FINTECH Adoption and Innovation in the Hong Kong Banking Industry May 2020 Hong Kong Institute for Monetary and Financial Research HKIMR Applied Research Report No. 1/2020 ABOUT THE HONG KONG ACADEMY OF FINANCE The Hong Kong Academy of Finance AoF has been established in June 2019 with full collaboration amongst the Hong Kong Monetary Authority, the Securities and Futures Commission, the Insurance Authority and the Mandatory Provident Fund Schemes Authority. The AoF brings together the strengths of the academia, the industry, professional training institutes and the regulatory community to develop f_inancial leadership and promote research collaboration. The mission of the AoF is to serve as a centre of excellence for developing f_inancial leadership and a repository of knowledge in monetary and f_inancial research, including applied research. ABOUT THE HONG KONG INSTITUTE FOR MONETARY AND FINANCIAL RESEARCH The Hong Kong Institute for Monetary and Financial Research HKIMR was established by the Hong Kong Monetary Authority in August 1999. Since then it has been conducting research in the f_ields of monetary policy, banking and f_inance that are of strategic importance to Hong Kong and the Asia region. With the establishment of the AoF in June 2019, the HKIMR undertakes the research activities of the AoF, and its remit is expanded to include applied f_inance research in cross-sectoral areas, carrying out research projects that are highly relevant to the policy deliberations in Hong Kong, and strategic to the long-term development of the local f_inancial industry. Contact us Email hkimrhkma.gov.hk Tel 852 2878 1706 Website https//www.aof.org.hk/research/HKIMR 1 HKIMR Fintech Adoption and Innovation in the Hong Kong Banking Industry CONTENTS Page Foreword 2 Acknowledgements 3 cutive Summary 4 1. Technology Revolution Banks view it as an opportunity rather than a threat 6 2. Have banks met their objectives Some early signs of payoff 18 3. Fintech Strategy and Implementation Most banks see themselves as “adopters” instead of “followers” 22 4. Overcoming challenges Ination security, talents, regulation related to Fintech evolution and legacy IT systems are key 28 5. Looking into the future Most banks are confident that they will continue to play a key role in customer relationship and core banking services in the next 10 years 34 6. Conclusions 38 Appendix A Survey Background 39 Appendix B The Effect of Fintech Adoption on Banks’ Perance A Preliminary Analysis 41 FOREWORD 2 HKIMR Fintech Adoption and Innovation in the Hong Kong Banking Industry This is the first in a series of research reports published under the Applied Research Programme of the HKIMR following the establishment of the Hong Kong Academy of Finance AoF, guided by the Council of Advisers for Applied Research that comprises representatives from the financial regulators, industry and academia. These reports will cover research topics that are highly relevant to the financial industry and regulators in Hong Kong and deal with broad research themes that explore new developments in financial markets with the aim of providing the financial industry in Hong Kong with ideas regarding its strategic development in the long run. We hope that this report offers insights and useful points of reference on Fintech adoption in the Hong Kong banking industry and its implications for the industry, markets and regulators. Mr Edmond Lau Senior cutive Director Hong Kong Monetary Authority In recent years, waves of financial technology or Fintech innovations, enabled by rapid developments in telecommunications and ination technology, have led to an increasing degree of digitalisation and the emergence of various new technological applications and solutions in the global financial sector. These developments promise to have profound implications for banks’ business operations and the structure of the banking industry. Depending on banks’ ability to adapt and adjust their business models, Fintech could be viewed as a competitive threat, or as an opportunity to leverage technologies to promote financial innovations, enhance customer experiences, facilitate financial inclusion and achieve greater cost efficiencies. Given their relative importance in Hong Kong’s financial sector and their integral role in intermediating funds for the economy, the effect of Fintech on banks’ business operations is expected to be of keen interest to the financial industry, regulators and academia in Hong Kong. This report explores the current landscape of Fintech development in the Hong Kong banking industry and how banks view the future of Fintech development in the next 10 years. It highlights the results of an industry-wide survey commissioned by the Hong Kong Institute for Monetary and Financial Research HKIMR to assess the status of banks’ adoption of Fintech in Hong Kong and to gather insights on the important trends and evolution of Fintech development in the Hong Kong banking industry. The surveyed entities include banks accounting for around three-quarters of total assets and more than 80 of total customer deposits in the Hong Kong banking industry, as well as recently licensed virtual banks. 