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Asia Pacific Equity Research

17 July 2019

Hong Kong Banks

101 on Virtual Banks - The Game Changers

Banks & Financial Services

Katherine Lei

(852) 2800-8552

katherine.lei@jpmorgan.com

Bloomberg JPMA LEI <GO>

J.P. Morgan Securities (Asia Pacific) Limited

Jemmy S Huang

(886-2) 2725-9870

jemmy.s.huang@jpmorgan.com

Bloomberg JPMA JHUANG <GO>

J.P. Morgan Securities (Taiwan) Limited/ J.P.

Morgan Securities (Asia Pacific) Limited

Leo Weng

(852) 2800-8511

leo.weng@jpmorgan.com

J.P. Morgan Securities (Asia Pacific) Limited

George Cai

(852) 2800-8557

george.cai@jpmorgan.com

J.P. Morgan Securities (Asia Pacific) Limited

Daqi Jiao

(852) 2800-8595

daqi.jiao@jpmorgan.com

J.P. Morgan Securities (Asia Pacific) Limited

Internet

Alex Yao

(852) 2800-8535

alex.yao@jpmorgan.com

J.P. Morgan Securities (Asia Pacific) Limited

See page 37 for analyst certification and important disclosures, including non

US analyst disclosures.

J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware th

at the

firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report

as only a single factor in

making their investment decision.

www.jpmorganmarkets.com

HKMA issued full banking licenses to eight virtual banks (VBs). We believe this

could be a game changer for HK banks, which reported materially higher retail

ROA than peers in other regions. In our opinion, the VBs will disrupt the

incumbents if they are able to offer a seamless user experience while managing

key risks. Small banks (BEA & DSBG) may see higher earnings risk in initial

years, and deposit leaders (i.e., HSBC & HSB) are likely to lose market share in

the years to come, leading to concerns on stock de-rating. We prefer BOC HK and

STAN, which are first-movers into VB business. Execution ability of VBs

remains a key swing factor.

 Key facts of VBs: There is no written limit on the business scope of VBs.

However, there is soft hurdle on scope as VBs have to demonstrate their ability

to manage risks (i.e., cyber security, AML, and credit and liquidity risk, etc.)

when rolling out new services. Tables 1-2 show background information on the

eight VBs. We highlight Livi and Infinium based on our scorecard (page 8).

 Key challenges for VBs: The biggest challenge is to create a smooth user

experience for customers while adhering to all the risk management and

compliance measures. This will be essential to VBs’ deposit-taking ability. VBs

are likely to leverage technology as highlighted in Table 4 to overcome some of

the obstacles. In addition, VBs are not allowed to participate in predatory

behavior, resulting in substantial losses in initial years. This limits their ability

to aggressively gain deposits market share (i.e., offer high-yield deposits) by

offering materially higher-yield products.

 Key opportunities for VBs: Banking penetration in HK is lower than those in

DM markets (Table 9, page 17), particularly in retail and SME segments. HK

banks’ retail ROA is higher than other regions (Figure 2, page 17), partly due to

low deposits cost. We expect VBs to take up to 0.8% of deposits market share

by 2020. On the asset side, they may target the near-prime retail customers who

borrow from high-yield lenders (i.e., UA Finance), which report average APR

(annual percentage rate) of ~30%. On SME loans, VBs may target those

borrowing from factoring companies at ~10-15% APR.

 Quantifying the addressable market for VBs: We estimate VBs to take up to

1.0% and 0.8% of market share in terms of loans and deposits by the end of

2020. And aggregate revenue could be HK$6.5bn in 2020e, equivalent to about

1.2% of total banking revenue (Table 13, page 21). Their share on banking

profits will be lower due to high cost-income ratio at initial years and elevated

credit costs due to higher inherent risk of their target borrowers segment.

 VB’s disruption to incumbent banks: VBs will disrupt the incumbent banks on

the liabilities side (i.e., deposits) and non-bank lenders on the assets side we

believe. However, the initial impact is inflicted by banks positioning pre-

emptively for the VB challenges. Banks have raised time deposit rates and

waived account service fees in recent weeks. Static sensitivity analysis shows

this could lead to 2.5%-9.7% downside on HK banks’ 2020e profits (Table 17,

page 23); this is not our base case. We think BEA and DSBG will see higher

negative impacts than peers. In the longer run, banks which profit from strong

liabilities franchises, such as HSBC & HSB, will lose deposits market share and

see de-rating risk in our view.

