OREANDA-NEWS. Brazil's large banks will have to rethink their digital strategy as the number of financial technology companies (Fintechs) grow, says Fitch Ratings. Still, at this point, we do not expect Fintechs to threaten the banks' credit profiles. Even with this rapid growth, the banking sector should remain dominated by large traditional banks and remain highly concentrated.

Brazilian banks face the challenge of competing with companies that are different from their traditional and sometimes rigid business models. To reinforce their footprints on the space, some banks have acquired or created partnership, incorporating local commercial banks that have moved to digital banking and online payments in recent years. However, banks with very costly operational structures will have to adapt quickly to new technologies, especially if they want to access new customers who are looking for more technologically advanced and consumer-friendly products. A modernized but reduced branch network should be more cost efficient in the long term, as branches and associated staff costs make up the bulk of the retail cost base at a larger bank. A lot of these costs can be removed via automation.

Higher mobile Internet penetration is shifting consumer behavior toward Fintechs as customers move to a digital-only channel. An increasing number of more agile start-up companies (most notably in the peer-to-peer (P2P) lending and digital payment segments) are tapping clients often underserved by traditional banks. In Brazil, there are around 150 Fintechs. These companies are growing and increasing their operations, taking advantage of gaps left by large and more conservative banks due to the more challenging operating environment in the past few years.

Fitch believes that regulation will play a key role in determining the survival rate and competitiveness of Fintechs in Brazil. As a relatively young industry, the local regulatory framework is not yet defined. This has supported the increase in the number of new firms, as they are not subject to the strict and complex banking regulation.

The Brazilian Central Bank already implemented a set of rules for nonbanking payment institutions and payment arrangers in 2013, but some rules are still not clear. Regulation for P2P lending is still lacking. The Comissao de Valores Mobiliarios (Securities and Exchange Commission) has established an Innovation Center of Financial Technologies to monitor the development and application of new Fintechs in the securities market. More rigid supervision could potentially increase regulatory scrutiny and increase operational costs for the sector, and it may affect the business model of some companies that usually operate with a very low cost base. Clear and transparent policies for new entrants should support the development of Fintechs in Brazil.

Fintechs will always have an advantage by being more agile and offering more customized and convenience alternatives. However, Fintechs have major challenges, including achieving economies of scale, strong competition from large Brazilian banks with larger capital availability and with a longer technology culture, regulatory development and the search for funding sources at competitive costs. The lack of a well-structured liquidity framework, distribution, scale, regulatory expertise and risk management culture may lead to consolidation in the sector, with larger banks incorporating niche Fintechs into their more complex structure.