Discover more from Pekingnology
Digitalization challenges small banks, ex-central bank governor warns
Zhou Xiaochuan urges against competing on tech with Fintech/Big Tech
Below is an article by 周小川 Zhou Xiaochuan, in his capacity as current President of the 中国金融学会 China Society for Finance and Banking, published at the beginning of 2022 on 中国金融 China Finance, a bi-weekly magazine under the central bank. Zhou is of course formerly the governor of China’s central bank.
Please note the key Chinese words Zhou used are 基层银行, which this unofficial translation put as small banks - in his own words - banks that ground their business in communities, villages, and towns, as well as relatively independent grassroots branches of some large banks.
But it’s not just banking. Zhou also shared quite some views on the Fintech and Big Tech firms. All the highlights are by your Pekingnologist, not by Zhou.
The Development of Information Technology and the Prospects of Small Banks
General Secretary Xi Jinping presided over the Central Financial and Economic Affairs Commission’s tenth meeting on August 17, 2021. At the meeting, Xi emphasized that common prosperity is the fundamental task of socialism and that we must stay true to the vision of people-centered development and promote common prosperity through high-quality development. This has drawn a lot of attention and spurred lively discussions in the entire society on the issue of prosperity for all and income distribution.
The theme of this conference is “financial support for common prosperity and high-quality development”, and that’s very timely. Today, I’d like to discuss the “development of information technology (IT) and the prospects of small banks” from the standpoint of economics and finance, because small banks should serve common prosperity and high-quality development. Of course, we only have preliminary ideas on this topic, but I hope that it will lead to more valuable discussions.
IT development brings new challenges to small banks.
As we all know, IT, particularly the Internet, big data, cloud computing, and artificial intelligence, has been developing in leaps and bounds. It has aided the growth of a large number of Fintech and Big Tech firms, opened up new channels for financial services, banking in particular, and also presented new challenges. At the same time, small banks, mainly those that ground their business in communities, villages, and towns, as well as relatively independent grassroots branches of some large banks, have undergone changes in their operations in the national economy, so their survival and development are being tested by new realities and new challenges.
The banking sector can be generally seen as an industry where IT is applied, because its account management, customer management, payment system, loan decision-making, pricing, etc. rely on information processing underpinned by IT. The bank’s user interface (previously brick and mortar outlets), payment methods, etc., have now all changed dramatically. It is unavoidable given the challenges brought by technological advancements that banking has to confront.
In the past, small banks mainly served the grassroots and the community level at a time when large, medium and small-sized banks coexisted. At the same time, small banks believed that large and medium-sized banks had a large service coverage in area and legions of customers, and there would be ample room for small banks’ own survival and development as long as they could share a slice of the cake of large banks.
Furthermore, local governments had the incentive to support the development of small local banks. Small banks also wanted to emulate big banks’ operations, including cross-regional operations and a focus on big customers. As IT develops, however, new financial service providers arise, and they are also new competitors.
In addition, non-bank financial institutions are also involved in the competition. Therefore, as the number of banking service providers increases, the situation changes. Even the customers that large banks were too busy to accommodate may not be necessarily passed on to small banks, because it depends on whether small banks have certain capabilities and strengths, particularly the strength in information.
Since the banking sector offers in fact services based on information, it is necessary to set up an information system, which includes hardware system, basic software, and application software. Previously, application software was developed in-house by banks or purchased from a third party. Given their limited capabilities in technology, sourcing from the outside became the primary choice of small banks. With the rise of fintech, software developers have gradually evolved from developing software according to the demand of some banks to creating more advanced and comprehensive software by themselves in some new fields, such as online business, customer management, and cloud computing, becoming providers of system-wide integrated services.
Subsequently, software developers can provide SaaS (Software as a Service), which enables banks to do their major business with the software. Some Fintech and Big Tech firms believe they are well-positioned to provide more advanced financial services, including providing application software, system integration services, and even SaaS. Other Fintech or Big Tech companies even believe that it is better to directly design and provide a suite of software by themselves instead of waiting for banks to make an order.
If the core process of banking is replaced by the information system, small banks will have few advantages - probably just in having a banking license and taking part in deposit insurance. In fact, small banks pale in comparison to Fintech and Big Tech firms in terms of customer acquisition and customer management over the Internet. If making loans mainly relies on the information provided by a credit reference system, or loan assistance/guidance/introduction provided by Internet platform companies, small banks will be outperformed by IT companies in areas of big data and credit reference.