Asia Pacific

Equity Research

17 July 2019

Katherine Lei

(852) 2800-8552

katherine.lei@jpmorgan.com

Table of Contents

Investment summary – understanding the disruptors..........3

What are the key challenges for VBs?......................................................................3

What are the opportunities for VBs? ........................................................................3

What is the potential revenue size for VBs? .............................................................4

Which VBs do we highlight?...................................................................................4

Will VBs disrupt the banking sector?.......................................................................4

Key facts about virtual banks in HK .......................................6

Business scopes of VBs...........................................................................................6

Ranking the VBs based on shareholders strength .....................................................6

Regulators’ role in Fintech initiatives-Sandbox and “Banking Made Easy” programs9

Opportunities and Challenges...............................................11

Challenges #1: balancing customer experience with risk management....................11

Challenge #2 – the subtle limitation on deposits taking & business scope ...............12

Challenge #3 - balancing profitability with growth.................................................15

Challenge #4 – limits on cross selling ....................................................................15

Challenges #5 - onboarding SME customers for VBs .............................................15

Opportunities – banking services penetration in HK is lower than other DM markets

.............................................................................................................................16

Opportunity #1 - Retail business in HK is lucrative................................................17

Opportunity # 2: SME business .............................................................................19

How disruptive can VBs be? .................................................21

Quantifying addressable market of VBs.................................................................21

Potential disruption to current banking landscape...................................................22

International comparison.......................................................25

A reference to developed markets..........................................................................25

Japan ....................................................................................................................25

Korea....................................................................................................................26

Lessons from Japan and Korea virtual banks..........................................................28

UK........................................................................................................................28

A reference to China .............................................................................................28

A refresher on HK’s banking market ....................................32

Market share and key players.................................................................................32

Capital and liquidity requirements .........................................................................35

Asia Pacific

Equity Research

17 July 2019

Katherine Lei

(852) 2800-8552

katherine.lei@jpmorgan.com

Investment summary – understanding the

disruptors

What are the key challenges for VBs?

 Challenge #1: balancing customer experience with risk management. VBs

have to create a seamless user experience which will be by a wide margin better

than the mobile banking platforms offered by incumbent banks. Unlike other

industries, banks are highly regulated; the challenge is how do VBs balance user

experience with risk management? This includes risk involving cyber security

breach, money laundering, fraudulent activities and banking risks

(credit/market/liquidity/compliance, etc.). This will be an essential factor on their

deposit-taking ability, in our view. But in general, as VBs can build the business

and the technology infrastructure at the same time, they have fewer burdens than

the traditional bank which have to incorporate new features into their existing

core banking infrastructure platform when building their online/mobile capacity.

 Challenge #2: subtle limitation on business scope & deposit-taking capacity.

There is no written hurdle on the scope or deposit taking ability for the VBs in

HK. However, both virtual banks and conventional banks observed the same

limitation on electronic banking as specified in the Supervisory Policy Manual

(SPM) module TM-E-1 "Risk Management of E-banking." This means that VBs,

like incumbent banks’ online/mobile platforms, have to ensure risks are properly

managed. This creates a de-factor barrier for some of the banking business. For

example, accounts opened online by incumbent banks will have lower transaction

and balance limits versus normal bank accounts. As a result, it will be a

challenge for VBs to on board corporate clients (including SMEs), conduct

mortgage business and handle complicated transactions required in private

banking business. This will, in turn, limit their ability to gather low-cost

transactional base CASA deposits. Thus, it is very important for the VBs to be

able to leverage technology in order to overcome the subtle hurdle. Table 4 on

page 11 lists the key technologies they are likely to deploy.

 Challenge #3: expanding in a balanced way. HKMA stated that virtual banks

should not plan to aggressively build market share at the expense of recording

substantial losses in the initial years of operation. This is to discourage predatory

behavior which may be detrimental to the stability of the banking industry. One

way for VBs to attract deposits is through offering deposits at rates substantially

higher than that offered by banks. In order to offset that, they can offer high-

yield loans by going up the risk curve. However, this is discouraged by HKMA.

The VBs have to balance profitability vs market share gains. So they won’t be

able to follow the business strategy of Alipay or Tenpay, by heavily subsidizing

merchants to adopt their payment solutions.

What are the opportunities for VBs?

Table 9 on page 17 shows that the banking services penetration rate is lower than

other DM markets. HKMA highlighted that the purpose of VBs is to increase

financial inclusion in HK, the business focus will mainly be in retail and SME

segment.

 Retail: HK banks’ retail ROA is significantly higher than peers in other regions

(Figures 2-3, page 17), mainly due to low funding cost and credit costs; for

example, composite deposit rate is 0.82% in 2019E. Sub-prime non-bank

Asia Pacific

Equity Research

17 July 2019

Katherine Lei

(852) 2800-8552

katherine.lei@jpmorgan.com

consumer lenders report annualized lending rate of 30%-40%. VBs, whose

funding cost will be higher than banks but lower than that of non-bank lenders,

can target the near-prime customers and benefit from the lucrative margin.

