Digital banks face asset quality risks

DIGITAL BANKS in the Philippines face asset quality risks as individuals in their target market, the underserved segment, have lower incomes and lack credit history, Fitch Ratings said.

“Emerging markets in APAC (Asia-Pacific) generally have lower credit and bank penetration than developed markets, offering digital banks a larger pool of untapped customers by avoiding direct competition with incumbents for lending,” the debt watcher said in a report released on Wednesday.

“However, we believe that the potential pool of bankable customers may be constrained by their significantly lower income and/or very limited credit or payment history that make it challenging for banks to price loans adequately. This is evident from the asset quality performance of some Philippine digital lenders, when their aggregate nonperforming loan ratio shot up to 14.1% in July 2024 (December 2022: 5.9%), resulting in credit costs that almost offset their entire interest spreads,” it said.

There are six licensed digital banks in the Philippines: GoTyme Bank, Tonik Digital Bank, Inc., Maya Bank, Overseas Filipino Bank, UNObank, and UnionDigital Bank.

The Bangko Sentral ng Pilipinas (BSP) has approved the lifting of the moratorium on the grant of new digital banking licenses starting January next year, opening four new slots.

The latest BSP data showed that Philippine digital banks posted a combined net loss of P4.11 billion at end-June and had P105.37 billion in assets as of end-August.

Fitch said majority of digital banks in the APAC region also target underserved retail and small and medium enterprises (SME) as their main borrowers, which exposes them to higher credit risks than their traditional counterparts.

“Nevertheless, we expect these banks to continue to derive a significant portion of their business from the underserved segments in the near term to preserve or improve profitability, or as per their business commitments to the regulators. These structural features are likely to persist for most of the digital lenders in APAC,” it said.

The report highlighted the differences between digital banks in emerging APAC markets like the Philippines and those in developed markets in the region and how it has affected their profitability.

“The majority of digital banks in APAC are still loss-making, reflecting in part their limited operating history, though a number of lenders have turned profitable or have narrowed their losses in recent years as they rebalance their asset compositions and adjust to the change in operating environment,” Fitch said.

“Most of the profitable players are supported by large conglomerates with complementary ecosystems, particularly in areas such as internet platforms, e-commerce and communication applications,” it said, citing digital lenders in Korea, China, and Japan.

However, digital banks in developed APAC economies face challenges like high banking penetration and intense competition.

Meanwhile, online-only banks in both developed and emerging markets have higher-risk, price-sensitive business models as they mostly source their income from interest spreads, Fitch noted.

“In most APAC markets, we expect loan contribution to rise as digital banks continue to optimize their balance sheets, with unsecured retail and SME segments likely to be the key growth drivers. The declining interest rate environment is also likely to accelerate the shift as digital banks’ risk appetite returns,” it said.

“Their enlarged exposure to these higher risk segments leaves them more vulnerable to swings in economic conditions and interest rates. This was also evident from their much faster rise in impairment costs relative to the system average last year, especially in markets that experienced steep rate hikes such as Indonesia, Hong Kong and the Philippines. We believe these increases are also a function of the digital lenders’ heightened risk profiles. On the other end of the spectrum, digital lenders in Japan are among the most conservative in the region, reflected in their almost zero credit costs in the past three years.”

Fitch added that the regulatory landscape of digital banks in the region varies by country, and “their ability to adapt and optimize their business models will be crucial towards achieving and sustaining profitability in their competitive markets.”

“The digital banks’ rapidly growing presence has generally intensified funding competition within their local markets. Some digital lenders in the Philippines and Indonesia, for example, are aggressively offering time deposit rates that are almost twice the rates offered by the incumbents. These promotional rates are unlikely to be sustained in the longer run, but the keener competition has dampened the net interest margin of several smaller traditional lenders that had to compete fiercely with the digital banks for deposits. Those with lagging digital capabilities are also likely to be vulnerable to intensifying competition,” it said.