In the coming weeks, we will publish a series of insights on financial innovation discussing several powerful secular trends relating to financial technology/innovation and its impact on the global financial services sector. We will also review how these trends influence the investment strategy of the Hamilton Financials Innovation ETF (HFT).
We launched HFT in 2020 to give investors exposure to these fast-growing themes, within “established” fintech firms (i.e., more conservative, less risky, mostly large-cap). To achieve this objective, we have divided HFT’s portfolio into three main categories: (i) digital payments, (ii) market data and technology, and (iii) other innovators, including wealth management. In our view, all Canadian investors should have material exposure to this large (and expanding) category, and importantly, consider HFT’s diversified portfolio of financial services innovators to be an attractive complement to investors’ core Canadian bank positions.
In this insight, we address digital banking, both the opportunities and the challenges. As we outlined in a recent note, “Hamilton Financials Innovation ETF: Invest in Digital Leaders Reshaping the Financial Sector”, the ETF does not have material exposure to standalone digital banks as we believe the powerful, ongoing shift towards digital/branchless banking favors the incumbents. In addition, the universe of publicly traded digital banks is currently small/negligible.
Digital banks (in theory) have attractive cost and ROE benefits
At first glance, the opportunities for standalone digital banks seem to be significant given the sheer size of the banking sector, which in most countries is dominated by large incumbents anchored by vast and expensive physical distribution in the form of their branch networks. Moreover, digital banks should not be constrained by geography as they would be able to service customers anywhere, and unlike the incumbents, do not need to adopt “hub and spoke” branch configurations (this could arguably reduce some of the barriers to entry from scale, given the lower fixed costs).
Therefore, the opportunity for technology to enable the emergence of nimble digital competitors to disintermediate branches, increase efficiency, and pass some of these savings onto consumers (in the form of lower prices), while generating higher ROEs, and earnings growth appears huge. However, the reality has been different so far, with no significant standalone digital bank competitors emerging in the past decade in Canada (or other major countries).
Significant challenges face standalone digital banks in Canada (and elsewhere)
Thus far, the emergence of a standalone digital bank with material market share or even the market presence needed to influence product pricing remains elusive. In our view, the investable universe remains small because competitors face significant competitive and regulatory challenges to creating a large standalone digital bank, particularly in countries with dominant oligopolies, like Canada and Australia. We believe the following four challenges explain why – despite major technological breakthroughs in financial services – a formidable, full-service, standalone digital bank has failed to emerge to challenge incumbents:
- Access to stable, low-cost deposits/funding: One of the most important sources of value in a bank is its level of non-interest-bearing deposits. This zero-cost funding source enhances net interest margins but is also an important source of funding for banks, as these deposits are diffuse and stable. Banks fiercely compete for these deposits as they are the bulwark of their franchises, and a key driver of profitability. As a result, new or small entrants are often left to scale their platforms using term deposits, including brokered deposits. These deposits are more expensive, price sensitive, less diversified and importantly are less stable (as the global financial crisis demonstrated vividly). Moreover, the cost of acquiring these customers can be very high, both from advertising and/or higher cost of funds. Thus, a key challenge for digital banks is the difficulty in raising a critical mass of deposits to form a stable low-cost funding base to match the incumbent competitors.
- Specialized underwriting expertise required for most loan categories creates challenges for digital-only channels. There are multiple loan categories that require varying degrees of underwriting expertise – some are commoditized, others require sophisticated bespoke lending criteria. Commoditized loans include mortgages, auto loans, credit cards, and secured lines of credit, as lending is largely based on standardized credit scores (internal and external). These more generic, retail loan categories are more suitable for digital banks since the loan sizes are smaller and banks can charge higher rates to compensate for the much higher cumulative loss ratios in these loan categories (except for mortgages). Unfortunately for digital banks, in many markets, these loan categories are dominated by oligopolistic competitors able to leverage their brands and scale (risk management, distribution, advertising) often leaving new competitors with the higher risk customers, namely those that find it more difficult to obtain credit.
