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BRANCH BANKING, RETAIL BANKING | Sandra Sendingan, Singapore
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How banks in Asia-Pacific can survive in an age of declining profitability

Cutting down branches and migrating banking services to online and mobile channels are key to keeping costs down.

There was no way it could have lasted forever. After enjoying double-digit annual revenue growth from 2010-2014, banks in Asia-Pacific are starting to witness tapering growth trends with annual revenue growth slowing to 5% in 2014-2018 and growth in profit pools easing to 3% over the same period, according to McKinsey’s annual banking review.

The average return on equity for Asia-Pacific fell from 12.4% in 2010 to 10.1% in 2018, signalling what some argue to be the end to the Asian miracle, although the region’s profitability still ranks above the global average of 9.5%. The negative trend can be observed across developed and emerging markets in the region with only lenders in Singapore, South Korea and Vietnam turning the tide and posting improved ROAEs in 2014-2018.

In an interview with Asian Banking & Finance, Joydeep Sengupta, senior partner, Singapore at McKinsey, highlights best practices for banks in the region to survive the fintech threat as well as the four growth areas that banks can embrace the shift of the narrative in their favour.

ABF: The good years of strong banking profitability may already be behind us. The conversation has been shifting towards cost efficiency and brand rationalization with Japanese banks after we shutting down branches and Chinese using ATMs less amidst the popularity of AliPay and WeChat. How do you see this playing out over the next 12 months?
If you look at return on equity, the pressure on return has come largely from two factors: one is the declining margins across most product categories virtually across all markets and the other factor has really been deteriorating risk environment, where the risk costs have systematically gone up across many markets. So even though we've seen a lot of effort made by banks in containing costs or getting more cost efficient, in aggregate, the cost efficiency gains have not been sufficient to overcome the declining margins and the risk increasing risk costs - the reason why we've seen this kind of decline.

At the same time, there are obviously four new opportunities for growth. If you looked at retail and SME business, these are businesses which are quite underpenetrated in many parts of Asia, simply because it had been very difficult to access in the past. Part of the reason is the lack of data - banks couldn’t underwrite as much. However, amidst the proliferation of the smartphone, plus other digital infrastructure being in place and data being available, I think these two segments are going to be massive growth areas, because the penetration level and the starting point across most markets are so low. If you look at retail lending in proportion of GDP, for example, it's in the early double digit in most of the Asian markets. Similarly, if you look at SME across markets, you can see that they are underserved especially in markets like China and India where around 70-90% are underserved. So, you do see massive opportunities in these two segments and the technology era is unlocking that opportunity.

Wealth, on the other hand, is a bit of a demographic trend. Across markets, there is a massive group of customers, in hundreds and millions, who are getting richer and moving away from the mass to the mass affluent, and then to the affluent segment. I would say this is probably the fastest growing opportunity from an asset accumulation and deposit gathering perspective. This is something which we see is unstoppable because it's not driven by any extraneous factor, but it is simply driven by demographics and wealth accumulation as economies developed.

Finally, transaction banking goes without saying that given the growth of trade - which represents the underlying growth in many of the Asian economies - we will see it being a big driver of that, and it will be linked to the opportunity in transaction banking, foreign exchange, trade, which will come through. That's the reason why we call out these four opportunities, because from a penetration point of view as well as from a natural growth perspective that these opportunities are well placed for people to capture in the next few years.

ABF: How do you propose that lenders in Singapore, and by extension Asia, keep margin pressure at a sustainable area against challenges from non-bank entrants and heightened risk environment?
Productivity will continue to be a big area of focus. So continuing to, as you rightly pointed out, cost efficiency. We haven't seen a lot of improvement in aggregate for the banks as a whole over the last four or five years. As margins come under pressure, there will have to be much more emphasis in driving productivity. The second is looking at new avenues for growth because higher margin growth will be quite important, even as margins and the existing businesses come under pressure. I think these are the two levers: growth and productivity, which I think will be a focus for banks over the next few years.

ABF: How have banks utilised technologies to streamline the process for assessing creditworthiness and loan approval?
One of the challenges historically in many of the markets in Asia had been the lack of availability of quality data for underwriting. However, developed countries like Japan, Korea, Singapore, but also developing economies like India and Indonesia have seen a massive amount of investment to enhance the quality of the infrastructure on the technology side. Whether it's 4G infrastructure, 5G infrastructure, the digitisation of the economies, enhancement of the credit bureaus, the ability to access a much better quality information is much higher as a consequence. What this implies is that people can use much more technology-based analytical processes for underwriting whether it be for credit scoring, behavioral scoring and looking at transaction and behavioural data. So using several of these factors, we think that the ability to assess credit worthiness and approving loans has become much will become much better, which is why we believe opportunities in retail lending or SME lending will go up quite significantly.

ABF: What's the regulatory situation like and how do they weigh in on earnings outlook for banks across the region?
By and large, across most Asian markets, regulators have been largely very progressive, meaning there is a lot of encouragement for innovation such as regulatory interfaces, open banking, changes in payment systems, and regulators creating regulatory sandboxes, Singapore is a good example that is allowing new innovative companies to come in. There's one dimension. At the same time, we are also seeing regulators beginning to worry about systemic risk and the world that some of these players are creating and the disruption they bring to the environment. They're worried about data privacy, they're worried about cyber security.

The regulatory environment will continue being progressive although we will see more debate around ensuring that institutions are allowed to provide the best deal for the customer while making sure that the system itself is stable, right? I think that that is the fine line, which many of the regulators are beginning to walk at this point.

