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The Future Of Banking: Growing Digitalization Of Brazil's Financial System Will Foster Efficiency And Intensify Competition

The Brazilian banking sector has been evolving rapidly, not only through the digitalization of existing banks, but also through the emergence of several digital-born banks, payment institutions, and financial technology companies (fintechs). In S&P Global Ratings' view, this shift was stimulated by changing customer preferences related to the convenience and speed of services used, perception of poor service quality or excessive fees from brick-and-mortar banks, and the relatively low access to credit in Brazil. The Brazilian central bank also enabled the transition through a number of initiatives to promote competition and push down the cost of credit in the country, such as regulations introduced in 2018 to allow fintechs to broaden their product offerings by letting them extend credit directly to borrowers without banks as intermediaries.

Digital Players Are Focusing On The Credit Card Segment

In terms of product offerings, digital banks and fintechs in Brazil mainly grant credit cards--most of them without fees or at lower rates than larger players historically have charged. Despite the increasing number of payment institutions and new players gaining market share in credit cards, we still view the industry as commanded by banking institutions. Banks hold 98% of market share by assets as of June 2021.

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We expect traditional banks to keep fighting to compete in the credit card sector by improving their credit card offers and increasing the range of benefits to customers, such as annual fee exemptions, reward miles, discounts at partner stores, travel assistance, and cash back. Moreover, large banks have kept investing in technology to keep up the pace of innovation without damaging their bottom-line results. Meanwhile, digital players have yet to prove their business model pays off, because despite receiving several rounds of investments at high valuations, most of them don't yet have stable profits. Nevertheless, during 2021 so far, we've upgraded several digital banks mainly due to stronger capital positions as a result of the abovementioned investment rounds, such as the upgrades of Banco Inter (to 'brAA+' from 'brAA') and Nubank (to 'brAA-' from 'brA-').

Central Bank Aims To Level The Playing Field For Digital Entities

Part of the financial system's evolution is being fostered by the Brazilian central bank. Following its agenda to increase efficiency and foster competition, the central bank began implementing the Open Banking Initiative in 2021. Privacy and data protection are among the pillars of the initiative, as the central bank aims to promote a more inclusive and competitive business environment while still preserving customers' security. The initiative's platform will allow customers to share their personal data with participating institutions with the goal of reducing information asymmetry, and, consequently, allowing customers to receive better offers of products and services with lower costs and interest rates. Shared data includes current account information, detailed account transactions, credit card transactions, and credit history.

The rollout of open banking has prompted financial entities to review their strategies in order to create more innovative and effective products. In our view, the fact that traditional banks will no longer be the sole holders of customers' information could change the current competitive dynamics, prompting players that currently offer mainly credit cards to explore a wider range of products. Additionally, we think the initiative will make the system more efficient because the sharing of information should lead entities to create new product offerings more quickly, as well as customized services that better fit customers' needs.

Traditional Banks Still Have Some Competitive Advantages

Existing brick-and-mortar banks in Brazil are making efforts not to fall behind the digital-only players and to stay competitive in this new arena. Larger banks have increased their digitalization in the past few years, with several banks reducing the number of brick-and-mortar branches and creating new virtual banks inside conglomerates. All of the major private players that lead the Brazilian banking sector today--with a combined market share of 72% of loans as of June 2021--have created new digital institutions inside their structures.

Table 1

Private Banks With Digital-Only Banks In Their Structures
Itau Iti Founded in 2019 as a digital wallet, now offers also a free digital account, withdrawals, and credit card. Reached over 8 million users, with more than half of them conquered this year.
Ion New investment platform that, other than regular products, offers a tool to aggregate multiple portfolios in one place, including those based in other financial institutions. *open banking*
Banco Bradesco Next Created in 2017, now with 5.4 million users, the digital account offers a debit and credit card, savings account, investment platform and market place. 77% of Next's customers are not Bradesco account holders.
Bitz Digital wallet created by Bradesco in 2020, offers debit card and transactions.
Banco Santander Superdigital Acquired by Santander in 2017, and with around 2 million clients in Brazil in 2021, the digital initiative provides cards (debit and credit) and personal loans.
BTG Pactual BTG+ With BTG Digital investment platform available since 2016, BTG+ was created to offer all digital-account tools. The strategy is to reach 4.5 million clients in 3 years.
Banco Pan In April 2021, BTG Pactual acquired full controlling stake in Banco Pan. The subsidiary makes up a large part of the parent's ongoing strategy, and complements BTG's current wholesale and investment banking businesses, offering lending and digital banking facilities for the lower-income retail segment.

