The Brazilian central bank (BACEN) is moving forward with a number of initiatives to promote competition and push down the cost of credit in the country, which has much higher spreads than peer emerging economies. In this sense, last year BACEN introduced regulation to allow fintech companies to broaden their product offerings by allowing them to extend credit directly to borrowers without the intermediation of banks. Moreover, upstart financial firms with narrow range of products and low complexity have lighter regulatory requirements than traditional banks, in line with the segmentation approach for prudential regulation implemented in January 2017. Now, with the opening banking initiative, BACEN is entrenching competition in the financial services industry. So far, fintechs in Brazil have been focusing on serving customers that banks have shied away from, or on products that previously were burdened with the perception of poor service quality or excessive fees, such as credit card processing services to small businesses, or offering credit cards without fees. S&P Global Ratings has also seen digital players growing significantly on the brokerage business, offering an investment platform. We believe fintechs will increasingly become a force to be reckoned with, and the impact will depend on how traditional banks respond to the new competition and the particular vulnerability of their business models. So far, Brazil's banking authorities are willing to implement the necessary measures to let this business expand.

Open Banking Is Progressing Rapidly

On April 24th, BACEN started the process of implementing open banking with the objective of increasing efficiency and competition in the Brazilian financial system, by publishing a document that establishes the main guidelines of the proposed regulation. Through open banking, BACEN is also seeking to promote a more inclusive and competitive business environment, preserving its security and the protection of consumers. The new requirements that BACEN established indicate that banks will share the following information and services with the third parties:

• Products and services offered by participating institutions (location of service points, product characteristics, contractual terms and conditions and financial costs, among others);
• Clients' personal data, following the client's permission (including name, registration number in the Physical Register [individual taxpayer's register], membership, address, among others);
• Transactional customer data, also with prior permission (including deposit accounts, credit operations, other products and services that customers bought from financial institutions); and
• Payment services (including initialization of payments, transfers of funds, payments for products and services).

At the beginning, the participating members will be those in segments 1 and 2, as according to BACEN's segmentation framework (Brazil's largest 12 banks are currently all under those segments). Subsequently, this obligation may be extended to other institutions, at BACEN's discretion. Through open banking, bank clients could, for example, view on a single application the consolidated statement of all their bank accounts and investments. This application will also allow the transfer of funds or make payments without the need to directly access the particular bank's website or visit the branch to do so. BACEN expects the open banking model to be implemented in the second half of 2020.

The Need To Lower Credit Cost

Brazil has a higher spread than those of peer emerging economies, but the banking regulator has taken a proactive approach to tackle this distortion in recent years. A study performed by BACEN with data from 2015 and 2017 showed that the main contributor to the Brazilian banks' spreads was delinquency (37%), followed by administrative costs (25%), and taxes (23%). Delinquency rates in Brazil have been higher than in peer countries during periods of solid economic performance, mainly due, in our view, to a weak payment culture. In addition, administrative expenses remain high in Brazil even though domestic banks have been focusing in recent years to improve their efficiency by encouraging customers to use alternative channels such as internet and mobile banking. Finally, Brazilian banks have a relatively high tax burden, which is transferred to ultimate borrowers.

We believe the further development of open banking and the fintech sector in Brazil could help on two fronts:

• Enhance the pricing for risk capabilities by leveraging big data and alternative data to underwrite credit and develop credit scores for customers with limited credit history; and
• Cut administrative costs, given that fintech firms are not burdened with legacy operations, IT systems, and expensive branches.

Brazil Is Following The Global Path

Globally, open banking entered the limelight with the implementation of the 2015 Revised Payment Service Directive in the EU and the 2017 open banking directive in the U.K. In the U.S., some large banks, such as JPMorgan Chase & Co., Wells Fargo & Company, and Citigroup Inc. have begun to create their own API networks, and various regulatory bodies have published guidelines on key subjects concerning open banking.

We believe open banking presents both risks and opportunities to the banking industry. By collaborating with third-party service providers, banks have the opportunity to expand their platform and scope of their services to their customers, increase their relevance by developing a financial services ecosystem, and save costs by transitioning to digital channels. On the other hand, increased transparency and innovation could weigh on banks through heightened levels of competition. Retail and small and midsize enterprise (SME) borrowers are likely to benefit as the industry continues to evolve.

For years, banks have enjoyed sole ownership of their customers' data and have gained valuable insights from spending patterns and transaction histories. Under open banking, subject to authorization by customers, incumbent banks may also be able to access data of other banks' customers. Third-party providers may also be privy to the data.

Ultimately, we expect open banking developments to increase competition in the industry. The nature and extent of this effect is not yet certain but could be profound given the fundamental changes in how data is shared and used. Access to a client's entire financial profile across multiple financial institutions could allow banks and new competitors to create customized product offerings to meet each customer's unique needs and more accurately price for risk.

