The Age of the Digital Bank

"The Rise of Digital Banks and Their Impact on Traditional Banking"

The popularity of "digital banks", which provide banking services exclusively through electronic service channels and have no physical branches, is growing rapidly. In this article, we will endeavour to convey to you certain fundamental matters concerning "digital banks".

We are witnessing how digitalisation, which has spread to almost every sector alongside advancing technologies, is also transforming financial services. It can be said that banks, one of the most important elements of the financial sector, have been affected by this transformation and that digital banks are one of the most significant parts of that transformation.

Known around the world as "neobanks", "challenger banks" and "virtual banks", the first examples of these banks emerged as "online banks" and have continued to develop. Today, highly successful digital banks have been established across the globe (e.g. the United Kingdom-based Monzo and Starling Bank, and the Sweden-based Klarna), and these banks have acquired a large number of customers.

Digital Banks Around the World

Around the world, ventures such as BankSimple planted the first seeds of digital banking, and in the ensuing period the number of digital banks and their customers began to grow rapidly.

According to projections made in the United States of America, as of 2022 the number of customers holding an account with a digital bank stood at 23.7 million, and this figure is expected to reach 34.7 million by 2026.

In some countries digital banks are required to obtain a restricted "virtual banking licence", while in others they must obtain a "full banking licence". For example,

• In Hong Kong, virtual banks operate under the regulation of the Hong Kong Monetary Authority (HKMA), and the first virtual banking licence in that country was granted in 2018.
• In the United Kingdom, Starling Bank obtained a UK banking licence (albeit with restrictions) in 2016.
• Monzo has been authorised as a bank by the competent authority in the United Kingdom.
• Revolut, on the other hand, operates as a fully licensed bank in most EU countries.
• Klarna has been authorised with a full banking licence by the Swedish Financial Supervisory Authority.
• N26 has been granted a banking licence by the European Central Bank (ECB) and the German Federal Financial Supervisory Authority (BaFin). Since July 2016, N26 has continued its activities as a fully licensed bank subject to the regulations of the European Central Bank.

Under their licences, these banks are able to offer their customers services such as deposit accounts, loans and payment services, either subject to restrictions or under their full licences, solely through digital channels and without any physical branches.

Although digital banks are highly open to innovation and change, in many countries they carry out banking activities subject to a separate licence. Each country, within the framework of its own legal order, strives to create an appropriate space for digital banks and to regulate their activities. Nevertheless, it would not be wrong to say that digital banks do not have the freedom to act as freely as they might wish.

Digital Banks vs Traditional Banks

The institutions we call traditional or conventional banks essentially offer their customers a wide range of services such as loans, deposits, custody services, fund transfers, credit cards, factoring, and the purchase and sale of capital market instruments.

Traditional banks offer those of these services that are suitable through electronic service channels, but also through their physical branches. Although the provision of banking services through electronic service channels is a significant innovation, branch banking is still the primary service delivery method of traditional banking. Even though branch banking has lost ground in recent years (for example, while the total number of branches of deposit banks in our country was 10,987 in June 2017, this number fell to 9,567 in August 2023), it continues to exist as the largest service channel.

Digital banks, by contrast, provide all their services through electronic service channels. At this point it can be said that, while the provision of banking services through electronic service channels is merely a feature for traditional banks, for digital banks it is their very reason for existence. From this perspective, the fundamental distinction between digital banks and traditional banks lies in "how" they provide services to their customers. In addition, digital banks' customer experience, ease of use, and competitive range of products and fees bring them closer to the segment referred to as the "unbanked" — those whom banks do not wish to reach or serve. Thus, a distinction also arises in terms of the target customer base. The precise target customer base of digital banks consists of those who do not have access to a bank or who prefer not to have access to a bank, young people, small enterprises (SMEs) and consumers.

We should also note that there are certain challenges for digital banks. These are:

• the absence of the customary face-to-face customer service,
• the fact that they can offer products and services only subject to restrictions,
• and the need for time to build trust compared with traditional banks.

