Abstract: The boom of information technology has posed new challenges to local banks. Compared to big banks and IT companies, small banks are disadvantaged in terms of capital, valuation, customer base, payment systems, operation model and IT capacity. They should recognize the difference, and focus on serving local clients. By strengthening customer relations and better leveraging knowledge of local businesses, these banks could better serve customer needs and forge a shared future for banks and enterprises. They should also study the development of IT and its impact on the banking business, and upgrade strategies and business models accordingly.
At the 10th meeting of the Central Financial and Economic Affairs Commission held on August 17, 2021, Chinese President Xi Jinping described common prosperity as “an essential requirement of socialism.” Stressing the need to adhere to “people-centered development philosophy,” he also called for “promoting common prosperity while pursuing high-quality development.” This has aroused heightened attention and heated debate over the issue of common prosperity and income distribution. Today’s annual conference of the China Society for Finance and Banking themed “Finance in Support of Common Prosperity and High-Quality Development” comes at the right time.
I would like to share some of my understanding and thoughts from an economic and financial perspective on “IT development and outlook for local banks,” an important topic given the role that local banks can play in promoting common prosperity and high-quality development.
I. IT DEVELOPMENT HAS BROUGHT NEW CHALLENGES TO LOCAL BANKS
The rapid development of IT, especially the Internet, big data, cloud computing and artificial intelligence (AI), has boosted the growth of many emerging FinTech and BigTech companies; it has also created new channels for financial services, especially bank services, while bringing unprecedented challenges. Against this backdrop, local banks, mainly community and village banks but also the local branches of larger banks, are finding themselves in a new situation filled with new risks and possibilities, and the scope and model for them to serve the national economy have changed accordingly.
The banking sector is now heavily deployed with IT that enables management of accounts and clients, payment systems, lending decision and pricing. The user interface (bank branches in the past) and payment methods today are very much different from before. Thus, it’s just inevitable that the IT boom poses new challenges to the banking sector.
Positioned to serve local communities, small banks were once convinced that they would be able to survive and thrive if only they could have a small share of the customer base. In addition, they had the support of local governments. They also spent a lot of efforts copying the business of large banks: whatever the large banks do, they tried to follow suit, such as cross-regional operations and focusing on large clients.
However, as IT developed, new types of financial service providers entered the competition, along with other non-banking financial institutions. Things have thus changed: small banks can no longer easily acquire the business that bigger banks can’t attend to. The deciding factor is their competitiveness, especially their information capacity.
Functioning partly as an information service provider, the banking sector has to establish its own information systems, comprised of hardware, basic software and application software. Banks could choose either to develop the application software themselves or outsource it; and with limited technological strength, small banks have tended to choose the latter.
As FinTech develops, in emerging areas such as Internet-based business, client management and cloud computing, many of the software developers have become system-wide integrated service providers, capable of designing software that is more advanced and comprehensive as the banks require. Soon after, Software as a Service (SaaS) emerged, and software now drives essentially all major bank service procedures. Many FinTech and BigTech companies also believe themselves to be capable of providing more advanced financial services including application software, system integration and even SaaS. Some of them think that it would be more efficient if banks, rather than asking outsourcers to customize software, directly purchase an entire package of programs they have prepared instead.
Should IT systems replace all the business procedures, there would not be really much room left for small banks, with their advantages narrowed down to having banking licenses and deposit insurance, among a few others. In terms of customer acquisition and management, small banks are less competitive than FinTech and BigTech companies; they are not as good as IT companies in terms of big data and credit investigation, now that these abilities are increasingly important for lending management; they are also no match to IT companies when it comes to wealth management, which is increasingly reliant on intelligent investment advisers. Besides, small banks may even lose their existing advantages going forward, such as possessing licenses and the associated deposit insurance, because in the future, the benefits provided by a license may be negligible. What’s more, it wouldn’t be hard for BigTechs with high market valuations to attract capital or talent, further sharpening their edges.
II. LOCAL BANKS STILL ENJOY IMMENSE POSSIBILITIES IN THE IT ERA
How can local banks push through these headwinds and explore other values they can provide? They need to do it in a “l(fā)ocal” way, by tapping into their own, unique advantages with a focus on local customers. They can’t keep following everything big banks do, like Internet-based customer management, credit investigation-based lending, investment adviser-based wealth management, conduct business through purchased software, or take a slice of the cake from big banks. That way, they would lose their unique strengths. And in the future, local governments would not be able to provide so much support as before.
We have already seen such efforts. After the city of Wenzhou experienced financial problems in 2012, there was a heated discussion as to the future models for small banks. Those in Taizhou city provided the useful experience of focusing on local customers, with a more in-depth exploration of local client information and business opportunities, which turned out to work very well.
Many insisted that small banks’ operations should still be Internet-based: they should work to acquire customers from across the nation rather than being geographically constrained; they should rely on credit investigation as the basis for deciding whether to lend or not, or seek support from technological companies. To what extent should lending decisions and pricing be based on big data and credit investigation remains a question open to discussion. After the global financial crisis broke out, the Financial Stability Board (FSB) and Basel Committee on Banking Supervision (BCBS) both advised banks to reduce reliance on external ratings which are pro-cyclical and risk more buck-passing (where management and staff responsible for the banks’ compliance and risk control are not held accountable for ill-advised decisions, as long as the decisions were based on external ratings). The Internet-based model may not be suitable for small banks, because big banks and IT companies have better Internet-based customer management abilities and access to credit investigation results, and they are more well-informed than small banks with richer data. In addition, the buck-passing risk could easily lead small banks to lose their ways.
