Will the digital economy, in which conventional business models are reimagined and moved online, change the future of banking in Brazil as it has done with so many other industries around the world? There are mounting signs of such a shift. As of September 2017, the number of financial technology firms (fintechs) in Brazil rose to 309 from 219 the previous year, according to "Finnovation". Known as "disruptive players", 28% of these entities operate in the payment business, followed by corporate financial management (19%), and the lending segment (12%). Lending from fintechs is likely to gain momentum in Brazil following the recent approval of a new regulatory framework. In addition, eight digital banks are currently operating in the country, according to Finnovation.

In view of these factors, the market's reaction to Banco Inter S.A.'s April 27, 2018, initial public offering (IPO) is providing evidence of how Brazil's banking industry is pushing in that direction. The online bank raised a significant amount of cash (R$722 million or about $200 million) to increase its equity by 2.4x, demonstrating the market's appetite and growth expectations that there is in fact a place for banks with digital accounts, no branches or tellers, fewer fees, and the flexibility of offering customers easy access to banking services. As a result, a growing number of e-banks and fintechs is now looking to raise funds through the stock market. This recent development is a stark contrast to one for the past six years, during which Brazil's banks backed away from public offerings due to difficult market conditions and political upheaval in the country.

Despite a new breed of competitors, S&P Global Ratings doesn't expect significant changes in Brazil's large, traditional banks' dominant business positions for several years. That's largely because online-only players still face challenging business and operating hurdles, while large banks have been investing in digital strategies and acquiring some of the new players to compete in this segment.

Dynamics In Brazil's Banking Industry Are Increasingly Shifting

Banco Inter is the first online bank to go public in Brazil and the first one to do so in the entire financial industry since 2012. Gyrating market conditions, a massive corruption probe that has implicated a sizable portion of the country's business and political establishment, and severe economic recession between 2015 and 2017 have prevented domestic banks from going public in the past six years. The Brazilian banking sector represented only around 16% of the traded volume in IPOs in the past 10 years. The last big wave of IPOs in domestic banking industry occurred in 2007 amid the small players' rising aspirations to diversify their business models, reduce funding costs, and take away market shares from large banks. However, traditional banks still have the upper hand, while delisting has been the main trend among the smaller lenders amid tough credit conditions and low demand in the equities market for these institutions (see chart 1).

Chart 1

Banco Inter's IPO came in a context of increasing debate over the digital banks' capacity to take market share from large banks and improve their profitability over time. In our view, the online banks' rapidly rising client base (see chart 2), along with high multiples in Banco Inter's IPO, are pointing to the rise of the nascent industry in Brazil. Unlike the last IPO wave, digital innovation is offering the opportunity for Brazil's small banks to attract low-cost retail funding in order to offer a broad range of products and services that were too costly to do so 10 years ago.

Chart 2

What's Holding Back The New Players?

Nevertheless, in our view, online banks in Brazil have yet to deliver consistent results given their choppy performance and short track record because most of them have started operating only in the past three years. Despite the increasing client base, the capacity to generate revenue will rely on e-banks' ability to increase cross-selling sales, the use of a wider range of products among new clients, and to deepen their asset allocation into profitable businesses such as lending. For example, digital banks may have accumulated substantial funding bases during the last few quarters, but most of them have been allocated in public bonds because of a still muted demand for loans among the disruptive players' clients. That's bound to change once Brazil's economic recovery is entrenched and political turmoil diminishes. However, as seen in the past, aggressive credit growth, combined with a fragile economic recovery, could widen banks' credit losses and impair market confidence. In addition, the ongoing disruptive innovations and industry stresses have yet to test the resilience of online banks' performance given their currently small scale and relatively short operating history.

Fintechs Are Getting In On The Action As Well

Apart from the rising popularity of digital banks, fintechs have also increasingly been offering their services to Brazil's younger generation in the last few years. Although these entities usually focus on specific products linked to the domestic payment system, such as credit cards, regulations have restrained fintechs from offering a wider array of services such as personal loans. In addition, rules required fintechs in the past to partner with traditional banks in order to grant loans to clients, which added costs and complexity to their business models.