Indeed, in the light of the research conducted, we can say that, in terms of volume and customer numbers, digital banks have not yet reached the level of being an alternative to and competitor of traditional banks worldwide. However, we cannot pass over without noting that, in line with the new generations' approach to banking and the requirements of a developing world, they are on their way to becoming strong competitors in the near future.

The Present and Future for Digital Banks in Türkiye

In our country, the work carried out for a long time on digital banks has finally been concluded, and the "Regulation on the Operating Principles of Digital Banks and on Banking as a Service" was published in the Official Gazette dated 29.12.2021 and entered into force on 01.01.2022.

Under this Regulation, the procedures and principles concerning the activities of branchless banks that provide services solely through electronic banking service delivery channels have been established, and a digital bank has been defined as a "credit institution that provides banking services through electronic banking service delivery channels rather than through physical branches". Accordingly, a digital bank may be established only as a deposit bank or a participation bank. This is because, under the Banking Law No. 5411, the term "credit institution" refers to deposit banks and participation banks.

When the provisions of the Regulation are examined, it can be seen that a digital bank is defined not as a new type of bank, but as a sub-type of a deposit bank or a participation bank.

For the establishment of digital banks, the conditions required for the establishment of a bank as set out in the Banking Law No. 5411 must be fulfilled. In addition, the provisions contained in the Regulation must also be complied with.

Since the date on which the Regulation entered into force, the Banking Regulation and Supervision Agency (BDDK) has granted establishment and operating permits to a number of banks. We foresee that, in the near future, many players operating in the financial ecosystem will apply to the BDDK to establish a digital bank in order to expand the sectors in which they operate and to benefit from the advantages thereof.

The Activities of Digital Banks

The Regulation restricts, on the basis of customer type, the lending activity that constitutes a core banking activity for digital banks, which are essentially credit institutions. Accordingly, digital banks may extend credit only to financial consumers and to small and medium-sized enterprises (SMEs). According to the Regulation, there are also certain exceptions to this lending restriction; the following

• Digital banks carrying out transactions counted as credit under Article 48 of the Law by operating in interbank markets or in money and capital markets,
• Extending credit to other banks,
• Extending foreign-currency credit to enterprises exceeding the SME size

will not constitute a breach of the restriction in question.

Following this general lending restriction, the Regulation also introduces a restriction concerning the amount of credit that may be extended to a single customer. Accordingly, the total unsecured cash consumer loans that a digital bank may extend to a customer (holding the status of a financial consumer) may not exceed four times the relevant customer's declared average monthly net income as confirmed by the digital bank and, where the customer's average monthly net income cannot be determined, may not exceed ten thousand Turkish Lira. This restriction introduced for financial consumers will not apply to certain consumer loans:

• Credit cards and overdraft accounts,
• Consumer loans to be extended against collateral, and
• Non-cash loans.

Consequently, a digital bank may allocate a credit card and overdraft limit to a financial consumer without being subject to this restriction. However, we must immediately point out that the general restrictions applicable to credit cards will a fortiori apply to digital banks as well. Likewise, digital banks may extend cash consumer loans without being subject to the restriction by taking some form of collateral, or may again extend non-cash loans without being subject to the restriction. No provision has been made here regarding the type and ratio of the collateral to be taken. On this matter, the Board is required to make additional regulation.

There is no restriction as to customer type with respect to collecting deposits or participation funds. That is, digital banks may establish a deposit relationship with financial consumers, SMEs, or customers exceeding the SME size.

Digital banks, which provide their services through electronic banking service delivery channels, may also provide custody services in the digital environment. With the exception of custody services carried out in the digital environment, it will not be possible for digital banks to provide safe-deposit box and safekeeping services.

ATM services are, of course, also among the services that digital banks may offer. Apart from these services, digital banks may also provide services through member merchants.

Finally, we should note that the Board has left the door open to lift these operating restrictions entirely, or within the framework of a transition plan it deems appropriate, provided that certain conditions are fulfilled.

In conclusion, as a result of the increasing digitalisation in every area of life, we believe that digital banks will increase their market share against traditional banks and that the downward trend in the number of traditional banks' branches will continue.