IT companies also have a competitive edge in selling wealth management products if small banks mainly rely on investment advisors in selling the products. Bank licenses are strictly regulated nowadays, and it is impossible to enjoy deposit protection without a license. However, if comparative advantages (between banks and tech companies) change over time, licensing may become less of a hindrance in the future. Moreover, tech companies have a comparatively higher market valuation than banks at the moment, and as a result, it won’t be a big issue for them to replenish capital and recruit talents.
There’s still great potential for small banks in the information age.
The issue on the table is how small banks cope with the situation and further tap their own potential. If small banks rely on the Internet for customer management, credit reference for loans, investment advisers for selling wealth management products, attracting deposits in picking up the leftovers from large banks, and purchasing application software for business operation, instead of taking advantage of its own advantages and attracting customers at the grassroots level, it will be problematic for them. If they stick with the traditional approach of taking a slice from the large banks’ cake, they will set on the path of losing their own advantages. On top of that, local governments may no longer be willing to provide huge support for the development of small local banks as they did before.
These are what have people have already observed in the market in recent years. Following the financial problems in 温州 Wenzhou in 2012, people have been talking about a development model in the future. 台州 Taizhou’s development experience is to keep a foothold at the grassroots level so that banks can obtain more information and grow their businesses from there. This model has performed well.
Certainly, some people are of the view that small banks should embrace the Internet, which would enable them to attract customers and businesses from the Internet regardless of physical regions and land boundaries, and issue loans mostly based on credit information, or rely on tech companies for support in issuing loans.
The extent to which big data and credit reference systems should be used in loan decision-making and pricing is still up for future debate. After the outbreak of the global financial crisis, the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS) have all said explicitly that banks should not unduly rely on external ratings.
[Principle II. Reducing market reliance on CRA ratings: Banks, market participants, and institutional investors should be expected to make their own credit assessments, and not rely solely or mechanistically on CRA ratings.]
External ratings are pro-cyclical, and there will be evident buck-passing (in terms of banks’ internal compliance and risk control, liability could be exempted as long as there is an external rating or credit review. In that case, even if the loan goes bad, clerks, supervisors, and managers at all levels at the bank would likely not be held accountable because they have the external rating).
It is likely that this Internet-based model is not suitable for small banks. Large banks and IT firms have more capacity to conveniently manage customers and access credit reference systems via the Internet and have more comprehensive data and information resources than small banks. In addition, the aforesaid cause of shirking responsibility will easily make small banks find the wrong way ahead.
By the way, lots of peer-to-peer lending problems that occurred in recent years have been almost resolved, but at a very high cost. A lot can be learned from this. For example, we should not easily underestimate the business experience and traditions accumulated by the banking sector over the years.
There is no denying that we must be aware that the development of science and technology may bring new technologies and new models, and even disruptive innovations, but we must not jump to conclusions. From a technological standpoint, any innovation and new technology may be exciting when it first emerges, and people are inclined to believe in their enormous potency, but this may be overblown.
As the peer-to-peer lending history shows, some ideas which were hyped up from early on tend to be proved wrong later. One of the main propaganda of peer-to-peer lending was that the public previously deposited money in banks which decided who to lend to, while the development of the Internet made data acquisition more convenient and transparent so that banks can be skipped. Depositors can find borrowers through the information system themselves without going through the banks.
This proved highly misleading. On the one hand, the amount of information required for lending is massive, and the information processing is also complex, which requires rich and rigorous financial analysis and comparison between companies in the same sector. Moreover, it requires the analysis of the sector characteristics and even various important factors such as overall and international situations. This is not something that a few enthusiasts can handle at home. On the other hand, even if these enthusiasts may know a few companies, they often cannot make correct judgments unless they examine them in the context of the sector and the broader economy.
In a nutshell, to face current challenges and learn from the past lessons, it is necessary for us to further study and investigate the banking sector, particularly small banks, for them to grasp the opportunities and space to serve the national economy and ensure their own survival and development.
The comparative advantage of smalls banks lies in deep roots at the grassroots level.
Economics, particularly international trade theory, emphasizes the use of comparative advantages. A country or an enterprise must consider its comparative advantage if it wants to develop, expand its market share, and become competitive. It must make full use of its comparative advantages, instead of relying on weaknesses to participate in the competition. Otherwise, it may be like “hitting the stone with an egg”. So, what are the comparative advantages of small banks? To know this, let’s first try to see where the strengths of big banks and IT companies lie.
For big banks, they have licenses, a high capital adequacy ratio, a wide customer base, a strong deposit base, in-house IT development teams, participation in the deposit insurance mechanism, so on and so forth. However, the valuation of big banks is relatively low, some even below their book value. Big banks are subject to various restrictions in terms of business development, and they cannot provide cross-sector and diversified services like fintech companies. Their brick and mortar outlets will come under great impact in the future.
