Change is coming to Australian banking. S&P Global Ratings believes the country's banking sector is poised for substantial upheaval on the back of fintech developments--both in the products banks offer and the way in which they deliver those products.

The ability of banks to take advantage of financial technology may ultimately affect their competitive dynamics--one of the key considerations in our assessment of credit quality.

In our view, technological developments can give banks the ability to more meaningful differentiate themselves and offer customers improved ways to navigate a complex financial landscape. We expect customers will benefit from increasingly personalized product offerings, as growing availability of data allows banks to see customer financial profiles across multiple institutions and industries, leading to cross industry partnerships and investments.

Over time, customers will come to expect more than just a basic home-loan product or savings account. They will expect their bank to understand their entire financial profile and offer a customized product, much like Netflix and Spotify tailor their product offerings. If today's banks can rise to this challenge, they have an opportunity to offer value beyond a competitive price for a mortgage loan. Equally, those that do not commit to digital transformation risk falling behind.

Economies of scale have traditionally been the crux of competition in Australia's banking industry, but the pursuit of increased efficiencies using technology may come to dominate. Regardless of how different parties achieve such efficiencies, we believe those that want to compete will have to adopt lean operating structures that use technology to minimize operating costs.

Inherent operational risks could increase, but fintech may also play role in risk reduction

In our view, change on this scale comes with inherent risks, from the operational challenges of moving to new core banking systems, to the responsible management of newly available customer data. Nevertheless, we believe there is also scope for significant risk reduction, through initiatives such as real-time payments processing and regulatory technology (Regtech) such as artificial intelligence-driven fraud monitoring.

The application of fintech is wide, but within Australia we believe there will be three key drivers that will help shape the future of banking in Australia (see chart 1).

Chart 1

Open Banking And Data Driven Analysis

We believe there are two key ways in which open banking will affect banking in Australia. First, improved data availability will increase the level of competition in the sector and result in product offerings tailored to a customer's specific needs. Second, banks will have to upgrade their data management infrastructure so they can provide financial data to third parties on request.

We believe data management capabilities will be a key point of differentiation. Open banking gives banks the ability to see their customers' entire financial profile across multiple financial institutions and industries. We believe access to comprehensive financial data will allow banks to more accurately price for risk and create tailored product offerings. Broader applicability of open banking may also bring other industries and sectors into play and create opportunities for cross industry partnerships and investments (see note 1). In this regard we believe that open banking is more ambitious in Australia than the rest of world, with the introduction not only in banking but also other sectors, including telecommunications and energy.

First movers that can effectively glean insights from this newly available data will have a distinct competitive advantage. Those that cannot will have to build the capability or risk being left with obsolete products and a declining market share.

We also see potential for big tech companies to become increasingly important players in the Australian banking industry through partnerships and collaboration. For example, we believe that the "pays" (apple pay, google pay, etc.) are an avenue through which they could take on increasing ownership of bank customers. However, we believe that the highly regulatory nature of the banking industry will continue to act as a deterrent for them to participate as direct competitors.

We expect the complex nature of the major banks' operations will make it harder, and more costly, for them to build the database management capabilities required to comply with open banking regulations. As a result, we believe the major banks face greater operational challenges in meeting open banking deadlines than some of their smaller counterparts.

We are also of the view that open banking will address some of the conduct and compliance issues that emerged from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (the Royal Commission) , especially as far as responsible lending is concerned. We expect open banking will add supplemental information to estimates or standardized benchmarks, such as Household Expenditure Measure (HEM), by allowing banks to obtain the actual income and expenses data from new customers' existing banks, facilitating more accurate serviceability assessments, although we note that this is still work in progress.

We believe smaller, tech-oriented lenders dubbed neobanks have the most to gain from open banking, as legacy systems or extensive branch networks do not weigh them down. Their lack of existing infrastructure--they operate digitally, usually from an app--and generally younger target customer base allows them to focus on using data to develop innovative product offerings. While the major banks have more resources to invest in data analysis, they stand to lose the competitive advantage historically afforded by their proprietary customer databases and extensive branch networks. Their reliance on legacy banking systems may also be an impediment in making the necessary changes.

Table 1

Mutual banks are less tech savvy. Outdated core banking systems may leave them with an uphill battle, as their small scale makes it difficult to invest in expensive data management infrastructure while also catering to the needs of their existing customer base--who are generally from an older demographic that values a physical banking presence. Mutuals that have kept pace with technological developments (mainly through their core banking vendors) are better placed and may use their position to attract a younger demographic to reposition themselves.

Digital Banking And Cloud-Based Infrastructure

The Australian banking sector's digital transformation is taking place on two fronts:

• Digital banking: in which banks provide their products and services through online platforms rather than physical branches, and
• Cloud-based banking infrastructure: banks are migrating their backend processes to the cloud, removing the need to maintain their own physical IT infrastructure.

We believe these two processes will complement each other, driving banks' operating costs down and accelerating the pace at which they can implement change.

Goodbye bricks and mortar?

We expect banks' digital transformation will continue to drive a reduction in both the size and number of physical branches. In our view, banks with large physical branch infrastructures, such as the major and regional banks, will stand to benefit the most. The branches that remain will focus on sales and advice, rather than carrying out transactional banking services; allowing banks to lower their front-line headcount and channel savings toward online customer platforms.

