After understanding the macroeconomic situation in Latin America, we recognize it as a typical emerging market characterized by significant uncertainties. However, there are also certainties in the economic development of Latin America, particularly in its banking sector. Since 2018, propelled by rapid technological advancements and catalyzed by the pandemic, the banking industry in Latin America has been undergoing significant transformations. Digital banking not only offers more convenient services but also extends financial services to many who previously had limited access to banking. Let's explore how digital banking has developed in Latin America, the challenges it faces, and its potential future directions, focusing particularly on Brazil and Mexico, the two major economies in the region.
Current Status of the Banking Industry in Latin America
The development of banking in Latin America is relatively backward. Data from Nubank's Q1 2022 Earnings reflect the immaturity of the banking and credit markets in the region at that time. Four key points were highlighted in Nubank's 2021 prospectus:
Latin America has about 132 million people without bank accounts, approximately 20% of the population.
Credit card penetration is very low: 27% in Brazil, 9.5% in Mexico, and 13.9% in Colombia.
Credit card TPV (Total Payment Volume) is low: 40% in Brazil, 24% in Mexico, and 15% in Colombia, compared to 51% in the United States and 62% in the United Kingdom during the same period.
The ratio of household debt to GDP is relatively low: 30.5% in Brazil, 16.2% in Mexico, and 27.6% in Colombia, whereas it ranges from 55% to 85% in other developed countries.
Currently, Brazil has about 170-180 banks serving roughly 200 million people, which means each bank serves an average of 1.2 million people. The United States has about 5,000 banks serving 330 million people, averaging 5,600 people per bank. The density of banks in Brazil is very low compared to the United States. Therefore, the market penetration of credit cards and loans in Latin America is low, especially with a large unbanked population, indicating a substantial unmet demand.
The second notable characteristic is that Brazil's banking sector is almost entirely composed of domestic banks, whereas Mexico has a larger proportion of foreign banks. Due to past trade protection policies, it has been difficult for foreign capital to enter Brazil. Additionally, mergers among traditional Brazilian banks have led to a significant concentration effect, making the top banks increasingly dominant. Brazil's five largest banks control 81% of the country’s banking assets and enjoy exceedingly high profits, with average interest rates exceeding 306%. Some consumers even face annual interest rates of up to 450%, leading to a lack of motivation for innovation among Brazil's major banks. Caixa and Banco do Brasil are state-owned banks, and as the Central Bank of Brazil continues to reform the economy, it might push these institutions to transition from government branches to private enterprises.
In Mexico, the concentration effect in banking is also pronounced, but the difference is the visible presence of foreign capital in the sector, including banks like BBVA, Citi, and HSBC. This diversity allows for more competitive dynamics and potentially more innovation in the Mexican banking market compared to Brazil.
Note: Brazil’s five largest banks
Note: Market share of Mexican banks
The third characteristic is the extremely low operational efficiency of traditional banks, making reform difficult. Traditional banks have many physical branches, which incur high fixed costs, including a large number of service personnel working in these branches. When the internet was less developed, traditional banks expanded their market reach by opening more physical branches, leading to substantial fixed expenses for leading traditional banks today. These costs are difficult to optimize, making transformation challenging.
In Brazil, the operational efficiency of traditional banks is particularly low; business processes are complex and often can only be completed offline. This significantly increases the cost and complexity for users, resulting in poor customer experiences. Consequently, some fintech startups have seen potential opportunities and have adopted an entirely online model to provide services such as credit card account openings, personal loans, insurance, and investments. This approach leverages digital technology to streamline operations and enhance user experiences, potentially disrupting the traditional banking model by offering more efficient and accessible financial services.
Brazil has a robust digital banking infrastructure and policies
The Central Bank of Brazil (Banco Central do Brasil) has made significant contributions to promoting digital transformation in the Brazilian banking sector. The Central Bank not only encourages companies like Nubank to actively engage in digital banking operations but also launched the instant payment system, PIX, in 2020. In Brazil, each individual can register for PIX using their mobile phone number, email address, or CPF/CNPJ (Brazilian tax identification numbers), with up to five registrations allowed. PIX enables real-time money transfers between individuals and companies, operable 24/7, including weekends and holidays. One of the main advantages of PIX over traditional bank transfers or payment methods is its immediacy and low cost, almost allowing instant transfers without additional fees. As of May 2024, nearly 160 million people use PIX, accounting for 74% of Brazil's total population. In 2022, PIX transactions accounted for 29% of all payment transactions in Brazil, surpassing credit and debit cards to become the primary payment tool. This trend is not unique to Brazil, as many emerging markets have similar government-led fast payment systems.
It's important to note that PIX operates on an Account-to-Account (A2A) basis, generally facilitated through associations with credit cards, meaning it supports credit card transactions. Notably, PIX also supports offline payments using QR codes, offering an experience almost identical to that of domestic apps like WeChat Pay and Alipay, making Brazil somewhat ahead in this aspect.