By contrast, other loan categories such as commercial loans (SME), corporate loans, construction loans, commercial real estate (multi-family) require significant and often highly specialized underwriting expertise. This specialized underwriting and risk management expertise includes not only understanding the businesses but also the character of the local markets. They are also larger in size, making it difficult for new entrants to assemble a diversified portfolio from a risk management perspective. Moreover, clients requiring these loans can be larger companies that also need other non-credit related banking services (e.g., treasury management). Together these factors represent significant challenges to digital banks seeking such mandates.
- Post-GFC capital and regulatory burden increase costs, regulatory risk, and capital levels, weighing on bank profitability. One of the most significant trends emerging from the post-financial crisis was re-regulation of the global banking sector that resulted in: (i) increased capital levels (and higher quality of capital), (ii) increased amount and quality of liquidity buffers, and (iii) minimized shadow banking. In the years immediately following the crisis, these regulatory reforms weighed heavily on bank ROEs/profitability in most major global economies. Other areas of regulation also became significant, including anti-money laundering (AML), which added compliance costs and – more significantly – the risk of large fines imposed by global regulators for non-compliance. By definition, digital banks do not interact in the same manner with customers as bricks and mortar platforms. With steep growth necessary to scale their platforms, digital banks could be more vulnerable to certain regulatory risks (money laundering, financing illegal activity) and operational risks (fraud, data breach).
- Smaller digital banks face trust and brand deficits (especially in early years). This trust/brand deficit can be particularly challenging in banking, especially in oligopolistic banking markets like Canada and Australia where incumbents enjoy brand loyalty and high confidence. Even with large and successful deposit insurance schemes, customers are often reluctant to switch to smaller and less recognized new entrants, making it challenging to gain market share.
Technology lowering entry barriers, but so far, the benefits from digital banking remain mostly with the incumbents
Notwithstanding that digital banks have the potential to be more nimble/flexible than incumbent “bricks and mortar” peers, the universe of standalone digital banks is currently very small and the challenges to gaining material market share remain high. We believe competitive and regulatory challenges are greatest in countries like Canada and Australia with well entrenched, oligopolistic banking sectors. In the U.S., which only has one “true” national bank (WFC) but several large competitors, the emergence of a regional bank/incumbent seeking to lever its scale to launch a national digital bank seems more likely than in Canada.
Generally, we expect the incumbents will benefit the most from the secular trend towards digital banking (including the declining use of cash) by continuing to close, shrink, and reconfigure their existing branch networks while offering additional services via online channels to support customers’ changing preferences. In the short- to medium-term, we believe lower operating expenses from a smaller branch footprint and increasing adaptation of online platforms could be supportive to earnings/ROE in the coming years, which is especially important in a low-rate environment.
However, in the long-term, easy capital access, changing demographics, and accelerating technological innovation are creating conditions conducive to the emergence of a competitor that could impact incumbent behaviour on product pricing, catalyze potential strategic partnerships, and influence incumbent banks’ plans for innovation (including their own digital banks). In our view, given the sheer pace of these changes, certain niche competitors are likely to emerge and experience material growth for their shareholders (and be a candidate for inclusion in HFT).
The potential growth of new digital competitors could be aided by pending regulatory changes such as the approval of open banking, which we will discuss in the coming weeks.
Global Financials: The Most Attractive/Important Investment Themes in 2021 (November 16, 2020)
Hamilton ETFs Launches Hamilton Financials Innovation ETF (June 1, 2020)
 U.S regional lender Citizens Financial recently disclosed that the pandemic had accelerated its goal of building a digital-first national bank.
A word on trading liquidity for ETFs …
Hamilton ETFs are highly liquid ETFs that can be purchased and sold easily. ETFs are as liquid as their underlying holdings and the underlying holdings trade millions of shares each day.
How does that work? When ETF investors are buying (or selling) in the market, they may transact with another ETF investor or a market maker for the ETF. At all times, even if daily volume appears low, there is a market maker – typically a large bank-owned investment dealer – willing to fill the other side of the ETF order (at the bid/ask spread).