management processes. HKMA requires virtual banks to implement appropriate safeguards to ensure that they comply with the data privacy requirements in Hong Kong and embody the spirit of data ethics. Virtual banks should also comply with the Code of Banking Practice and adhere to principles in the Treat Customers Fairly Charter.
3. AML/CFT since virtual banks will primarily deliver banking services through the internet or other forms of electronic channels, their risk assessments should take into account the specific risks which arise from their digital-based business model, such as impersonation risk and establish effective mitigating controls.

So, to help virtual banks manage the risks associated with the use of innovative technologies, HKMA encourages them to make use of its Fintech Supervisory Sandbox. This allows banks and their partnering technology firms to conduct pilot trials of fintech initiatives in a controlled environment without the need to achieve full compliance with HKMA’s supervisory requirements.

Virtual banking is a new business model in Hong Kong and market receptiveness to virtual banks will need to be observed. With this in mind, HKMA requires each virtual bank to have an exit plan in place before business commencement so it can unwind business operations in an orderly manner. In general, an exit plan should cover matters such as the circumstances under which the plan will be triggered, the authority to trigger the plan, the channels to be used to repay depositors and the source of funding for making the payments.

Driving Collaborations
Key to the development of virtual banking is collaborations between banks and non-banks. With this in mind, the HKMA has rolled out the following programmes:

1. Industry liaison: Events and Haccelerator Programme
   The Fintech Facilitation Office (FFO) of HKMA regularly organises industry liaison events such as workshops and seminars for banks and non-banks to not only exchange ideas and insight into fintech development, but also to explore collaboration opportunities. Since 2016 to now, the FFO has organised 44 events, attracting more than 15,500 participants locally and from around the world. HKMA organised networking events and panel discussions during the annual Hong Kong Fintech Week the past three years. This enabled HKMA, banks and non-banks to touch base as well as connect with each other. FFO launched the Haccelerator programme in 2017 in collaboration with Cyberport, offering banks and stored value facility (SVF) operators a platform to run fintech-related competitions including hackathons and accelerators to explore innovative solutions, identify talents, and seek co-operation opportunities with fintech startups and innovators. To date, four banks and one SVF operator have organised competitions using the platform.

2. Regulatory interface
   HKMA has launched the Fintech Supervisory Sandbox (FSS), which allows banks and their partnering technology firms to conduct pilot trials of their fintech initiatives in a controlled environment without the need to achieve full compliance with HKMA’s supervisory requirements. The usage of the FSS has continued to increase steadily since its launch in September 2016 with very positive feedback from the industry. Until the end of July 2019, 70 cases of pilot trials were allowed in the FSS. Additionally, with the launch of the Fintech Supervisory Chatroom in November 2017, banks and tech firms can obtain HKMA’s regulatory feedback during the early stage of their fintech projects, thus reducing abortive work and expediting the rollout of new technology applications. As at end July 2019, 331 Chatroom requests had been received.

3. Research and application
   HKMA published an Open Application Interface (API) Framework in July 2018 following the completion of a two-month public consultation. The framework’s conducive to the collaboration between banks and non-banks as it serves as a guide for banks and third party service providers to work together under a secure, controlled and convenient operating environment and develop innovative and integrated banking services that improve customer experience. HKMA began a research on Distributed Ledger Technology (DLT) in 2016 and conducted Proof of Concept (PoC) trials to explore the collaboration between banks and non-banks in terms of application of DLT in financial services. The PoC trials were on trade finance, mortgage valuation applications and digital ID management respectively. Riding on the success of the trade finance PoC trial, a blockchain-based trade finance platform named eTradeConnect was launched in October 2018 to digitise and share trade documents, automate processes, and reduce errors as well as the risk of fraud.

Impact of Virtual Banking
The business model and target customers of virtual banks are usually different from those of conventional banks. Unlike conventional banks, virtual banks primarily deliver retail banking services through the internet or other forms of electronic channels instead of physical branches. In addition, virtual banks normally target small customers, be they individuals or small-to-medium sized enterprises.

This should provide a commercially more viable alternative for banking operators, Islamic banks included, to better serve communities whose population is less concentrated or under-served because of costing consideration of banks.

Its Next Big Step
The next big step for virtual banking in Hong Kong and its move towards Smart Banking era will be the virtual banks’ formal commencement of business. The eight virtual banks are currently completing the build-out of their systems and processes, all along in close communication with HKMA.

According to the virtual banks’ latest indications, virtual banking services are expected to be rolled out to the public in the fourth quarter of 2019 at the earliest. HKMA will monitor and assess the impact of virtual banks on the local banking sector after they commence business and carefully take such observations into account when determining how to take forward virtual banking in Hong Kong.

Tips for Virtual Banking Startups
HKMA’s monitoring of the eight virtual banks provides necessary guidance and they are:

1. Like conventional banks, a virtual bank should put in place an effective risk management framework to identify, manage and control the risks they’re exposed to. HKMA expects the boards of directors as well as senior management of the virtual banks to foster a sound corporate and risk culture across the bank. Any attempt by a virtual bank to rapidly grow businesses at the expense of effective risk management and internal controls can end up holding back business growth, as HKMA may require the virtual bank to implement remedial actions before it can pursue further growth.
2. When launching their businesses, virtual banks should aim to achieve HKMA’s three policy objectives mentioned earlier for introducing virtual banking in Hong Kong. Virtual banks should strive to offer customer-centric experiences supported by technology, whilst conducting their businesses in a safe and sound manner.

3. As virtual banks are new to Hong Kong, they may need to adjust their business strategies more frequently than the established conventional banks to respond to customer feedback and competition in the banking sector. The business model risk shouldn’t be underestimated, especially as some of the conventional banks are playing catch up and accelerating their fintech development as well as digital offerings. Therefore, virtual banks should be alert to the strategic challenges faced by them.