Philippine digital banks may redefine the industry. Youthful demographics, a large untapped market, low costs, and regulatory latitude will all help the early entrants. And S&P Global Ratings believes the incumbent banks may have to make aggressive moves to hold off online rivals.

Digital banks will likely need three to five years to become profitable, as they scale up in markets largely ignored by the big lenders. Incumbent banks will step up their digital efforts, particularly as the COVID-19 outbreak has increased the popularity of electronic transactions.

The large banks we rate should retain their market share over the next three to five years supported by their strong brand recognition and longstanding customer relationships. We anticipate no ratings effect for the incumbent banks for the next two years at least.

This contrasts with developed markets such as Australia, Hong Kong, Singapore, and Malaysia where incumbents compete fiercely for digital share, and the underserved market is small.

Counting On All Digits

The first entities to get digital banking licenses in the Philippines are likely those that primarily cater to retail customers and micro, small, and midsize enterprises (MSMEs). The incumbent banks have largely ignored these segments given the high risk of serving low-income borrowers with little credit record, and the high cost of building a branch network through the vast sprawl of rural Philippines.

The traditional banking sector primarily lends to large conglomerates and the mass affluent, leaving the market for small-ticket, unsecured lending open to digital entrants. We expect traditional and digital banks to coexist, serving different segments of the economy.

As of June 30, 2020, large corporate loans comprised about three-quarters of Philippine banks' loan books. Loans to MSMEs were derisory--just 7% of lending. Retail borrowers took 18% of total loans, but almost all the lending went to a small slice of affluent clients.

The banking sector's lending to MSMEs has fallen to 7% of total loans from 16% over the past 10 years, and falls short of the central bank's minimum requirement of 10%.

Philippine regulators want banks to bring their services to more people, and digital banking may be the answer. The central bank, Bangko Sentral Ng Pilipinas (BSP), recently issued draft guidelines on the establishment of digital banks, opening the doors for such entities.

This follows similar announcements by Singapore and Malaysia earlier this year that their respective central banks will each issue up to five digital bank licenses each.

About two-thirds of Filipinos aged 15 years old and above do not have a bank account, according to a 2017 World Bank report (see chart 1).

Chart 1

The central bank spelled out its virtual banking push in its Digital Payments Transformation Roadmap 2020-2023. The BSP also created the National Payment Retail System framework in 2015 to make electronic fund transfers affordable, secure, and convenient. The institution launched PESONet in 2017, and InstaPay in 2018, for high- and small-value electronic transfers, respectively.

BSP has mandated payment service providers to adopt a national QR Code payment standard. The central bank aims to make at least half of all payments electronic by 2023, with 70% of adult Filipinos holding an account to do electronic transactions by that time. Digital payments comprised one-fifth of all payments in the Philippines, by value, in 2018, up from 1% in 2013. [1]

The Young And The Bankless

Demographics favor the digital players. The country is young and receptive to technology. About four-fifths of the Philippine population is between 15 and 50 years old. Just over half of the adult population (aged 15 years and above) owns a smartphone and has internet access, according to a 2019 report from the BSP.

COVID-19 and social distancing measures have accelerated adoption of digital payments. As such, the value of transactions has risen 100% for PESONet with a 125% increase in volume, while the value of InstaPay transactions has increased 200% and volume 275% (see chart 2). This trend is also apparent in higher traffic for banks' digital channels.

For example, Bank of the Philippine Islands' monthly new customer sign-ups for mobile and internet banking have more than doubled from pre-COVID levels. These trends have spurred large banks to scale down their network expansion plans for larger cities, and shift focus to digital offerings.

Chart 2

The highly underpenetrated retail and small-business markets, characterized by large unbanked segments and low leverage, offer ample growth opportunities. To capitalize on this, CIMB Bank Bhd. and ING Bank N.V. have gone purely digital in the Philippines in the past two years, though their combined market share is marginal.

Digital banks have cost advantages over their bricks-and-mortar counterparts. The incumbents have to manage sizable overheads, a less agile culture, and legacy systems that inhibit change.

Digital banks' lower operational costs give them room to offer higher deposit rates, which may trigger deposit price competition. CIMB and ING offer 3%-4% annual returns on deposits with no minimum balance requirements. This contrasts with the 0.1%-0.25% regular savings rate for peso deposits at traditional banks.

CIMB's deposit offering is popular. The bank has acquired 2.3 million customers since the launch in 2018. Incumbents are not far behind. For example, Rizal Commercial Banking Corp.'s mobile app, DiskarTech, launched in August 2020 offers 3.25% returns on deposits.

Everyone Converges On The Mass Affluent

The Philippine digital banking story is not without its wrinkles. Fintech development in the Philippines has lagged behind its neighbors.

Many regional banks have rolled out sophisticated digital products and services while trimming their physical footprint. However, Philippine banks find it difficult to eliminate physical networks and face-to-face interaction in rural areas, where consumers may be uncomfortable with technology, and prefer the security of a bricks-and-mortar space.

Like most institutions, digital banks are targeting mass-affluent customers, who offer high margins. In so doing, they are directly competing with traditional banks, especially in metro Manila and Cebu.