Brazil also has its own credit platform, Serasa. In 2012, the world’s largest credit bureau, Experian, acquired Serasa, Brazil's largest credit bureau, established in 1968 by a consortium of leading Brazilian banks to enhance the operational capacity of bank loans. Similar to early credit bureaus in the United States, Serasa provides risk assessment services based on negative data obtained from banks and public sources. The advent of Serasa greatly advanced the industry, as credit card loans rely heavily on credit data, and robust credit assessment capabilities can reduce the risk of default, ensuring better returns on loan investments. Additionally, when defaults occur, Serasa Limpa Nome also acts as a renegotiation platform in Brazil, helping banks assess the risk levels of borrowers.
Rapid Rise of Digital Banking in Brazil
Since 2018, digital banking in Brazil has seen rapid growth, attributed to several factors:
Firstly, the pandemic accelerated the penetration of mobile phones, increasing from 41% in 2018 to about 80% currently. Especially in Brazil, where there is a predominance of younger demographics, the average usage time of mobile devices is significantly higher compared to the U.S. Young people's quick adoption of new technologies has facilitated the rapid penetration of digital banking in Brazil.
Secondly, in an effort to break the monopoly held by traditional banking giants, the Central Bank of Brazil has implemented various policies to inject more vitality into the industry, with data analytics becoming a core competitive strength.
In 2018, the abolition of the lock-in on payroll cards was a significant move: According to 2021 data from Morgan Stanley, traditional banks and Nubank now capture the major market share. Caixa and Banco do Brasil, two state-owned banks, hold larger shares, with Nubank in fourth place, accounting for 12% of the market. The market is highly concentrated, with little opportunity for digital banks other than Nubank to enter the market.
In 2020, Brazilian banks were required to report credit data to credit bureaus for free every 10 days, including data for both individuals and companies, thereby establishing the first large-scale credit registry. This initiative aimed to reduce the credit costs for individuals and companies by better defining risks and reducing defaults and excessive debt. Every institution could equally access this data, leading to increased supply and competition in the credit market, and ultimately lowering interest rates. From 2020 to 2024, this program has been in place for over three years, and the credit database, having undergone iterations, is likely to have developed some predictive capabilities. The algorithms used by institutions will increasingly depend on their pricing mechanisms and operational efficiency.
In 2021, the implementation of the Open Banking policy in Brazil promoted inter-bank information sharing. This policy mandated the sharing of product and pricing data as well as customer data among banks, which spurred the growth of online payment services, including wire transfers, PIX, boletos, and debit-to-account transactions. In 2022, the policy was further expanded to include data sharing in areas such as insurance, investments, pensions, foreign exchange, and acquiring services, intensifying competition among banks. This shift has made data analytics a central focus of competition in the banking sector.
We also see many traditional banks actively transforming into digital banks and increasing their investments in IT departments. However, due to the constraints of their traditional business models, even if they can match the service levels of leading digital banks, they are unable to reduce operating costs. Under the impetus of a series of government policies in Brazil, digital banks have inherent advantages over traditional banks due to their lower cost to serve and stronger data analytics capabilities, particularly in controlling default risks. As a result, digital banks, including Nubank, have experienced rapid growth in scale.
The Cash-Dominant Mexican Market Holds Great Potential
Only 49% of adults in Mexico have bank accounts, meaning that 66 million people in Mexico are unbanked. Historically, Mexico has been a cash-dominant country, with cash transactions accounting for 38% of point-of-sale (POS) transactions.
Cash can also be used for online transactions through the OXXO retail chain, which has 20,000 stores nationwide and offers a post-payment method using vouchers. According to Susquehanna data, OXXO accounts for 21% of payment transactions, with other popular payment methods including the domestically used Carnet credit/debit cards. This presents a significant opportunity for digital banks.
High Interest Rate Spreads in Brazil Provide Banks with Strong Profitability
According to the monthly data published by the Central Bank of Brazil, it is evident that Brazil has extremely high-interest rate spreads. The overall interest rate spread for the residential sector reaches an astonishing 40%, with credit card interest rates exceeding 80%. Compared to most large-scale economies worldwide, such levels of interest rate spreads are unprecedented.
The first question is, why does such a high interest rate spread exist? We speculate that there might be five factors contributing to Brazil's high-interest rate spread.
1. High Fiscal Deficit: The Brazilian government has maintained a high fiscal deficit, which reached as high as -13% of GDP in 2020. This is related to the current left-wing political ideology of Brazil's ruling party, which prioritizes social welfare, inevitably sacrificing fiscal expenditure. For foreign investors, this is a risk signal, necessitating higher risk compensation.