 SME: SMEs are underserved by incumbent banks. SME loans only account for

2-7% of total bank loans for banks we cover. And ~30% of SMEs surveyed by

HKMA stated that it is challenging for them to obtain bank financing. As a

result, SMEs are willing to pay up to 10%-15% of annualized borrowing cost to

factor companies in order to cash out on their receivables. This indicates that

VBs may see lucrative profits on SME financing, if they are able to offer

seamless on boarding and management credit risk at a reasonable level for SME

loans. But the key challenge will be the on-boarding of SME clients, as discussed

above.

 Greater Bay Area (GBA) expansion: GBA consists of 71 million population, 11

cities and aggregate GDP of US$1.6trn, compared to HK of 7.5 million

population and GDP of US$363bn in 2018. Despite that HK VBs will focus on

the HK market initially, we believe there is opportunity for the VBs to eventually

roll out some services to GBA, as there is no geographical limitation for VBs.

The key barriers will be on regulation, and we expect HKMA to work closely

with CBIRC to resolve this in the years to come.

 Strong support from regulators (HKMA): The key difference between HK VBs

and their peers in China (i.e., WeBank and Mybank) is the regulatory hurdle.

First, there is no written limitation on the business scope of VBs. But in China,

there are written limitations on the transaction amount and balance of internet

bank accounts and deposits rates, capping internet banks’ deposits-taking ability.

In addition, the banking regulator in HK (HKMA) has launched two initiatives to

create a friendlier environment for banks, VBs and Fintech firms to operate in.

This includes the Sandbox and Banking Make Easy initiatives. Please refer to

page 9 for discussion. We VBs in HK cause more disruption to incumbent banks

than the internet banks do in China.

What is the potential revenue size for VBs?

Table 13 shows that we estimate VBs to take up to 1.0% and 0.8% of market share in

terms of loans and deposits by the end of 2020. We expect that the aggregate

revenue could be HK$6.5bn by end 2020, equivalent to about 1.2% of total banking

revenue. Please refer to page 21 for our key assumptions.

Which VBs do we highlight?

Table 1 on page 8 shows the key shareholders and business strategy of each BVs

base on publicly disclosed data. We created a score card (Table 2, page 8) to rate the

relative strength of VBs. Based on shareholders data and strategy, we assessed their

strength in banking knowledge, technology know-how and synergy with local

partners, etc. We conclude that Livi (BOC HK’s subsidiary) and Infinium (joint-

venture of ICBC Asia and Tencent) are in better positions than others.

Will VBs disrupt the banking sector?

"Yes". There are near-term and long-term impacts. In general, we believe VBs

disrupt banks on the liabilities side (i.e., deposits) and non-bank lenders such as

factoring companies and high-yield consumer lenders on the assets side.

In the near term, the disruption is mainly from incumbent banks' pre-emptive

adjustments to prepare for the challenge from VBs. We noted that banks have

Asia Pacific

Equity Research

17 July 2019

Katherine Lei

(852) 2800-8552

katherine.lei@jpmorgan.com

waived and increased their time deposit rates (Table 16 in page 23). We conduct a

static sensitivity analysis assuming a 20bps increase in time deposits and a 20% to

30% decline in account service fee by banks. We concluded from our analysis that

total negative impact could be 0.5-3.9% on operating revenue and 2.5%-9.7% on

net profits in FY20E.

Banks which have smaller deposits base, less resources to invest into technology and

weaker transaction banking capacity will see more downside effects we believe. Our

analysis shows that BEA and DSBG will see more negative impact than peers do.

Banks which have stronger high-new worth management and corporate capacity may

be in a more defensive position (i.e., HSBC and Hang Sang Bank). BOCHK and

STAN, which invest into VBs and likely to create crossing-selling opportunities,

are positioned to gain market share, in our view.

In the long run, banks which made lucrative profits through liabilities franchises

(i.e., HSBC and HSB) are likely to lose deposit market share, which may be a de-

rating factor for both if not handled properly. We believe both banks are actively

preparing to take up the challenge. For example, HSBC aggressively expanded its

private banking business and HSB on SMEs financing. We see these as sensible

strategies.

What are the implications for technology and internet

companies?

We believe the VB license will allow Chinese Internet companies to legally extend

their existing financial service offerings to HK. For example, Ant Financial will be

able to operate payment, consumer lending, wealth management and SME lending in

HK. Nonetheless, the VB license does not remove any regulatory constraints they

currently face in China. This puts Internet companies in a complementary

relationship with the incumbent financial institutions (internet operators focus on

traffic, lead generation, origination, data analytics, etc. part of the operation in

individual and SME financial services while financial institutions focus on the

financial risk management part of financial services with greater flexibility in deposit

taking). The financial impact from VB license should be insignificant in the near

term, in our view.

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