Of the major and regional banks, we believe Bendigo and Adelaide Bank Ltd. (BBB+/Stable/A-2) and Bank of Queensland (BBB+/Stable/A-2) have the greatest scope to realize operating efficiencies through branch consolidations as their loan balance per branch is materially lower than peers (see chart 2), notwithstanding that their cost-to-income ratio is in line with that of larger peers. We see origination through digital channels, and greater utilization of existing branches, as essential to realizing operating efficiencies through branch reductions without negatively impacting origination volumes.

Chart 2

Cloud migration favors smaller players

Cloud-based technology infrastructure--which organizations such as Amazon Web Services (AWS) and Microsoft Azure provide--presents an opportunity for banks to reduce their infrastructure costs substantially by moving to an "infrastructure as a service" operating model. Instead of owning the expensive servers needed to host core-banking systems, we expect many banks will choose to host their back-end systems on cloud-providers' global network of data systems.

Banks with substantial legacy systems, in particular custom core banking platforms, will likely find the move to the cloud difficult. They will need to modify their systems or build new cloud-compatible systems from the ground up. In contrast, many of Australia's smaller financial institutions use off-the-shelf core banking systems from providers such as Ultradata and Temenos, who have partnerships with Microsoft Azure and AWS, respectively, to provide cloud-based core banking solutions.

We have seen a resurgence in online banking recently with the approval of banking licenses for online banks such as Volt (full banking license), Judo Bank (full banking license) and Xinja (restricted license), as well as existing banks entering the online banking space (UBank, NAB; Up, in collaboration with Bendigo; and 86400, Cuscal). Most of these banks make use of a cloud-based infrastructure, working on a "platform as a service" operating model that allows them to operate at significantly lower costs and achieve economies of scale sooner while simultaneously allowing them to continue to evolve their product offering and its stability through multiple, real-time updates to apps on a daily basis. We also note that some of the smaller mutual banks may be looking at establishing their own online banking platforms.

Chart 3

We expect Banks' operating margins to remain unchanged in the short term. Given the significant technology investments required to keep up with the rapid pace of development, we expect Australia's banks will feed much of the savings generated through increased efficiency back into technology investment, keeping their cost-to-income ratios close to current levels in the short to medium term. Over the long term, we expect technology-driven cost savings will help to instigate a structural reduction in banks' cost base.

On the regulatory front, we view the Australian Prudential Regulation Authority (APRA) as cautiously supportive of cloud-based computing services. The regulator acknowledges the benefits of such services but has cautioned banks that it will not tolerate compromise in risk management practices in the pursuit of technology enabled cost savings. The regulator has also emphasized that banks that transition to the cloud must maintain adequate business continuity plans, such that they can continue to operate independently of their cloud service provider, should that be required.

RegTech To Bolster Risk Management Practices

For banking systems worldwide, including Australia, the pace, complexity, and volume of regulations is higher than ever and regulation technology (RegTech) creates opportunities to address related challenges. We believe RegTech initiatives will not only help banks manage compliance costs, but also improve the quality of their risk management practices.

Recently, the Royal Commission highlighted that banks had downplayed their nonfinancial risk exposure to the detriment of bank customers. These nonfinancial risks manifested as regulatory, compliance, and conduct risks. Moreover, the Commonwealth Bank of Australia (CBA), the country's largest lender, was fined A$700 million by regulatory agency AUSTRAC for failing to effectively monitor illegal deposit-taking activities. Although still small in an international context, the fine was a record for an Australia-based company.

Thus, banks in Australia are also becoming increasingly aware that penalties and fines are not only the only risk they face; reputational risks can hurt their long-term franchise strength.

Against this backdrop, we expect Australian banks to ramp up spending in regulation and compliance risk mitigation over the next few years, thus fueling the country's growing RegTech startup sector. We also note that Australia has the highest number of RegTech startup companies in the Asia-Pacific region and the joint third-highest globally (according to Boston Consulting Group).

The use of RegTech startups should help banks improve and lift industry standards in how they manage regulatory, compliance, and conduct risks as data driven analysis provides greater insights and consistency in analysis. At the same time, RegTech will improve the efficiency of managing these risks, which will ultimately result in significant cost savings for banks. RegTech will also help banks to leverage off each other's insights and learnings, creating synergies that will be beneficial to the industry and help set best practice standards.

Examples of where we may find RegTech include: data analytics and artificial intelligence, which could play a big role to combat money laundering and detect illegal activity; robotics and process automation, which could help transform regulation and legislation into business practices; and blockchain technology, which could enhance the quality of information accompanying interbank swift messages.

Notes

1. For example, a household may pay a certain amount for electricity. In an open banking regime that has broad applicability, financial institutions could look at offers from other energy providers and notify clients of potential savings if they switched providers.

Related Research

• The Future Of Banking: Asia-Pacific Opens Up To Open Banking, April 11, 2019
• Hong Kong's First Virtual Bank Licenses Will Rejuvenate The Banking Sector, March 28, 2019
• Singapore Banks Must Adapt To Fintech Or Lose Out, Feb. 20, 2019
• The Future Of Banking: New Rules Foster FinTech At Chile's Banking Industry, Feb. 13, 2019
• The Future Of Banking: The Growth Of Technology And Its Impact On The U.S. Banking Sector, Feb. 13, 2019
• The Future Of Banking: Is Orange Changing The Color Of Banking In France? Dec. 11, 2017
• The Future Of Banking: Is PSD2 Yet Another Threat To Revenues In Europe? May 16, 2017
• The Future Of Banking: How FinTech Could Disrupt Bank Ratings, Dec. 15, 2015