2. High Domestic Savings Rate: The real interest rate in a country is determined by both investment and savings. If investment exceeds savings, interest rates will rise. Brazil's entire capital market is not highly marketized, with significant government-led investments. For instance, the Brazilian Development Bank (BNDES) accounts for 20% of investments, keeping interest rates high.
3. Relative Lack of Transparency in Government Institutions: While central banks theoretically require strict independence, the Central Bank of Brazil lacked such independence in the past. It wasn't until February 2021 that the Central Bank of Brazil started making independent decisions separate from the federal government. Although institutional transparency is gradually improving, it remains a point of concern for investors.
4. Historical Reasons: Brazil's history of severe and prolonged hyperinflation is rare compared to other countries, significantly impacting the psychology of both the Central Bank and the public. As a result, the Central Bank's policy interest rates are more aggressive, aimed at preempting inflation issues. Currently, the target interest rate set by the Central Bank of Brazil is around 4%, much higher than the 2% target common in many other countries, reflecting these considerations. Additionally, residents are more inclined to spend rather than save.
5. Capital Controls and Exchange Rate Risk: The inflow of foreign capital could alleviate the savings gap caused by excessive investment, reducing upward pressure on interest rates. However, due to a lack of confidence among foreign investors in Brazil, they often attach significant risk premiums when providing funds. Consequently, Brazil cannot fully benefit from the low-interest-rate environment internationally and maintains overall interest rates much higher than global levels. Furthermore, the historical default experiences in Latin America have left lasting scars. The large fluctuations in exchange rate risks necessitate additional risk compensation for foreign investors.
Secondly, what is the pattern of interest rate spreads and how should we view them in the long term?
Brazil's overall interest rate levels are anchored to the Central Bank's Selic benchmark rate. Observing changes in other interest rates, the transmission of the central bank's policy rate to terminal rates is generally effective. The two rate hike cycles since 2010 have been well reflected in end-user interest rates.
Currently, the Selic rate is around 10%. The average interest rate for new loans is approximately 40%, which is 30% higher than the Selic benchmark rate, resulting in a spread of about 30%. Over the past decade, the spread has tended to increase with rate hikes. This means that the actual interest rate for users rises roughly in line with the Selic rate, exhibiting a magnifying effect. Personal loan interest rates are around 40%, slightly lower than the 50% rate for new personal credit, with credit card interest rates at approximately 85%.
The default situation in Brazil is directly related to interest rate levels, with the highest volatility observed in credit cards, followed by corporate loans, and then personal loans. During the interest rate hike cycle from 2012 to 2015, a significant increase in defaults occurred, especially with credit card NPLs (Non-performing Loans) reaching around 8.5%. This led to a tightening of credit. As interest rates declined, NPLs also decreased. The interest rate hike cycle during the pandemic exhibited a similar trend. Therefore, when the Central Bank of Brazil prepares to raise interest rates, banks experience an increase in NPLs but also raise their spreads to balance their returns.
We believe that the interest rate spread in Brazil will gradually decrease in the future. The main driving forces include increased industry competition, higher household savings rates, more effective control of inflation and foreign exchange, and more efficient government governance. These factors will help bring the interest rate spread back to a reasonable profit level for banks.First, various policies in Brazil are pushing both traditional banks and digital banks to participate in the industry's transformation. A data-driven banking sector will further improve operational efficiency, forcing traditional banks to lower their spreads to maintain competitiveness. Additionally, we can clearly see that the household debt-to-income ratio in Brazil is rising, a trend accelerated by the pandemic. However, from the perspective of debt servicing capacity (Household debt service ratio), it remains relatively stable at around 25%, with the principal accounting for 17% and interest accounting for 8%.
note: Household debt to income ratio – Ratio of total household debt held by financial institutions to available income accumulated over the past twelve months.
note2: Household debt service ratio – Ratio of expected household debt payments to available income as a quarterly moving average. Additionally, Central Bank publishes household debt service ratio seasonally adjusted.
Latin American users are accustomed to using credit cards and installment payments.
According to a McKinsey report, the global payment industry grew at a rate of 6% from 2017 to 2022, with an expected growth rate of 7% by 2027. Latin America, while the smallest in scale, has the highest growth rate, with a 14% growth from 2017 to 2022 and an expected 11% growth from 2022 to 2027. The payment structure in Latin America is quite similar to that in North America, with credit cards being predominant. Credit card revenues account for 50% of total payment revenues in both personal and commercial sectors in Latin America, compared to 48% in North America. According to the Worldpay Global Payments Report, in 2021, 39% of people in Latin America used credit cards for payments, while 19% used e-wallets. The proportion of e-wallet users is expected to increase further in the future.
Installment payment is the most popular payment method for Latin American consumers. In order to attract consumers, many merchants provide interest-free installment payment services, so merchants have a large backlog of accounts receivable.
