Background

March 27, the Hong Kong Monetary Authority (HKMA) has granted three virtual bank licenses and is processing five more. JD Digits is among the first batch receiving the permit. The Chinese internet giant such as Alibaba, Tencent, and Xiaomi all applied but failed to be included in the first batch.

According to the regulatory requirement, virtual banks to be at least 50 percent owned by a well-established bank or other financial institution. Thus, JD Digits partnered with Bank of China Hong Kong (BOC HK) and Jardines, a British but Hong Kong-headquartered conglomerate with dual listings on London and Singapore. The joint venture is called Livi VB limited. In this joint venture, BOC HK will contribute traditional banking experiences, JDD will provide advanced fintech technologies, and Jardine will provide large existing customer bases.

The other two companies received permits are SC Digital Solutions, a joint venture between Standard Chartered’s Hong Kong, HKT, and Ctrip Financial; and ZhongAn Virtual Finance, a company set up by ZhongAn Online and Sinolink Group.

The ownership structure of Livi VB limited:

Although the virtual bank is not a completely new concept, EqualOcean believes it will bring new opportunities to the Hong Kong banking industry and challenges to the traditional banks. If JDD has done well in Hong Kong then soon it could possibly transfer the success models back to China and elsewhere such as the Greater Bay Area (GBA) and Belt and Road countries.

In the domestic market, there are two large internet banks - WeBank are backed by Tencent and Alibaba. The chance for JDD to surpass them is little; however, in Hongkong, there might be opportunities left for it to take the first mover advantage.

EqualOcean also believes by the initiative to develop virtual banks will bring Hong Kong into a new era of smart banking and also bring JDD into the next level.

Virtual bank 

Definition

The virtual bank is similar to the direct bank.  Other than no physical branches, virtual banks basically offer similar services as traditional banks do such as taking deposits and approving loans.

Players

In the narrow sense, virtual banks refer to those banks approved by HKMA. 

In the broad definition, the first virtual bank pioneer is ING Direct established in Canada in 1997. It expanded rapidly in the western countries; however, its business was seriously hit in the 2008 financial crisis. In 2011, ING Direct USA has been sold to Capital One for USD 9 billion. In 2012, ING Direct Canda has been acquired by Scotiabank for CAD 3.1 billion. 

The acquire price paid is high which might mean that traditional banks see the opportunities from operating virtual banks.

First batch virtual bank players 

Other than JDD, there are other two joint ventures who also received permits.

- SC Digital Solutions 

Standard Chartered represents traditional banks. It started the business in Hong Kong back in 1859 and is one of the three commercial banks licensed by the Hong Kong Monetary Authority to issue banknotes. Wai Yi Huen (Mary Huen, 禤惠仪), the head of retail clients for greater China region at Standard Chartered, said that the barriers for opening accounts and having services will be lower, retail customers and SMEs will be the main targets, innovation is highly encouraged; however, a price war will not happen, reported by Epoch Times, a Hong Kong-based media. For now, its virtual bank team has around 100 staff and still recruiting. 

PCCW is a Hong Kong-based information and communications technology company, known for being the majority owner of telecommunications company HKT Limited. 

Hong Kong Telecom (HKT) is one of the largest telecommunications company in Hong Kong. The Club, the subsidiary of  HKT has around 2.7 million users.  HUI Hon Hing (Susanna HUI, 许汉卿), executive director and group managing director, said HKT will touch fintech for sure in the future and she hopes that virtual banks can bring more customers and revenues to HKT.

Ctrip Financial is the finance arm of Ctrip. FENG Yan (冯雁), the vice president of Ctrip Financial, claimed that it has served more than 10 million customers in mainland China. Its financial services rely on different traveling scenarios. She hopes virtual banks and the traveling could come up with synergies and benefit the Ctrip Group as a whole.

Overall, in this combination, Standard Chartered will provide its sophisticated banking experiences, and the other three will provide customers and a variety of applications scenarios.

- ZhongAn Virtual Finance 

ZhongAn Online is a China-based online-only insurance company, while Sinolink Group is a Hong Kong-listed property developer. They claim that virtual bank services will be launched in six to nine months and the user's engagement is highly encouraged. Their virtual bank website is currently on, registered users will be the seed users who might later get involved in the product design and develop processes.

Coming players
HKMA says more than 5 companies are under review. Alibaba, Tencent and Xiaomi are likely to be included in the next batch.
Similar players

In Mainland China, there are so-called internet banks which have a similar concept - running online and eliminating physical branches. Two famous examples are  MyBank (网商银行) and WeBank (微众银行), backed by Alibaba and Tencent respectively.

Who will it affect

In this part will be divided into two parts - who will be positively affected and who will be negatively affected.

Who will benefit from the virtual bank:
EqualOcean believes SME (small and medium-sized enterprises) and retail customers will benefit from the innovations provided by virtual banks. This time, virtual banks will also be focusing on providing retail bank services.

-SMEs

Underserved SMEs will benefit from cheaper and easier credits. According to Bibby Financial, a financial service provider, 43 percent of Hong Kong companies user retained earnings or their own money to grow. It means  SMEs rely heavily on personal savings.

On the other side, banks in Hong Kong are also conservative in lending to SMEs, especially after the Asian Financial Crisis and the 2008 Financial Crisis. Before granting loans, banks normally would require collaterals and extensive disclosures of the business operation details. Some small businesses' inadequate collaterals and lack of track record of their business performances hinder banks lending to them. In addition, getting bank loans can be a long and complicated process for many SMEs which will reduce their incentives to borrow from banks and have a bigger plan to grow their businesses. However, inadequate funding will limit SMEs' operation and expansion.