By the way, China has managed to clean out the P2P lending problems in recent years, though at a great cost. It should be a lesson for us; for example, don't underestimate the experience and traditional business models accumulated over the years in the banking sector.
There is no denying that technological advancements could bring new technologies, paradigms, and even disruptive innovations, but it is also important not to be hasty in our judgment. From a technological standpoint, any kind of innovation or technology may be exciting when it first appears, and people may be inclined to believe in their immense effectiveness, but it may also be over-hyped.
As evidenced by P2P lending, what was rashly promoted proved to the false.
One of the mechanisms promoted by P2P online lending is: people usually save money in the bank and the bank decides who to lend it to, but in the future, thanks to the Internet, data will become more accessible and transparent, allowing depositors to bypass the bank and find potential loanees through the information system.
Such kind of publicity is highly misleading. On the one hand, the amount and complexity of information for loan business necessitate extensive and rigorous financial analysis, comparisons among firms in the same sector, analysis of industry characteristics, and even macro and international factors, which are far beyond the grasp of laypeople. On the other hand, even if they are familiar with a few companies, it is difficult to make a good decision without examining the entire sector and the economy.
In a nutshell, faced with various challenges, we must draw lessons from past experience to consider the opportunities and space for the banking industry, particularly the small banks, to serve the national economy, and to survive and thrive.
III. COMPARATIVE ADVANTAGE OF A LOCAL BANK IS SERVING LOCAL CLIENTS
Economic theories, especially in the international trade field, stress the importance of comparative advantages. Countries and businesses must figure out their comparative advantages so they can grow more competitive and expand their market shares. In other words, they need to exploit their strengths and not compete in areas where they are weak. So, what are the comparative advantages of local banks? Before answering the question, let's find out the advantages of the big banks and IT firms.
First, big banks. Big banks are licensed and have higher capital adequacy ratios, large customer bases, strong deposit bases, in-house IT staff, deposit insurance, etc. However, currently big banks' valuations are relatively low, with some still trading below net worth; big banks are subject to various restrictions, preventing them from diversifying businesses as FinTech firms can. Furthermore, bank branches will face a huge shock in the future. Some big banks in Western countries are seeking to convert their branches into units that offer integrated services (not just commercial banking), but this may need regulatory support.
Now turn to the IT companies. They attract more talents and capital, especially because their valuation is high, and thus they are able to raise more capital through the capital markets and other means. They have new potentials for customer management and deposit, particularly with network customers. Furthermore, the advancement of payment systems has provided IT firms with the ability to acquire, expand, and manage their customer base. Although most FinTech and BigTech companies do not yet have banking licenses, there is still hope; however, for the time being, they cannot provide deposit insurance with no licenses. In terms of information processing, an important component of banking business, FinTech and BigTech companies have built up relevant skills through the development of systems, software and SaaS. Moreover, IT prevails in the service of all financial sectors as they are not restricted by business divisions.
Small banks, on the other hand, have disadvantages in terms of capital, valuation, customers, payment systems, cross-sector capability and IT capabilities. One of the strengths of the small banks is their licenses and the deposit insurance they could provide, but if they compete with their weakness, the outlook is bleak.
As a result, it is even more critical for local banks to be rooted in the community, to better connect with local customers, and to capitalize on their comparative advantage of having information on local customers. This path offers plenty of room for development. There is also the comparison of efficiency and competitiveness between a centralized planned economy and a market economy. According to information theory, decentralized information can be processed efficiently at the local level to achieve supply and demand balance. In other words, information that can be processed and balanced at the micro level does not need to be passed on to a more centralized level.
Big data and data processing improvement will not change the logic of information efficiency. A lender could get some information about a loan applicant from the credit information system, but it also needs to examine the competitiveness and financial health of the applicant, e.g. by looking at its balance sheet, income statement and cash flows. In addition, it needs to judge the relative position of an enterprise in the industry, its prospects and advantages in an M&A deal, etc. These decisions cannot be made merely based on alternative data.
Because there is also conflict of interests among stakeholders, over-reliance on information processing for decision making could create incentives for data fabrication, leading to fraudulent behaviors such as faking sales, logistics or transaction volumes, manipulating market through illegal matched trades, as well as swaying public opinions via paid internet trolls and influencers. It is critical to have a somber understanding of such phenomena.
The success of some local banks in China has demonstrated that there is an active role for local banks to play. They can take advantage of their closeness to local customers to establish mutually beneficial bank-firm relations, and in this way, carve out a space in the market and leverage their unique advantages to serve the national economy. They would face a bleak future if they choose to compete in areas where others are better than them.
IT will continue to evolve dynamically in the long run, and the path of which is not yet fully visible. I hope you will pay attention to these trends and research this topic, particularly from the following perspectives.
First, it is important to pay great attention to the challenges brought by IT development, including the challenges it poses to the organizational structure, business development and regulation of banks.
Second, small banks continue to have a significant comparative advantage and role to play in the local context. Of course, this is already a departure from traditional banking thinking and will require some adjustments.
Third, local banks should play by its comparative advantages, instead of trying to leverage their weaknesses for development.
Fourth, the evolution of the banking system, including the future function of bank branches, could be a good starting point for research. To some extent, this could be extended to other types of financial institutions as well, as the reasoning is similar.
Fifth, in terms of overall research methodology, while in the past the main focus was on the business of banks and their role in the national economy, there may be a shift in the future toward analysis based on information systems and structures to guide financial institutions in making business choices and development strategies, so they could adapt to the new era, and contribute to the goal of common prosperity and quality development.