Broad applicability of open banking may also be applied to other industries and sectors, and open up opportunities for cross-industry partnerships and investments.

The Beauty Of Fintech

Fintech companies, with simple products, lower banking service costs, and a trendy marketing campaign appeal the younger crowd. Digital entrants also hold many potential benefits including bolstering financial inclusion through increasing access to finance for lower-income individuals and small businesses. SMEs are crucial for economic growth and job creation, but securing the financing can often be difficult. Fintech can offer services that are efficient and effective at lower scale, which could benefit SMEs and provide them with greater access to a wider range of funding options. Innovative products can be better tailored to their needs. Fintech is allowing banking customers to conduct transactions through their mobile devices, improving efficiency and the customer experience. Data aggregators can synchronize financial data from various sources and integrate bank accounts from various financial institutions, reducing the costs for business. By reducing information asymmetry in the marketplace, fintech is not only improving the ability to match investors, lenders, and borrowers, but providing a more level playing field that allows retail investors to have greater participation in the market.

Digital players can also provide advantages to banks through partnerships, which could reduce costs and redundancies, result in solid technical know-how, and increase efficiency. This could help lower the cost of credit for the system as a whole.

Regulatory Initiatives Have Helped Foster The Sector In Brazil

According to the latest report by Finnovista and the Inter-American Development Bank, Brazil is home to the largest number of fintechs in Latin America, with around 380 entities, 188 of which were launched in the past 18 months. The rapid growth was mainly driven in the segments of digital banking, trading and capital markets, lending and insurance. Currently, 16 companies are offering digital banking services in Brazil. The growth responds to regulatory incentives to support the entry of digital players aiming to boost the competitiveness of the sector, improve service quality and, ultimately, reduce credit cost to borrowers. In addition, the growing importance of application technologies in banking transactions and consumer services encourage ongoing investments in financial innovation, which trends favorably in the entire region.

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The New Players Come With Risks

Innovation associated with open banking is not without its risks, some of which are difficult to conceptualize and quantify. An obvious risk is fraud or the mishandling of data, which could be costly for a bank from both a financial and reputational standpoint. Other risks include cyber security risks, third-party reliance, contagion, and pro-cyclicality. In this sense, BACEN has introduced regulations to strengthen cyber security in Brazil.

On the other hand, banks may be disadvantaged regarding data sharing if regulations lack reciprocity in the nonbank financial institution or corporate sectors.

Could Fintech Pose A Threat To Traditional Banking In Brazil?

The unique nature of banking may offer some protection against the digital players. Customers typically build a long-term relationship with their banks, to which they entrust their money and personal information. Major concerns among bank clients are over payment transfers, data confidentiality, and controls to prevent fraud. They don't yet perceive banking services as a commodity, so we expect traditional lenders to remain the core players in the Brazilian financial system. Customers have yet to start changing banks frequently, because of the prevalent view that lenders aren't as easily replaceable as digital providers. However, we believe a shift could occur in the medium term as the new legal framework eases banking mobility and because a new generation of financial services clients is more open to the change. With that in mind, fintechs' strategy is to provide high-quality services at a competitive cost. But given that they don't typically offer the full range of traditional banking products and services, they need to convince clients of the value of their currently narrow range of offerings. Moreover, higher funding costs and the need to offer an economically competitive product make it difficult to show good operating performance. This is why, in our view, the FinTech business has not yet expanded as quickly as its potential may suggest.

However, banks are aware of the implications of coming changes, given technological "disruptions" in other industries. Traditional players are mindful that the future of banking is on the digital front, and will definitely influence the future of Brazil's large, traditional banks. All of them are looking to steadily rein in high costs by reducing manual processes, centralizing back office operations, increasing the number of standard operations carried out online or via mobile devices, and widening the use of their branches for higher-value activities.

In this sense, 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 in digital service developments in the past years. Big banks have expanded their services through mobile apps, digital platforms for investments, and banking account services.

We view fintech as the competitor, but not yet a game changer for banks' credit quality. Moreover, banks could benefit from the digital developments through partnerships with fintech startups, which could reduce costs and redundancy, enhance technical know-how, and increase efficiency.

However, we believe the rise of digital financial players as an increasingly powerful trend in the industry. The eventual impact on banks' credit quality will depend not only on how traditional entities respond to the new competition and the particular vulnerability of their business models, but also on the response of regulators to fintech's growing clout.

Related Research

• The Future Of Banking: Asia-Pacific Opens Up To Open Banking, April 10, 2019
• The Future Of Banking: New Rules Foster FinTech At Chile’s Banking Industry, Feb. 13, 2019
• The Future Of Banking: Does Banco Inter's IPO Point To A Potential Digital Banking Boom In Brazil?, May 30, 2018
• The Future Of Banking: Is Orange Changing The Color Of Banking In France?, Dec. 11, 2017
• The Future Of Banking: How FinTech Could Disrupt Bank Ratings, Dec. 15, 2015