As part of the Brazilian financial authorities' attempts to decrease banking spreads and fees, bolster credit growth, and to expand financial services in the country, the national monetary council (Conselho Monerário Nacional) has published two resolutions (Resoluçãos 4,656 and 4,657) in April 2018. The new regulations allow fintechs to run their own banking services such as lending, payment collections, and insurance brokerage. Fintechs interested in lending are now able to do so by seeking licenses that come in two varieties. The first one--"Sociedade de Empréstimos Entre Pessoas" commonly known as 'peer-to-peer lending'--enables fintechs to grant loans without an intermediary (traditional banks). The regulation caps the individual loans at R$15,000 and precludes fintechs from using their own capital to grant loans. The second one--"Sociedade de Crédito Direto"--requires online lenders to employ their own capital for loans disbursements, although they may use securitization (only to qualified investors) to leverage their portfolios.

Despite the regulatory aim to expand the fintechs' operations, the latter are now subject to the central bank's operating requirements and supervision. Existing and new players need to adapt their business models, internal processes, systems, and controls in order to comply with the resolutions, which compound operating challenges in the short term. But we believe this burden to be manageable, because the central bank's 'Agenda BC+' seeks to promote fintechs' expansion in Brazil and give legal clarity to this segment. We view as positive the regulation and supervision of this segment given the increasing use of digital channels in the Brazilian payment system.

What Impact Has The Financial Innovation Made On The Large Banks So Far?

Brazil's largest banks have decided to jump into the new field to prevent the digital boom from threatening their services. They have made extensive investments and acquisitions in digital service developments in the past two years. Big banks have expanded their services through mobile apps, digital platforms for investments, and banking account services. Itau Unibanco Holding S.A.'s acquisition in 2017 of a 49.9% stake in the financial services and brokerage firm XP Investimentos underscores the large banks' increasing attention to the new developments. In contrast to restrictions on investing in products that only banks manage, XP Investimentos grants access to a broad range of investment products that multiple financial institutions offer.

In our view, competition in the financial tech industry should continue to increase as innovations provide clients with simpler, faster, and lower-cost services. However, we don't expect significant changes in the large Brazilian banks' business positions in the short to intermediate term given their solid leadership in multiple financial services (lending, insurance, asset management, brokerage services, among others) and substantial investment capacity to take advantage of new technological opportunities. The country's three largest banks control roughly 60% of total deposits in 2017, up from 54% in 2009. This is higher than in other countries across the region and only comparable to that of the Peruvian financial system (see chart 3). In addition, the exit of large international players from Brazil contributed to a further market consolidation in the past two years. In 2016, HSBC sold its Brazilian operations, which accounted for 1.7% of total loans and 2.7% total deposits in the country, to Banco Bradesco S.A.. Furthermore, Itau Unibanco acquired Citibank's local retail unit in 2017, which accounted for roughly 0.2% of total loans and 0.3% of total deposits.

Chart 3

Despite A Promising Potential, Disruptive Players Have A Long Way To Go In Transforming Brazil's Financial Industry

The rising attention to Brazil's fintech startups and digital banks is likely to result in more IPOs during the second half of 2018 and the following years, depending on market conditions. However, they will face enormous business and operating challenges in order to claw some market share from large banks in the concentrated Brazilian banking system. Furthermore, concerns about online fraud and cyber attacks aren't yet fully addressed, although the regulator released a resolution (Resolução 4,658) in order to establish minimum cyber security standards amid the increasing use of electronic payment systems and technological innovation in the financial sector. Financial institutions will have until May 2019 to implement cyber security policies and appropriate internal controls. Finally, we also have yet to detect signs of credible threats to large banks' earnings capacity and very strong business positions in domestic market given their leading status in multiple financial businesses and in their investment capacity to cash in on the digital gold rush.

Only a rating committee may determine a rating action and this report does not constitute a rating action.