Brazil’s big banks had it good for years.

A small club of institutions dominates the high street in Latin America’s largest economy, long notorious for its costly banking fees and borrowing rates, with their fat margins often the source of public anger.

“Profits are enormous at the banks. They are really excessive,” was the verdict in 2019 by one politician — not a leftist firebrand, but the country’s pro-market economy minister, Paulo Guedes.

But as the oligopoly faces a trifecta of low interest rates, the economic impact of Covid-19 and digital upstarts snapping at their heels, lenders are under pressure like never before to accelerate reforms and provide better value for money to clients.

The chief executive of the country’s biggest private sector bank, Itaú Unibanco, puts a positive gloss on what he describes as “a fierce scenario” when it comes to competition

“The Brazilian banking sector has been changing rapidly, and this is very good for both consumers and the so-called traditional banks,” said Milton Maluhy. But he admitted: “We need to be quicker and better for our products and services to outdo competition.”

Line chart of Return on equity (%) showing Brazil’s banking sector is highly profitable compared to peers

The five giants that tower over the country’s financial system — Itaú, Bradesco and Santander Brasil, along with state-controlled Banco do Brasil and Caixa Econômica Federal — have in recent years embarked on investments in technology in a bid to stop customers switching to challengers such as Nubank, Brazil’s internet banking unicorn.

Since the start of the coronavirus crisis, many have also deepened cost-cutting measures, with branch closures and redundancies. The need for reform is more urgent than ever with the pandemic having hastened the pace of digital change.

Regulators are attempting to boost customer choice too: the central bank is rolling out an “open banking” initiative, aimed at giving clients greater control over their data and boosting competition, and last November introduced an instant payment system that is free for individuals.

Christened “Pix”, it offers a way for ordinary Brazilians to avoid at least some of the range of charges that banks have typically attached to standard services, such as current accounts and money transfers.

Moody’s has estimated over the next year the banks could lose R$16bn ($2.9bn) of those fees, almost 10 per cent of the total earned, as free or cheaper alternatives become available. Fees account for about 30 per cent of bank earnings, according to the rating agency.

As with many Latin American countries, margins in Brazil’s banking sector are the envy of peers elsewhere. The average return on equity (ROE), an important industry metric for profitability, stood at 17.2 per cent in 2019, according to S&P Global Market Intelligence. That compared with 10.6 per cent in the US, 8.8 per cent in Asia-Pacific and 5.8 per cent in Europe.

“There’s a big debate going on in Brazil [on] what’s going to happen to the profitability of the big banks,” said Mario Pierry, an analyst at Bank of America. “Now interest rates have come down, they can’t just survive buying government securities — they need to start lending more.”

But the big lenders are not standing still. Along with around 1,500 branches closed and 13,000 job cuts last year, according to annual reports, many are pursuing copycat strategies to ape the fintechs’ success.

Line chart of (%) showing Lending rates are high in Brazil

This has ranged from launching their own digital banks and investment brokerages to tap into the wave of new retail investors in Brazil, through to acquiring stakes in promising start-ups.

Itaú now offers third-party products in its insurance and asset management businesses, while Santander Brasil has followed rivals by introducing a virtual assistant bot.

Bradesco has announced plans to float or sell a stake in its separate digital bank, Next, which does not charge fees and has 4m users, within the next couple of years.

“When you have lower margins, the only remedy for this is to gain scale,” said chief executive Octavio de Lazari Junior.

For consumers and businesses a shake-up is well overdue. Credit has traditionally been very expensive and often hard to access, partly a reflection of the high interest rates that were a legacy of the country’s long-running battles with inflation.

For a long time, the banks made easy returns by stuffing cash into high-yielding government debt. However, with the central bank’s benchmark Selic rate at 2.75 per cent, recently raised from an all-time low of 2 per cent, that model has come under strain.

The pandemic delivered a serious dent to earnings in 2020. Although lenders remained in the black, considerable provisions to cover bad loans contributed to the biggest percentage terms drop in two decades with sector-wide profits down almost a quarter, according to data provider Economatica.

But it is the confluence of competitive forces and regulatory changes that has raised questions about the longer-term trajectory.

Despite a downward trend over the past few years, borrowing costs in Brazil rank among the highest in the world.

Profitability of Brazil’s largest public banksGM290303_21X GM290303_21X

The average annual interest on a loan has crept up to 22 per cent for households and 11.3 per cent for businesses, according to central bank data.

Ilan Goldfajn, chair of Credit Suisse in Brazil and central bank president between 2016 and 2019, believes that low rates are here to stay and will eventually feed through into credit.

“Lending rates are still very high and they’re now going down over time — it’s a process.”

A jolt to the incumbents and their comfortable ways of operating has come from a band of homegrown fintechs with lower overheads and no branches.

Leading the pack is Nubank, which boasts almost 35m customers in Brazil out of a population of 213m. Following a $400m fundraising this year, it has a valuation of about $25bn, according to two people familiar with the situation. Other rising brands include Neon and C6.

Rafael Schiozer, a professor at the Fundação Getúlio Vargas, said while traditional banks had adapted their investment products they were still behind fintechs on the lending side. “They need to go faster, because the fintechs have credit operations that are easier to use and with better prices.”

However, there is some scepticism about how much of the lending pie the fintechs can grab. “At the end of the day, the new entrants in digital credit don’t have the balance sheet to keep all of the [loan] origination on their books,” said Jorg Friedemann, an analyst at Citi.

For the time being, incumbents still have the advantage of scale, brand power and physical presence.

Although low interest rates tend to squeeze bank earnings, they provide the conditions to expand lending in a country with a weak level of credit penetration.

“Brazil has never had a time like this in terms of [low] rates to stimulate mortgages,” said Ceres Lisboa, analyst at Moody’s.

Publicly-owned Caixa Econômica Federal is seeking to boost financial inclusion for the poorest one-third of Brazilians.

Already the biggest lender by customer numbers, Caixa created 35m new accounts last year to pay government coronavirus benefits to people who were previously “unbanked” and is now opening new branches and promoting its digital arm.

“We are going to launch micro-credit for 10 to 30 million people through mobile phones,” said chief executive Pedro Guimarães. “These clients of [our app] who are entering the financial market can get micro-insurance and a cheap credit card, step by step.”

Additional reporting by Carolina Pulice