ABF: FinTech and BigTechs have proven their merit in targeted areas like digital payments and lending but they have yet to fully capture the full-credit cycle. How do you see this landscape developing, especially when the conversation is shifting towards a need for both competition and cooperation?
What is certainly true is that these players have had a profound impact on the market and the consumers especially with the very strong analytical tools and capabilities, which they bring for underwriting. They use data much more intelligently and profusely in their lending models than many of the banks historically have done. As a consequence, they have driven digital lending into retail and the small business segment, but at the same time, putting a tremendous amount of pressure on margins, because their cost of acquisition is much, much lower than many of the traditional banking models.

If you look at where most of the tech players are like K bank, Kakao or WeBank, they usually target the lower end of the consumer segment, which has not been penetrated by the banks. In this case, they have a very natural advantage over these players since their reach has been quite high where they were able to amass hundreds of millions of customers and their cost of acquisition and conversion has been much lower than traditional banking models. They also have much more information and data about these customers, unlike the banks. So in a way, they do have a significant advantage in this segment relative to the banks for sure.

We certainly think that this is a terrific trend, and we think it will continue but at the same time, the quality of the loans needs to be tested through a down cycle. Unlike the traditional banking model, which has gone through many up and down cycles over decades, I think this is a relatively new phenomenon that hasn't been tested in an economic down cycle. We're not saying that they won't hold true or they won't be solid but to confidently declare victory of this, it needs to have been tested through a down cycle.

ABF: You mentioned partnerships are inevitable in an increasingly connected ecosystem. How do you think players will be able to manage interactions with fintechs that try to pose a direct threat to their operations? For instance, reports say that Grab is considering a virtual banking license in Singapore even though it already has existing payment partnerships with big banks. How do you see these types of interactions developing?
While I won't comment on Grab, per se, I think we will certainly see some element of coexistence between the two because what you will find, as people get into the virtual bank licenses, some of these existing partnerships might either morph or they will dissolve. That's one scenario, which we could see. From a banking point of view, the banks’ ability to claim a segment will depend on the partnerships that it has with the FinTechs or the BigTechs, or other ecosystem players with whom it can access customers, and information at a much lower cost.

An alternative scenario we could see is people playing in different segments so you could imagine a scenario where there is a partnership operating for a different customer segment - let's say mass affluent - and an aspect in the partnership targeting the mass market which could actually be done through the virtual bank. We could see any of these scenarios play out but it's hard to predict because it will obviously depend on the strength of the incumbent in that domestic market, the platform player wants to leverage and the regulatory environment that sets what will be allowed to do versus not to. So in many of these markets, I think it's still a little bit unclear as to what the regulatory, you know, parameters are going to be and that will, in many ways, define the kind of approach that these players will take to partnerships.

ABF: What will be the role of branches in the age of digital banking?
If you go back historically, the role of the branches, to a large extent had been threefold. One is really acquiring customers, a second is enabling and helping the transactions that customers do and a third is offering advice and cross selling other products.

What’s happening with the whole digital plays is that a large part of the transaction business is disappearing. In fact, most banks are seeing a sharp drop in transaction volume happening at their branches so many banks are trying to find a way of moving the transactions out to a call center, to digital channels or even to the ATM. For many banks, today, 95-98% of transactions are done outside of the branches.

What it implies is that in the less mature markets, the roles of branches for customer acquisition remains even as the digital channel proves to be a good channel for acquiring. In more mature markets, banks are also reorienting branches to focus on customer acquisition since there aren't that many new customers to acquire but are shifting towards advisory. This means that the look and role of the branch is shifting from an acquisition and a transaction point to advisory point.

You're beginning to see that the role of the branches change, which is why the configuration change and the kind of people that need those branches also change. That's the dynamic which we will see happen, as opposed to just a blind a shot at cutting the branches. The rationalisation of the physical network as part of banks’ cost initiatives - whether it's the branch network, or the ATM network - I think those will continue as well as the continued rise of the adoption rate on the digital side.

ABF: The report is arguing for consolidation as a way to ensure growth although it identified the mature markets of Hong Kong, Singapore and Australia as less prone to consolidation. It also hailed upskilling as a method to future-proof the workforce against digital threats. Can you elaborate more on this report finding?
These three countries are also fairly mature markets. In Singapore, there are really three major banks and a couple of large other banks. If you sit back and say, ‘Is there room for more consolidation?’ The answer will be probably, but is it obvious and less so.

On the other hand, if you look at some of the markets like China, India, Indonesia and the Philippines, they are far more fragmented markets. Given the pressure on economics, we feel that many of the smaller players are unlikely to be able to withstand the pressure and economics and unable to make the necessary investments, which is why we feel that many of these markets are more ripe for consolidation than the others.

Certainly, upscaling and rescaling of the workforce is going to be quite important largely because the workforce of tomorrow is going to be quite different from the workforce today, in terms of the skills required. A lot of the work type will shift to advisory work as opposed to transaction related work because a lot of the transaction related work will largely get automated. So there is a big agenda for rescaling and upscaling either through collaborative mechanisms within the industry, cross industry or even within the institutions, there is a real imperative for institutions to train their workforce to meet the challenges of the times.

Clearly, there are two big imperatives. As we step back and look at this environment, one imperative is really to look at consolidation as a way to grow. One of the big growth factors for many of the banks is organic in the new areas we talked about, but it's also through acquiring portfolios and acquiring other weaker institutions.

The other is to have the right to be the bank that is making the acquisitions by modernising and reinvent yourself for productivity. So whether it's around your reorienting your technology, architecture, investing in data and analytics, or really thinking about investing in this rescaling and upscaling your workforce, I think that's going to be an equally important parallel initiatives and both of these will have to kind of go hand in hand as banks begin to make this transition over the next few years.

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