Virtual banks: Opportunities and challenges

A virtual bank is a bank which predominantly delivers retail banking services through the internet or other forms of electronic channels instead of physical branches. This covers all online transactions whether it be via the web, email, mobile check deposit and ATM machines. This is different from the ubiquitous internet-based option offered by regular banks through online banking.

The rationale for the development of virtual banks is two-fold:  

• Utilise the application of financial technology and innovation to offer a new kind of customer experience.
• Promote financial inclusion by targeting the retail segment, particularly low-income customers and small size enterprises.

The exponential growth in financial technology has posed challenges to the traditional banking model by innovative methods of financial transactions. Financial inclusion is a concept which has been aggressively promoted, for instance, by India’s Prime Minister Modi. It is estimated that nearly 75 million of the population not only do not have bank accounts but are in fact unable to open accounts because of stringent on-boarding requirements. Laudable as it may, the Indian experiment has encountered difficulties due to the reluctance of banks and regulated financial institutions to relax mandatory requirements governing the opening of accounts. 

Hong Kong has now taken the lead to promote ‘virtual banks’ to achieve the two-fold goals referred to above. The Hong Kong Monetary Authority (HKMA), after a round of consultations, enacted new rules earlier this year and already over 30 companies, including Standard Chartered, have either lodged or will lodge applications for licences. 

In Hong Kong, the financial services market has a fairly representative presence of traditional service providers but virtual banks will be expected to offer faster and cheaper services and higher interest rates than traditional banks. As virtual banks will not be having the overheads of physical branches, customers will expect a virtual bank to offer higher interest rates on their accounts. However, virtual banks are not expected to impose any minimum account balance requirement or low-balance fees on their customers. 

A virtual bank applicant, if authorised, must maintain a physical presence in Hong Kong, which will be its principal (and only) place of business. This is necessary to provide an office in Hong Kong for interfacing with the Regulator, as well as with customers to deal with their enquiries or complaints.

Applicants to set up a virtual bank must establish that the project has ‘substance’ and not merely a ‘concept’, taking advantage of the growing popularity of new technology.

In Hong Kong, both existing banks as well as nonfinancial firms (including technology companies) may apply to own and operate a virtual bank in Hong Kong. Ownership requirements of virtual banks assume importance because they are new ventures which can be subject to higher risks in the initial years of operation. It is essential that the parent companies of a virtual bank are committed to supporting the bank and are capable of providing strong financial, technology and other support. Virtual banks must maintain adequate capital commensurate with the nature of their operations and the banking risks they are undertaking. Currently the capital requirement is estimated at US $ 38 million. 

Virtual banks will be subject to the same set of supervisory requirements applicable to conventional banks but some of the requirements will be adapted to suit the business models of virtual banks under a risk-based and technology-neutral approach. Hence, the board of directors and senior management of virtual banks should have the requisite IT knowledge and experience to enable them to discharge their functions effectively. 

Even though Virtual banks will be required to satisfy the same corporate governance standards as conventional banks, given their technology-driven business the board of directors and senior management of virtual banks should have the requisite knowledge and experience to enable them to discharge their functions effectively.

Technology related risk, especially information security, system resilience and business continuity management, is of vital importance to a virtual bank. The security and technology related controls in place should be “fit for purpose”, i.e. appropriate to the type of transactions which the virtual bank intends to carry out. Independent assessment of the actual design, implementation and effectiveness of its computer hardware, systems, security, procedures and controls have to be undertaken to the satisfaction of HKMA.

Applicants must demonstrate that they have designed appropriate controls to manage at least eight basic types of risk, namely credit, interest rate, market, liquidity, operational, reputation, legal and strategic risk. The submission of a credible and viable business plan which strikes an appropriate balance between the desire to build market share and the need to earn a reasonable return on assets and equity is another requirement. 

HKMA has assured that while it will not interfere with the commercial decisions of individual institutions, it would be a concern if a virtual bank planned to aggressively build market share at the expense of recording substantial losses in the initial years of operation without any credible plan for profitability in the medium term. This is for the reason that predatory tactics could be detrimental to the stability of the banking sector and could undermine the confidence of the general public in the bank itself. In any case, a virtual bank should not allow rapid business expansion to put undue strains on its systems and risk management capability. As virtual banking is a new business model in Hong Kong, HKMA will require a virtual bank applicant to provide an exit plan in case its business model turns out to be unsuccessful. The purpose of the exit plan is to ensure that a virtual bank, should it become necessary, can unwind its business operations, in an orderly manner without causing disruption to the customers and the financial system. In general, an exit plan should cover matters including 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.

Customer protection is an important aspect and rules in Hong Kong specify that a virtual bank should treat its customers fairly and adhere to, inter alia, the Treat Customers Fairly Charter. Customers must be made aware of their responsibilities to maintain security in the use of virtual banking services and their potential liability if they do not. 

In particular, the terms and conditions should highlight how any losses from security breaches, systems failure or human error will be apportioned between the bank and its customers. In this regard, HKMA’s view is that unless a customer acts fraudulently or with gross negligence such as failing to properly safeguard his or her device(s) or secret code(s) for accessing the e-banking service, he or she should not be responsible for any direct loss suffered by the customer as a result of unauthorised transactions conducted through the account.

Outsourcing is permitted so long as the operations outsourced remain subject to adequate security controls, that confidentiality and integrity of customer information will not be compromised and that the requirements under the Personal Data (Privacy) Ordinance and common law customer confidentiality are complied with. 

Virtual banks will be able to save millions of dollars by not having to pay rent and salaries for the staff at every branch. Customers would be spared of the need to wait to be served. On the other hand, customers who prefer face-to-face interaction with a relationship manager may find that this model is unsuitable for their particular needs. Anti-money laundering requirements will apply to virtual banks but start-up ventures and small enterprises will not find the documentation too cumbersome as with traditional banks.  

The first set of applications are currently being vetted and as operations begin early next year, Hong Kong’s initiative is worthy of close study and hopefully might blaze a new trail to be followed by other countries.   

(Dr. Dayanath Jayasuriya, PC, is Chairman, Orient Finance PLC; former Director-General and Chairman, Securities and Exchange Commission and Insurance Board of Sri Lanka; Chairman, IOSCO Global Presidents’ Committee in 2005; and former Member, Public Utilities Commission and the National Procurement Agency.)

(This article is a synopsis of a presentation by Dr. Dayanath Jayasuriya, PC, recently at the Corporate Lawyers’ Conference.)