New players have the competitive advantage of smaller structures, more agile systems, and better customer experience (with generally better digital apps and more consumer-focused approaches). However, conventional banks benefit from well-established franchises, brand recognition, and reputation obtained after decades of operating in the country. Furthermore, due to their operational track record, large banks have more experience when dealing with fraud and cyber security risks, which are currently very significant and are highlighted in the central bank's agenda after recent waves of scams and frauds involving PIX (a system launched last year by the central bank that allows for money transfers using smartphones).

Strong Growth And Increasing Relevance Of Digital Players Come With A Regulatory Price

As large banks in Brazil started to question the regulatory asymmetries between banks and fintechs in terms of compliance, taxes, and capital allocation, the Brazilian central bank opened a public consultation on the potential prudential rules for domestic payment institutions. The new draft rules were motivated by an increase in the complexity of the services provided by fintechs and additional risks incurred by digital players, and, therefore, a need to establish regulations compatible with the new scenario.

Finalized in late January 2021, but still not implemented (waiting on congressional approval), this new regulation may change the prudential treatment the government gives to payment institutions. The central bank has said its main goal is to have capital requirements compatible with the volume of transactions of each group of institutions, covering credit, operational, and systemic risks.

Since 2017, the central bank has classified financial institutions into five segments (S1-S5), depending on their size and risk profile--at the top are the large banks, while credit cooperatives and fintechs are at the base. Current regulation states that payment institutions' capital requirement is 2% on the transactions carried out in the last 12 months, but the proposal submitted to public consultation would divide the payment institutions into three large groups:

  • Type 1: Controlled by a financial institution;
  • Type 2: Controlled by a payment institution and not integrated with a financial institution (such as Mercado Pago, Nubank, PagSeguro, and Stone); and
  • Type 3: Controlled by a payment institution but integrated with a financial institution.

The new regulation would establish a scale of requirements for each group to follow, with progressive implementation until 2025. Type 3 groups will fall into one of the existing segments (S1-S5), subject to the prudential regulation for each of them. Payment institutions and Type 2 conglomerates will follow a new definition of regulatory capital, moving to the payment institution reference equity (PRip) from the current equity adjusted by income accounts (PLA). The methodology established for calculating the PRip minimum requirements aims to provide coverage for the risks associated with the payment services and the risks arising from all other activities, enabling these entities to absorb unexpected losses.

Finally, Type 1 conglomerates will calculate a new portion of risk-weighted assets related to payment activities, according to the same methodology applied to these operations for Type 2 and Type 3 conglomerates--with the methodology for Type 1 no longer only focused on credit risk. The exception is Type 1 conglomerates classified as 'S1', which will remain subject to the credit risk methodology following the Basel criteria.

Changes In Competitive Conditions Will Likely Benefit The Financial System

In our view, the recent and proposed regulatory updates will help level the competitive field, generate more symmetric regulation (where not only the largest banks have to comply with requirements), and strengthen the financial industry as a whole. However, we think the proposed changes will likely bring challenges to the fintechs because they'll have to deal with increased capital requirements and possible additional costs associated with the new requirements. While these changes will create a more complex financial ecosystem, in our opinion the proposed adjustments will also stimulate competition and consider the specifics of each player, without undermining the smaller ones that could lack the capacity to deal with more rigid regulations and so penalize the fintech sector.

The imminent entrance of big tech companies like Google, Facebook, and Apple into digital financial services could also shake up existing players and be a focus of regulators. With the advantage of a large amount of existing users, and consequently, customer data, tech giants could increase the competition in the system even more. However, regulators could delay the rollout of their entrances. In Brazil, WhatsApp pay, a feature that allows users to send and receive payments directly inside the app's conversations, had its launch delayed for nearly a year. Citing concerns over potential threats to the national financial services system, authorities suspended the system and only approved it after months of testing and evaluations related to privacy and market competition.

While we think the changes in the Brazilian financial sector's competitive landscape will make the system more efficient, we don't expect these developments to affect our ratings. The increase in competition and the open banking initiative could bring benefits to the entire financial services industry, not just specific entities. Furthermore, as a next step to the open banking initiative, open finance is still to come and will allow for even more information sharing, and with fintech's improvements in accessible and convenient financial services to clients, we see them having an essential role in this future transition.

Additionally, we think the central bank will likely roll out the new regulations gradually, and since nonbank financial institutions (NBFIs) have already been strengthening their capital positions through the capital markets, we don't think the new requirements will have a significant impact on the NBFIs.

This report does not constitute a rating action.

Primary Credit Analyst:Nicole Lazari, Sao Paulo;
Secondary Contact:Guilherme Machado, Sao Paulo + 30399700;

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