3 HKIMR Fintech Adoption and Innovation in the Hong Kong Banking Industry The research report is based on the study by Kelvin Ho of the Hong Kong Monetary Authority HKMA Market Research Division and Jim Wong, entitled “The Impact of Fintech innovations on the Hong Kong Banking Industry”, published as HKIMR working paper ACKNOWLEDGEMENTS No. 8/2020. The HKIMR also thanks the Council of Advisers for Applied Research and colleagues at the HKMA Banking Supervision Department for their continued support and guidance and for their useful comments and suggestions on earlier drafts of the report. CUTIVE SUMMARY 4 HKIMR Fintech Adoption and Innovation in the Hong Kong Banking Industry Fintech has been widely applied across all types of financial services by incumbent banks, with about half or more of them adopting the innovations in payment and fund transfer, personal finance, savings and deposit account services, investment and wealth management services, back-office operations and IT security systems. As for virtual banks, most of them indicate that they would apply Fintech innovations in almost all the services that they plan to operate. Innovations relating to “mobile banking”, “open banking APIs”, “machine learning and predictive analytics”, “customer identification and authentication” and “cloud computing” have been commonly applied by over 40 to up to two thirds of the incumbent banks. While related applications for “robo-advisory”, “regtech solution”, “distributed ledger” and “smart contracts” have been less widely used, most respondents have plans to apply them in the future. As for virtual banks, they have shown keen interest in almost all identified solutions. The incumbent banks have taken a pragmatic approach, adopting a wide range of Fintech innovations across financial services whilst eschewing applications of marketplace plats that could facilitate a shift to disintermediation. This is in contrast to virtual banks, about 40 to half of which indicate likely adoption of these applications. Overall, the incumbents view Fintech more as an opportunity than a threat to their business operations, now and in the next five years. Notably, a higher percentage of the incumbent banks see Fintech as presenting opportunities across all financial services in the next five years ranging from 50 to 77 compared to now ranging from 35 to 56. Fintech innovations enabled by rapid developments in telecommunications and ination technology have led to an increasing degree of digitalisation and the emergence of various new technological applications and solutions in the financial sectors globally. These developments in the financial sector have been driven by several factors, including cost optimisation, operational efficiency improvement considerations and responses to greater competition from non- bank players that necessitate the adoption of new technological innovations. With growing interest in Fintech and an increasing trend of global investment in related areas, it is envisaged that banks’ business operations may be significantly affected. Depending on banks’ ability to adapt and adjust their business models, Fintech could present as a competitive threat, or as an opportunity to achieve greater cost efficiencies, improve customer experiences and facilitate financial inclusion. Given their importance in Hong Kong’s financial sector and their integral role in intermediating funds in the economy, the impact of Fintech on banks’ business operations, and how banks view the future of Fintech development are expected to be of interest to the financial industry, regulators and academia. This report presents and discusses the results of a survey conducted with banks in Hong Kong, including the recently licensed virtual banks, to obtain industry-wide qualitative ination and to gather insights on the important trends and evolution of Fintech development in the Hong Kong banking industry, both currently and in the future. The survey results indicate that Fintech is viewed as a complement and enabling technology by the Hong Kong banking industry. 