- Retail customers 
Virtual banks can make banking easier and more convenient for retailers. Since virtual banks will not own physical branches, it is likely for virtual banks to offer more competitive products; for example, providing deposit products with higher interest rates while lower rates charged for lending products. In addition, virtual banks will be more tech and data-driven than their traditional counterparts. With the advanced technology, borrowers' credits can be better assessed in more dimensions and hopefully in real time. Thus, with more data and clues, virtual banks are possible to tailor products aligning with customers' needs and risks. 

Who virtual bank will challenge: 
EqualOcean believes that traditional banks will be negatively affected by virtual banks' cheaper but better product offerings. 

Global Financial Centres Index (GFCI) ranks Hong Kong at the third most powerful centers; however, 2018 IFZ Global FinTech Rankings placed Hong Kong at the tenth place after Singapore (No.1), London (No.4) and New York (No.8). This means innovations in Hong Kong is insufficient compared to its standings.

Moreover, the traditional banking industry has dominated by traditional banks for years. Those traditional banks tend to lend to large institutions rather than small ones. While the growth of small business is critical to the dynamics and stability of Hong Kong society. Thus, 

Nevertheless, consumers in Hong Kong tend to be more conservative about new technology. This takes some time for virtual banks fully get accepted. 

The banking industry in Hong Kong

Market size

Although Hong Kong only has a population of around 7 million, it is one of the most important financial service hubs in the world. In addition, Hong Kong accounted for 31 percent of HSBC's global revenue and 25 percent of StanChart's operating income, says Bloomberg.

Phone banking users

According to a survey conducted by Accenture that 63 of Hong Kong respondents treat phones as the main tool to do daily bankings such as accessing banking information and transferring money. If the sample is well selected, the conclusion that more than half of Hong Kong residents are using phones to do banking and have open and positive attitudes towards virtual banking can be drawn.

Banks 

The Hong Kong retail banking sector is dominated by traditional banks such as HSBC (including its subsidiary Hang Seng Bank), BOC HK, Standard Chartered Bank. Market shares for retail banking as follow:

Goldman Analysts says the retail banking sector is twice as profitable as the corporate business. China's state-own banks are eyeing Hong Kong, and now so are Chinese fintech companies.

Advice for JDD

Take the first mover advantage 

Among first batch banks receiving the permit, JDD should better utilize the first mover advantage. BOC HK's Chinese entity is one of the largest and the most well-established bank in the nation; therefore its past successful banking experience is shared to JDD. For Jardine, a low profile conglomerate, its large business coverages and customer bases will help the expansion and user acquisition of JDD's virtual bank. 

Banking experience + Fintech + Customer = Good synergies 

Following the rules and regulations 

Hong Kong market is more regulated and costs of breach the rules will be financially costly and will cause damage to companies' reputation. 

Focus on innovations, not the price war

It is not surprising to see virtual banks would start with high saving rates and lower lending rates products to attract customers and start their businesses. However, the long-term price war may not be sustainable. 

Technological innovation is one thing, business model innovation is another. For the business model innovation, cross-selling can be one. And it seems will works for JDD since its Chinese business unit offers a great variety of financial products such as saving, lending, and insurance offerings. In addition, JD.com is the second e-commerce platform after Taobao/Tmall, the virtual banks might later be treated as a traffic pool for its e-commerce unit.

Make business-led innovations 

Hong Kong Banking Outlook 2018 states that business-led changes tend to more successful than the technology-led ones. It means it is critical to sort out the questions that banks are facing first instead of randomly applying advanced technologies will provide limited and sometimes negative effects on the business. In this scenario, it is good to see JDD and other fintech companies are using new and advanced technologies such as big data and AI, but more important, they need to solve problems faced by retail customers and SMEs.

Hong Kong and beyond

First of all, Hong Kong is the world's key financial hub and also an important launch pad for Chinese companies

Hong Kong plays a key role as a financing, risk management, and professional services hub in the Belt and Road Initiative. Thus, Hong Kong will be an important gateway to target 65 belt and road countries.

Investment Risks 

Regulation 

The virtual bank is new and it is in Hong Kong where the banking industry is matured and under careful examination. The chances for virtual banks to successfully take "regulatory arbitrage" or advantages of loopholes will be low. Tighter regulation will also hinder innovations.

Also, tighter control will add up the compliance costs.

Uncertainties on future earnings potentials

The first thing is about winning customers and the second is about retaining customers on a reasonable profit margin. Lowering the profit margin temporarily to attract new users will work; however, the consistent low margin will lead to low or even negative profits.

Moreover, virtual banks will focus on retail banking where the user acquisition costs are high. The shifting costs from one virtual bank to another are also likely to drop, thus remaining customers will be more costly.

Security Concerns

According to HKMA, cyber attacks on the bank doubled in 2018. In 2018, there are 142 cases concerning online scams such as false banking websites, phishing emails, and fake banking apps. The figures for that were 44 in 2017 and 35 in 2016.

Thus, banks must set up risk management to combat cybercrime and protect customer customers' interests. 

Money laundering

According to Bloomberg, Hong Kong financial institutions are still struggling with developing and enforcing AML (anti-money laundering) policies and regulations. The number of suspect transactions was 92,115 in 2017, rising from 76,590 in 2016 and 42,555 in 2015, reported by the Joint Financial Intelligence Unit, an agency run by the police and customs departments.