1. 1 “The Future of Banking in Hong Kong - the Impact and Implications of Internet Banking” David Carse Deputy Chief Executive Hong Kong Monetary Authority 14 June 2000

2. 2 The “Age of the Internet” l Ignore the hype about dot.com companies l The internet is here to stay and will revolutionize banking l Banks that neglect the internet do so at their peril l How to handle the challenge posed by the internet and technology in general is the biggest strategic issue in banking

3. 3 The potential in Hong Kong l Internet banking will succeed in Hong Kong because there is the supply, the demand and the infrastructure l Penetration rates for electronic delivery channels are among the highest in the world: »over 50% of households have PCs »80% of households have access to broadband »55% of the population use mobile phones »about 30% of the population are internet users l Electronic Transactions Ordinance provides legal basis for electronic commerce »recognition of digital signatures and certification authorities

4. 4 The current situation l So far about 14 banks have introduced transactional internet banking services either directly or using the JETCO virtual ATM service l More are planning to do so in the near future l Main focus at present is on the consumer (B2C), including on-line stock broking l But a number of banks are also exploring business-to-business opportunities (B2B), including bill presentment, payment services and trade finance

5. 5 The economics of the internet l The internet offers banks the chance to cut costs and to increase revenue through more effective marketing and cross selling l But cost savings are expected to be minimal over the next few years l Spending will increase on front and back- end IT and associated expenses such as advertising »though the operating expenses seem manageable for the time being - average of about 1.5% of annual total l Revenue gains from cross-selling are uncertain l Margins will come under pressure from greater price transparency

6. 6 The strategic challenge for the banks l Despite the uncertain benefits over the next few years, the banks have no alternative except to embrace the internet l Internet capability will be necessary to provide credibility (“respect rather than revenue”) and to fend off new, low-cost entrants: »virtual banks »e-lenders »portals and aggregators

7. 7 The nature of the dilemma “For many institutions the Internet is a double bind. Embrace it, and you may still find yourself losing business, or at least seeing profit margins dwindle. But ignoring it could be terminal.” The Economist

8. 8 The strategic opportunities l Despite the threats, banks are not defenceless »multi-channel distribution (including via revamped branches) seems the best model at present »the virtual bank model is unproven »e-lenders need to obtain funding »established customer base and brands are important – “online banking from a company that’s been around longer than a week” (American Express) l But the banks need to get it right »must be greater focus on quality of service (ease of access, range of products, degree of personalization) »must migrate customers to low-cost channel »must integrate front and back-end systems

9. 9 Security risks l Although banks face all sorts of security risks day to day, the internet poses new challenges because of its open nature l Security is the biggest concern among customers and therefore the biggest barrier to customer acceptance of internet banking l The technology does exist to provide protection but it requires continuous review and upgrading

10. 10 Reputational and legal risk l Successful hacking of a system or system breakdown may cause bad publicity and undermine customers’ confidence in internet banking even if they suffer no loss l If customers do suffer loss it is necessary to determine how this should be apportioned between them and the bank: »terms and conditions should be clear and fair »customers should be warned of their responsibilities on security »customers should not be responsible for direct losses due to security breaches etc unless they have acted negligently or fraudulently

11. 11 Banking risks l The internet may heighten the risks inherent in conventional banking, eg: »liquidity risk may increase if depositor loyalty is reduced and/or it becomes easier for depositors to transfer deposits at the touch of a button (the “virtual” run) »credit risk may increase if the relationship with the customer becomes more distant and transitory, or if competitive pressures lower credit standards l However, the enhanced ability to gather and interpret customer data can reduce these risks »reinforces the need for banks to enhance their management of customer data

12. 12 The role of the HKMA l The HKMA’s role as regulator is to help minimize the risks of internet banking while not standing in the way of progress l This requires us to upgrade our own skills, eg by hiring examiners with specialist IT knowledge

13. 13 The regulatory framework l Existing banks seeking to offer an internet banking service should consult with HKMA in advance »security is a major supervisory issue l Banks should also keep us in touch with plans for internet joint ventures - need our consent for investments of 5% or more of capital base l New companies wishing to take deposits in Hong Kong (including virtual banks) require authorization under the Banking Ordinance »note that the ability to set up a new local bank from scratch is limited under the current law

14. 14 The regulatory framework (2) l Issuers of smart cards also require authorization under the Banking Ordinance l E-lenders, portals and aggregators need HKMA’s consent to use a “banking name” l Offshore internet banks should comply with rules on advertisements directed at persons in Hong Kong

15. 15 Virtual banks l Some local banks have already indicated their intention to set up separate virtual banks l HKMA has recently issued a Guideline on VBs »objective is to accommodate VBs without disruption to the system l Underlying theme is to remind sponsors that VBs must have substance rather than simply be concepts l VBs are subject to the same risks as conventional banks and should be subject to the same prudential criteria l Don’t be blinded by the technology!

16. 16 Key features of our Guideline l VBs must fully address the various risks to which they are exposed (including security) »need for independent assessment of security controls l Appropriate balance to be struck between acquisition of market share and earning a reasonable return l Local VB cannot be newly established except through conversion of existing local AI l Local VB should be at least 50% owned by a well established bank

17. 17 Offshore internet banks l One of the features of the internet is that it removes physical boundaries l Will make it easier for overseas banks to use the internet to attract offshore deposits from Hong Kong residents l In doing so, they should comply with our advertising rules but, »how to enforce? »what is the legal position of ISPs who transmit advertisements? l Cross-border cooperation with other regulators will become more important l Meanwhile, depositors should beware!

18. 18 Conclusions l Internet banking is clearly the way forward for the banking industry and the banks in Hong Kong are well placed to capitalize upon this l However, the task of managing the change will not be an easy one and the economic benefits, in the short-term at least, are uncertain l It will be another factor in increasing the intensity of competition in Hong Kong and it may help to accelerate the industry consolidation which must inevitably come