Hong Kong’s virtual banking industry is relatively new, with the first virtual banks launching in the city in 2019. The Hong Kong Monetary Authority (HKMA) granted eight virtual banking licenses in total, and as of 2021, all eight virtual banks are operational. Despite their rapid growth in popularity among consumers, Hong Kong’s virtual banks have yet to achieve profitability.
It seems counterintuitive for a bank to be unprofitable. Afterall, banks are the mother of all industries. In theory, banks should be profitable because they pay a lower interest rate to depositors and in turn lend out the acquired capital to borrowers at a higher interest rate. At its essence, a bank’s business model is simple and proven — buying (capital) low and selling (capital) high. Of course, there are much more complexities to it, such as composing the mix of the loan book, managing the duration mismatch between assets and liabilities, running additional businesses such as investment banking, and more. Occasionally, a bank may fall prey to episodes of misfortune, such as an unrecoverable bank-run, over-exposure to bad debts, or outsized speculative bets that go awry. But normally, even small community banks should be profitable.
According to a recent report from Quinlan & Associates, a consultancy, the unprofitability of Hong Kong’s virtual banks is partly due to the high customer acquisition costs (CAC) of retail customers, which ranges from USD 65–90. With so many virtual banks operating in Hong Kong’s overbanked market, it is difficult for any new bank to stand out and attract new customers. Additionally, virtual banks rely solely on their digital platforms to interact with customers, which can make it challenging to build trust and establish a strong brand identity among more conservative consumers.
Sustainable Fund Flow is a Bank’s Bread and Butter
However, whether the customer acquisition cost (CAC) is too high or not is relative to the potential lifetime revenue (or lifetime value, LTV) that the acquired customer is expected to generate. In the banking context, acquiring depositors is equivalent to acquiring capital. Not just any capital, but cheap, long-lasting customer deposits, which are preferable to more expensive funding sources such as interbank financing.
All banks face the issue of CAC, especially in overbanked markets such as Hong Kong. Occasionally, banks offer too-good-to-be-true deposit deals to entice customers to open a bank account. Usually, a good deal for depositors can be justified by an even better deal for the bank, since banks have done the math on how to profit from these additional deposits. The key idea of a sustainable banking business model revolves around a “closed loop” of fund flow.
That’s why primary bank accounts are so sought after by banks. A primary bank account is one in which a bank customer receives salary. From a bank’s perspective, this means a steady, automatic inflow of monthly deposits which would become stable capital of the bank. Naturally, the depositor would also use the primary account to pay major expenses such as mortgage payments, kid’s tuitions, credit card bills, and other regular outlays. Hence primary bank accounts can often be long-term revenue generators via a wide range of banking services, including credit cards, foreign exchange, investment products, and most importantly, mortgage loans. A single mortgage loan can easily lock in 30 years of stable lender-borrower relationships between a bank and its depositor, creating a highly sticky, decades-long, almost unshakable, circularity of a fund flow. This makes the initial CAC highly justifiable.
Such perfect picture aside, the competition between banks can be fierce. Consumers can be easily enticed by mortgage and refinancing offerings from other banks, and the hassle of switching bank can be easily compensated by a better deal. Poaching a customer for other banking services, such as a new credit card, only involves minor inconvenience for the customer which can be easily compensated by a competing bank.
But taking all depositors in aggregate, the closed-loop fund flow among salary deposits, credit card and other payments, and mortgage payments, comprise the bread-and-butter of a traditional bank. This is what fuels the “buy (capital) low, sell (capital) high” business model of a typical bank, which in turn would drive its long-term and sustainable profitability. Hence banking is good business (as long as it does not blow up).
Challenges Faced by Virtual Banks
How about virtual banks in Hong Kong?
Unfortunately, virtual banks have never quite achieved such self-sustaining fund flow circularity. As new entrants, virtual banks had to fight uphill to begin with. There were no existing banking relationships to upsell to, no prior relationships or communication channels to rekindle, and no word-of-mouth or physical presence to put them on a customer’s radar. Virtual banks had to start from a clean slate from a customer acquisition perspective.
Undoubtedly, virtual banks have their advantages. They can save a lot of overhead costs by not having to maintain physical locations as well as staff them with a lot of employees. Virtual banks are also digital-native, which means their organization and IT infrastructure can be designed from a clean slate, adopting the best technologies of the day, be it cloud-based infrastructure or automated customer service. Moreover, there is no need to worry about the additional costs of integrating with existing systems, which is a major hurdle of many traditional banks while they voyage toward the holy quest of digital transformation.