In some Western countries, some big banks will turn their brick and mortar outlets into offering comprehensive services (not only engaged in commercial banking businesses), but this may require regulatory support. The IT companies have the strength to recruit talent and raise capital. In particular, IT companies have high valuations and are able to raise more capital through a slew of measures such as from the 资本市场 capital market. [Within the Chinese financial context, the 资本市场 capital market typically indicates private placement, IPOs, and other financing activities that fall within the jurisdiction of the securities regulator CSRC]
From the perspective of customer management and the potential to attract deposits, IT companies have new ways, especially in acquiring new customers from across the Internet.
In addition, along with the development of payment systems, IT companies are more capable of acquiring, expanding, and managing customers. Most Fintech and Big Tech companies do not have banking licenses yet, but there is hope in the future. Without a license, they cannot enjoy deposit insurance for the time being, which is a disadvantage.
Due to the information processing nature of banking, Fintech and Big Tech companies with their strong IT capabilities have mastered the skills of financial services to a large extent through system building, software development, and SaaS promotion. Furthermore. Because IT services for various financial sectors are not restricted by the principle of “separate operation”, the IT companies’ advantages are more obvious.
In comparison, small banks are at a disadvantage in terms of capital, valuation, customers, payment systems, “separate operation”, and IT teams. One of the strengths of small banks is that they have a license and deposit insurance. If small banks leverage their weaknesses instead of strengths, the prospects will be grim.
Therefore, small banks should deepen roots at the grassroots level, strengthen ties with grassroots customers, exploit the comparative advantage of having the information on grassroots customers, and focus on serving them. There is great potential in this, and it is also a matter that concerns the overall economy.
This involves the comparison between the centrally planned economy and a market economy in terms of efficiency and competitiveness. From the standpoint of information theory, decentralized information can be processed more efficiently at the grassroots level and achieve the balance between supply and demand. To put it another way, according to the principle of the market economy, it is not necessary to involve the upper level, if information processing and supply-demand balance can be addressed at the micro-level. Although there is big data and stronger data processing capability, it will not change basic laws in information efficiency.
Although certain information can be obtained from the credit reference system for the issue of loans, in practice, it is necessary to judge the competitiveness and financial health of an enterprise for the issuance of loans - to a large extent, a company’s balance sheet, profit and loss statement, and cash flow statement must be investigated.
Moreover, it is not enough to rely on alternative data and information processing from those data to judge the position of an enterprise among its peers, its prospects, and its advantages in terms of mergers and acquisitions, horizontal competition, etc. In addition, various stakeholders also have their hands on the data. The more information processing is relied upon to make judgments, the more likely that some people will engage in manipulating the data and information processing. In consequence of that, information could be falsified, such as artificially hyping data on sales, logistics, transaction volume, matched orders, and hiring spammers and opinion shapers to manipulate public opinion. We must be soberly aware of this.
Judging from the experience of some well-run small banks, there is great potential. They have strengths in grassroots-level information and services and a close understanding of grassroots-level customers. They may also build a “bank-company community with a shared future”. If they capitalize on their potential advantages, small banks will have the space to serve the national economy and ensure their survival and development. If they compete by their weaknesses, it will be a cause for concern.
In the long run, IT will develop dynamically, and the overall picture remains to be seen. I hope that we can keep abreast of these trends and study this topic, including the following aspects.
First, we must attach great importance to the challenges posed by IT development, including challenges it poses to a bank’s internal organization structure, the scope of business for banks, as well as the regulation of banks.
Second, small banks still have comparative advantages for taking root at the grassroots level, and there is still some great potential. Certainly, it is different from the traditional thinking of banking, and changes must be made. Third, small banks should take into account the law of comparative advantage, and do not use their weaknesses as the growth engine.
Fourth, we can try to study the evolution of the structure of the banking system, including the future functions of brick and mortar outlets. To some extent, this can be applied to other types of financial institutions, because the principles are the same.
Fifth, the overall research methodologies mainly focused on the banking operation and its role in the national economy in the past. In the future, we could put more emphasis on the analysis and demonstration based on the information system and structure to guide financial institutions to make relevant choices and formulate development strategies, so that they can better adapt to the New Era and to meet the needs of common prosperity and high-quality development.
(This article is the author’s keynote speech at the 2021中国金融学会学术年会 “2021 Annual Conference of China Society for Finance & Banking” held on December 11, 2021)