5 HKIMR Fintech Adoption and Innovation in the Hong Kong Banking Industry considered as key challenges by most banks. These challenges are not unique to Hong Kong and can be observed in the banking industries of other economies. For some of these hurdles, policymakers could have a role to play. How Hong Kong’s banking industry structure may evolve over the next decade in the face of Fintech developments has been widely debated. Incumbent banks are confident that, through adapting to the new environment, they will continue to play a key role and would not be displaced by new competitors. Most incumbent banks 73 of the respondents consider the “better bank scenario”, where banks digitise and modernise themselves to retain the customer relationship and core banking services, as highly possible. Nonetheless, they appear not to rule out other less but still dramatic scenarios as possibilities. While most virtual banks 63 of the respondents consider the “better bank scenario” as highly possible, half of them also see both the “distributed bank scenario”, where banks and Fintech firms operate as joint ventures or partners, and the “new bank scenario”, where traditional banks are replaced by new technology-driven banks, as highly possible. This suggests that virtual banks in general expect a bigger impact of Fintech innovations on traditional banking services and a more dramatic change in the structure of Hong Kong’s banking industry. If banks’ views are any guide, precautionary preparations for more dramatic changes in Hong Kong’s banking industry structure, such as strengthened monitoring on the Fintech development as well as increased cooperation with different authorities responsible for oversight of regulatory functions related to Fintech, may be warranted. Although in general it may appear premature to uate the effectiveness of Fintech adoption, there are already some early signs of payoff, with more than a third of the incumbent banks stating that their prime objectives of adopting Fintech have been met. Initial results show that changes in banks’ cost-to-income ratio and return on assets ROA are statistically correlated with their Fintech adoption status. Banks with more widespread adoption of Fintech are associated with greater cumulative reduction in cost-to-income ratio and larger cumulative rise in ROA, other things being equal. These preliminary findings suggest that the adoption of Fintech has so far produced some positive effects on banks’ perance. Most banks take either a “proactive adopters” approach to achieve first mover’s advantage or a “reactive adopters” strategy where transational changes are implemented at a steady pace, rather than engaging in Fintech only when the technologies are more mature and widely adopted or not dealing with Fintech at all. To that end, most retail and virtual banks have or plan to set up dedicated divisions or teams, mostly located in Hong Kong, though fewer foreign banks have so far established their teams domestically. To accelerate the adoption of Fintech innovations, various s of engagement in relation to Fintech have been undertaken, including “develop in-house”, “purchase Fintech products and services from external parties”, “ing partnerships with Fintech firms” and others. The pace and degree of Fintech adoption will, however, hinge on whether certain challenges can be overcome, amongst which difficulties in ensuring ination security, data privacy and protection, difficulties in retaining and attracting talents, domestic as well as international regulation related to Fintech evolution, and banks’ legacy IT systems are BANKS VIEW IT AS AN OPPORTUNITY RATHER THAN A THREAT Fintech is viewed as a complement and enabling technology by the Hong Kong banking industry. Most incumbent banks have taken a pragmatic approach, adopting a wide range of Fintech innovations across financial services whilst eschewing applications of marketplace plats that could facilitate a shift to disintermediation. Overall, the incumbents view Fintech more as an opportunity than a threat to their business operations, currently and in the future. TECHNOLOGY REVOLUTION 1 7 HKIMR Fintech Adoption and Innovation in the Hong Kong Banking Industry TECHNOLOGY REVOLUTION BANKS VIEW IT AS AN OPPORTUNITY RATHER THAN A THREAT Understandably, most incumbent banks are not keen on applications of marketplace plats, including “crowd-funding”, “lending marketplaces” and “savings and deposit marketplaces”, which could facilitate a shift to disintermediation. This is in contrast to virtual banks, about 40 to half of which indicate likely adoption of these applications. Across all financial services, an even greater proportion of the incumbent banks view Fintech as opportunities in the next five years compared to now, with the proportion corresponding to opportunities continuing to exceed that for threats. Overall, the incumbent banks view Fintech more as an opportunity than a threat to their business operations, both currently and in the next five years. The Hong Kong banking industry has been embracing Fintech actively. Incumbent banks consider Fintech as a complement and enabling technology which facilitates efficiency improvements and financial inclusion, out- numbering significantly those seeing it as a threat and a replacement for their existing businesses. The impact of Fintech is being increasingly felt, with most bank surveyed that consider no impact currently, realising that they could not be unaffected in the future. Most incumbent banks have taken a pragmatic app