In our opinion, it will be challenging for the digital players to chip away at the entrenched market positions of top banks given their strong franchise and brand value, especially in metro Manila. The top-five banks in the Philippines handle about 60% of the country's loans and deposits (see chart 3).

Digital banks will only meaningfully compete for the mass-affluent market if they provide significantly improved, and cheaper, products and services. Otherwise, while they may make inroads into specialized financing, their market share will remain small. Entrants also need to earn consumers' trust, which traditional banks have locked in.

Chart 3

We believe the entry of new digital banks may accelerate innovation in the banking sector, raising technology investments over the next few years. Traditional banks with large, well-established client bases and wide resources are better prepared to take on virtual banks, as compared with small banks or stand-alone fintech companies.

Large banks have also been increasing their digital offerings in response to changing customer preferences. This is reflected in the significant increase in PESONet and InstaPay transactions over the past few years, with some players offering digital-only banking products that are simple and convenient.

Many lenders are pushing self-service at their branches, maximizing their physical space for high-profit services such as wealth advisory. We believe large banks may also forge strategic alliances and partnerships to stay ahead.

Union Bank of the Philippines has over the past two years rolled out branches incorporating digital self-service, showing that some midsize banks are embracing this strategy. Its fintech subsidiary, UBX, focuses on small-business services, including peer-to-peer lending.

While regulators have yet to issue a digital banking license in the Philippines, a number of entities now provide digital-only services under their existing universal, commercial, rural or thrift bank license (see box).

Digital banks may carve a niche by catering to the non-affluent retail market and small businesses--segments long ignored by traditional banks.

In recent years, banks have focused on growing their retail portfolio to improve net interest margins and diversify loan books. However, this has only led to a slight increase in the share of retail lending--to 18% of banks' loan books (see chart 4), from 16%, in the past 10 years.

Secured mortgages and auto loans in large cities drove much of that growth. People outside of these centers remain largely unserved, with little access to personal loans and credit cards, for example.

Chart 4

Large banks prefer to pay the penalty for noncompliance with the minimum MSME lending requirements rather than deal with high operating costs and credit losses.

If they do lend to riskier customers, the interest rates charged on loans may be very high after pricing in the credit risk and operating costs. For example, the annual interest on large banks' microfinance loans can run as high as 45%-50%.

Significant cost advantages on overhead and infrastructure allow virtual banks to offer digital products to underserved customers at low cost. Digital banks' ability to use data to correctly price risk will determine their success.

Neighboring markets have vibrant fintech ecosystems. Digital banks such as China's WeBank and Korea's KakaoBank are already profitable. We believe the underwriting and risk management capabilities of Philippine digital banks may be tested over the coming three to five years given their rapid growth since the launch.

Regulators Are Supportive

We believe the regulations for digital banks are intended to foster financial inclusion by lowering barriers to entry. Less onerous capital requirements in initial years will likely make inclusive finance more viable and promote faster growth in underserved regions.

Notably, a Philippine digital bank needs only Philippine peso (PHP) 900 million of paid-up capital. This contrasts with the minimum paid-up capital requirement for a universal or commercial bank in the Philippines, which could be anywhere between PHP2 billion and PHP20 billion, depending on size of the branch network. By reference, the minimum capital requirement for a full digital bank in Singapore is S$1.5 billion (PHP53 billion).

Unlike markets such as Singapore, where digital banks operate on a level regulatory playing field with the incumbents, the central bank will likely give the digital banks in Philippines several years to meet minimum capital and liquidity requirements.

We believe BSP could follow a phased implementation of digital banks, giving them some lead time before bringing regulations on par with the universal and commercial banks.

Although not our base-case scenario, if the gap persists for a long time, then it may weaken system resilience. Digital banks may gain significant market share while being less capitalized than universal and commercial banks. There is no revolution without risk.

Related Research

• Tech Disruption In Retail Banking: Agile Thai Banks Have An Upper Hand, Aug. 26, 2020
• Tech Disruption In Retail Banking: Digitalization Will Divide Taiwan Banks, July 30, 2020
• Tech Disruption In Retail Banking: Korean Banks Accelerate Digital Transformation, July 30, 2020
• Tech Disruption In Retail Banking: Singapore Banks Are Front-Runners In Digital Race, June 3, 2020
• Tech Disruption In Retail Banking: Australia's Big Banks Hold Their Ground As Tech Takes Center Stage, June 2, 2020
• Tech Disruption In Retail Banking: Hong Kong's Large Banks Are Pioneering The City's Fintech Development, June 3, 2020
• Tech Disruption In Retail Banking: Better Late Than Never For Japanese Fintech, Feb. 6, 2020
• Tech Disruption In Retail Banking: Nordic Techies Make Mobile Banking Easy, Feb. 4, 2020
• The Future Of Banking: Will Retail Banks Trip Over Tech Disruption? May 14, 2019
• Tech Disruption In Retail Banking: China's Banks Are Playing Catch-Up To Big Tech, May 14, 2019

End Notes

[1] The State of Digital Payments in the Philippines, December 2019, Better Than Cash Alliance