But in the end, growing the pie is what makes a newcomer bank (virtual or not) successful — i.e. growing the number of customers and their deposit base, expanding the borrower base and enhancing the efficiency of capital deployment, as well as building partnerships with other financial institutions, corporations and consumer ecosystems. Afterall, traditional banks had been profitable for ages without deploying glitzy new IT infrastructure (or a cute app interface).
The key hurdles for virtual banks are primarily threefold, one related to another:
- The stickiness and inertia of primary bank accounts are formidable, and it is really difficult to ask consumers to switch their day-to-day salary and spending accounts to another bank, whether it’s virtual or not.
- Even if a virtual bank can entice mass onboarding of new customers through viral marketing or genuinely better user experiences, these new customers may just go through the account-opening motion and deposit some mundane amounts of money in order to take advantage of a good deal (whatever the bank is offering to entice them onboard). This means that the bank’s deposit base will be limited, constraining the amount of capital available to be deployed for revenue generation, and ultimately its growth potential.
- Without a large enough deposit base, virtual banks do not have a deep enough pocket to compete in the elephant of the banking business — mortgage lending. Mortgage lending is a volume and scale business, and banks mainly compete in price. Tapping the interbank market cannot be a sustainable solution either, as it is a more expensive source of capital which also price-discriminates against smaller players.
Without access to primary bank accounts, the largest source of deposits, and mortgage loan businesses, the largest use of bank capital, the aforementioned closed-loop fund flow cannot be established. Virtual banks thus need to deploy their deposit base to other forms of lending, such as consumer lending and small-to-medium enterprise (SME) lending. The problem is, these borrowers usually do not overlap with the depositors (who had spare savings to try out a virtual bank in the first place), hence they need to be acquired at a cost. For a virtual bank, after spending significant CAC to entice depositors to open accounts and deposit money into, it will need to spend additional CAC to acquire new borrowers such as cash-strapped consumers or SMEs.
That’s a double if not triple whammy, because a virtual bank needs to pay CAC twice to: 1) acquire new depositors, who are unlikely to give it lucrative businesses (e.g. mortgages) anyway, and 2) acquire new borrowers, who are not as natural or convenient a customer as compared to the closed-loop fund flow between salary income and mortgage loans with respect to traditional banks.
Opportunities and Hopes for Hong Kong’s Virtual Banks
Whither the virtual banks, then?
To answer this question, let’s go back to the original purpose. Why would the Hong Kong Government license eight new virtual banks in the first place? According to the Hong Kong Monetary Authority (HKMA):
The introduction of virtual banks in Hong Kong is a key pillar supporting Hong Kong’s entry into the Smart Banking Era. The HKMA believes that the development of virtual banks will promote fintech and innovation in Hong Kong and offer a new kind of customer experience. In addition, virtual banks can help promote financial inclusion as they normally target the retail segment, including the small and medium-sized enterprises (SMEs).
In other words, virtual banks are supposed to bring in more innovations, provide better kinds of customer experiences, and serve underserved markets, in comparison to the stodgy and mature traditional banking world.
But innovative customer experiences can be copied, so the novel front-end banking experiences that bring new excitement to customers are more or less a level playing field between virtual and traditional banks. In contrast, serving the underserved markets will be a key differentiator. SME banking markets have been underserved for a reason, and this would not be something that traditional banks are able or willing to proactively resolve. In addition, virtual banks can add value to retail customers by providing more innovative and user-friendly wealth management services. Resolving these pain points and adding new value would unleash substantial new market potential for virtual banks.
Several Hong Kong virtual banks, including PAO Bank, Livi Bank and WeLab Bank, are working hard to find their respective niches and differentiate themselves from traditional banks as well as each other:
- PAO Bank has been actively marketing its core focus in SME banking services.
- ZA Bank is heeding the Government’s call to provide decent banking services to Web3 companies, in particular, to serve as the settlement bank for regulated Web3 entities in Hong Kong.
- WeLab Bank is providing goal-based, smart wealth management solutions to retail customers.
For example, if a virtual bank can successfully bring in significant SME deposits and borrowings, this will create a new closed-loop between SME deposits and revenue-generating SME lending:
Last but not least, Hong Kong’s regulator and its banking industry as a whole can remove the remaining hurdles to the development of virtual banks. The incumbents’ price discriminations against virtual banks in direct debit transactions (“pull transactions”) are well known, and many virtual banks are essentially shut out from the legacy salary payment system (called ECG), which is being phased out in slow motion. Removing these restrictions will help put the virtual banks on a more equal footing against the incumbents, and give the city’s consumers and businesses more banking choices and more innovative financial services.
With smart market positioning and strategies, strong commitment to the market and their customers, and a more welcoming competitive landscape, there is no reason why Hong Kong’s virtual banks cannot serve their original purposes and find their worthy (and profitable) place in the local banking market.
