Digital transformation is essential for Singapore's banking industry. S&P Global Ratings believes that embracing financial technology (fintech) and the innovations it heralds will improve Singapore banks' long-term competiveness. Fintech promises to improve the efficiency and effectiveness of financial transactions among large established institutions and start-ups alike, a process often relying on an increase in online access and smartphone penetration. Singapore is well-positioned as a fintech hub, given its infrastructure capabilities, extensive smartphone penetration, and supportive regulatory environment.

On the flip side, the big Singapore banks that began their digital journey several years ago have yet to demonstrate significant cost savings or income boost. These benefits will accrue mainly from branch and staffing reductions, which will likely need sizable investments in digital innovation or solutions and information technology infrastructure. The payoffs from fintech are not obvious, and the profitability and efficiency ratios of the Singapore banks we rate have remained flat.

In our opinion, fintech is a necessary investment for Singapore banks to defend their position. It may appear to be neutral in the short to medium term, but failing to adopt it is a negative as banks will lose customers and market share. Our ratings on Singapore banks are underpinned by these banks' strong business positions and dominant market shares. A bank's failure to adapt to new technology could erode its customer base, and ultimately its profitability, leading to rating pressure.

Fintech Is Essential For Survival

The current equilibrium of the financial industry in Singapore and globally could collapse if new service providers begin offering convenient services to customers via fintech, potentially threatening the profitability of existing financial institutions. Today, banks are no longer competing just with other banks or financial institutions. Fintech companies pose the biggest threat to banks, followed by non-financial services firms such as telecom companies and retailers, and then internet payment firms such as PayPal. Notably, the "Big Tech" firms have considerable size and resources at their disposal to rival, even dwarf, financial institutions (see chart 1).

Chart 1

Improving customer experience to maintain market share and retain existing customers ranks at the very top of the reasons for investing in fintech. This typically involves using digital channels to cut transaction times and artificial intelligence to enhance customer experience. Fintech could also improve banks' cost-to-income ratio, given digital customers' lower servicing costs, which make them theoretically more profitable than traditional customers. In practice, material cost savings are yet to emerge.

We believe the major Singapore domestic banks and large qualifying full banks are best positioned to thrive in the fintech era. They have two necessary advantages: The required resources to invest in technology and acquire start-ups; and a rich pool of customer data to harness the technology into a commercially viable product or app. Complacent or weaker banks that do not adapt to the changes may not survive.

The Banking Industry And Fintech Are A Good Match

Singapore has several advantages in moving toward a digital society. The country is small, highly connected, and has a regulator that is an early adopter of innovative technology. The Monetary Authority of Singapore (MAS) is keen to move the country toward more widespread adoption of cashless payments, and more generally to drive innovation in the financial system. For example, the government has been amending patent regulation to increase flexibility in the patent application process. In November 2018, it proposed a new regulatory sandbox (a testing environment) with fast-track approvals to enable financial institutions and fintech players that intend to conduct regulated activities to embark on experiments more quickly.

Within the Association of Southeast Asian Nations (ASEAN), Singapore stands out as having solid infrastructure and extensive smartphone penetration that favors digitization. Singapore's high average income is also much greater than that of its ASEAN neighbors, and makes a compelling case for payment and cashless service providers. In our opinion, MAS is progressive, and has thus far succeeded in achieving a fine balance between preserving financial stability and promoting innovation.

We note that China had taken a similar soft-touch approach in regulating the fintech industry in the past, but has become more stringent in the last two years. In China, innovations are driven by Big Tech rather than banks, and some of these tech-giant driven initiatives have grown large enough to pose systematic risk to the financial system. For example, Ant Financial's Yu'e Bao fund has become the biggest money market fund in the world, and could pose settlement, liquidity, and systematic risks to the financial system. This has prompted the regulator to tighten its oversight. We do not see MAS heading down this path at this juncture, given tech firms have yet to establish a local dominance in Singapore.

But The Fintech Journey Is Not A Bed Of Roses

Singapore's financial markets have characteristics unique to developed economies. While Singapore provides a conducive environment for fintech, it is a small country which lacks scale. Other larger ASEAN countries, such as Indonesia, offer major potential in terms of scale, but have business and legal obstacles to overcome.

Being technologically advanced does not guarantee high adoption rates. For example, cash payment rates in Singapore are very high for a developed market. Around 40% of payments are still made through cash and checks. Cash in circulation in Singapore is about 10% of the country's total gross domestic product, compared to about 2% in Sweden.

China, in contrast, has surged ahead in cashless payment. The country's mobile payments totalled Chinese renminbi 81 trillion as of Oct. 31, 2017, the world's largest volume. Mobile payment businesses have evolved out of the major social media and e-commerce companies, and are now a significant part of the financial system. It is an oligopolistic environment dominated by two leading players, Alipay and WeChat.

Singapore's e-payment ecosystem is not quite developed. Key segments in Singapore, such as hawker centers, food courts, and wet markets, are heavily cash-based. A number of different solutions are in the marketplace, with different merchants accepting different payment mechanisms. Unique mobile payments such as NETSPay, DBS PayLah, GrabPay, and Alipay, led to the need for multiple payment terminals and payment apps. This can be confusing for consumers, causing them to use cash. Difficulties in operating the various systems and the lack of uniformity are likely to present additional challenges to the widespread adoption of fintech by merchants.

To make a payment method prevail, it must be accepted by a large majority of merchants and service providers. Singapore's payment industry is a natural monopoly where one or a few service providers meet the demand with highest efficiency. Governments in other countries have solved this problem by creating a common platform, such as PromptPay in Thailand, a government e-payment initiative for moving the country to digital money.

The Promise Of Tomorrow

Despite investments in digital banking, we are yet to see signs of branch closures in Singapore. Expectations of cost efficiency are currently being driven by a shift from "traditional" to "digital" customers, not branch reduction per se. In Singapore, management guidance is toward branch restructuring rather than branch closure, such as having smaller branches with fewer counter staff and more self-service kiosks. In contrast, banks in Thailand have been consistently closing down branches as they build up their digital capabilities.

For activities other than digital payments, retail banks with physical bank branches continue to be the primary choice of provider for customers in Singapore, particularly for applying for personal and business loans, and seeking investment advice. Customer behavior in Singapore suggests that this is likely to continue.

We believe banks are maintaining branches to protect their deposit market share. Singapore has a ageing population with a sizable pool of customers that rely on branch banking. Although it is a diminishing pool, deposits from the older demographic are of the highly inelastic and sticky variety, which banks prefer. Maintaining deposit market share is crucial for banks to see the benefit of higher rates flow through to net interest margins. Also, cutting branches and headcount is often a very sensitive topic locally, and we believe rationalization will be incremental and protracted.

More Collaborative Than Disruptive

Fear mongers have proclaimed that technology will end banking as we know it and hailed it as the most important innovation since the Internet.

Banking in Singapore is alive and well. Banks are not being annihilated by tech start-ups. Far from it, they are joining hands with innovators to seek win-win outcomes.

From a bank's perspective, the advantages of fintech are straightforward: Large banking conglomerates are slow and held back by tradition and compliance to make an internal culture of innovation work. Tapping into an external talent pool of young minds is more efficient and much faster.

The tech companies benefit too. They have great ideas but don't always understand the heavily regulated banking sector or have the funding. Also, banks provide access to a huge anonymized customer data base--a very valuable commodity in the digital world. This enables tech companies to operationalize their ideas and technology for fintech applications, such as robo-advisers or credit platforms.

With the cooperative approach, banks can safeguard their future against digital disruption. Banks' fintech investments will ensure that current and future dominating technologies in banking remain under their control.