Nubank
Nubank was founded in 2013 and is the absolute leader in digital banking in Latin America. It started out as a credit card company, and its core business is still credit cards. Later, it gradually expanded its business to personal loans, SME banking, insurance, investment, home loans, BNPL (Buy Now, Pay Later), etc.
Nubank currently has more than 100 million users, covering 92% of the adult population in Brazil, 7% of the adult population in Mexico and 1% of the adult population in Colombia.
The main revenue is obtained through interest on credit cards and personal loans, accounting for 60%.
The CAGR of FX Neutral revenue reached 75%, and the growth rate still showed no downward trend. And with the continuous improvement of UE and the gradual increase of GPM, the GAGR of FX Neutral Gross Profit reached 99%.
Specifically, the average annual income per capita ARPAC is $11.4, while the ARPAC of the oldest users has reached $27. This means that even if the number of users does not increase, the increase in ARPAC can drive more than double the income.
Cost of Revenue consists of three parts: interest expense, transaction cost and credit loss provision. Interest expense can be roughly understood as Nubank's financing cost, while credit loss provision is related to the ratio of non-performing loans and provision rate. The expense side mainly includes user support and operation, marketing, etc. UE is gradually improving, and the proportion of revenue is decreasing year by year.
Competitive Analysis
For Nubank, there are three main types of competitors. The first type is traditional banks represented by Itau Unibank. The second type is payment/credit businesses affiliated with e-commerce, such as Mercado Pago. The third type is other new digital banks similar to Nubank.
Traditional Banks
For traditional banks, the advantage lies in their large existing customer base and the significant scale of personal and corporate loans. This gives traditional banks strong profitability, especially in Brazil's high-interest-rate environment, where corporate default risk is much lower than individual default risk, and corporate loans are predominantly handled by traditional big banks. However, the constraints of traditional banks include a large number of physical branches and employees, resulting in very low efficiency. Even though many traditional banks are also improving their digital banking products, compared to Nubank, there is still a gap in data analysis capabilities and operational efficiency, which does not pose a significant competitive threat.
E-commerce-affiliated Payment/Credit Businesses
E-commerce payment and credit businesses also have a certain scale. However, it is important to note that in Latin America, e-commerce companies' payment and credit services are tightly integrated with their e-commerce operations and have not yet shown the ability to operate independently from the original e-commerce business. For example, Alipay in China has a TPV (Total Payment Volume) scale more than six times that of Tmall and Taobao combined, but Alipay's operational logic from the start was to address the long-tail market's credit/payment issues, making it a frontrunner in China's digital payment industry. In contrast, the situation in Latin America is different. The digital payment/digital banking market in Latin America has some advantages of late development, as there are many lessons to learn from China and the United States, and the technical barriers are not high. Furthermore, Alipay and WeChat Pay expanded significantly through offline scenarios during the payment war in 2014. Although some offline stores in Latin America accept digital payments, the scale is much smaller than in China. Thus, it is overly optimistic to assume that Latin American e-commerce payment/credit businesses can achieve the same success. E-commerce loans mainly come from BNPL (Buy Now, Pay Later) and are tied to consumption scenarios, giving them a natural advantage but also tying their growth to GMV (Gross Merchandise Volume). Overall, the scale of e-commerce-affiliated payment/credit businesses has not yet reached the same level of market expansion as Nubank.
Other Digital Banks
The competition among digital banks focuses on data analysis capabilities and operational efficiency, which reflect in transaction volume, credit and savings scale, and profitability.
Morgan Stanley's 2022 AlphaWise compared the market share and product rankings of traditional banks and new digital banks across various dimensions. Nubank's credit card penetration far exceeds other banks, reaching 82%. However, traditional banks have low market penetration in non-credit card loans such as personal loans, payroll loans, and auto loans. Currently, Nubank's personal loan segment is growing rapidly and is expected to gradually capture a share of the non-credit card loan market from traditional banks. From a product strength perspective, Nubank ranks first or among the top in almost all indicators except for lacking physical branches and ATMs. Lower fees and higher service levels further demonstrate Nubank's long-term competitiveness. Compared to other digital banks, only C6 and Pagbank have slight advantages in certain areas, but none are as competitive as Nubank.
Therefore, considering the above, we believe that Nubank's core competitiveness comes from the following aspects:
Nubank has a strong cost advantage:
Low Customer Acquisition Cost Early on, Nubank's customer acquisition cost was less than $5. The low cost was primarily due to the very low market penetration in the early stages, resulting in high demand. Nubank's credit card product offered the best user experience in the industry, leveraging simple word-of-mouth to achieve such low costs. As market penetration gradually increased, the customer acquisition cost rose to $7. However, compared to the hundreds of dollars it costs American banks to acquire a new customer, Nubank's cost is negligible. From a future revenue perspective, the income generated in just one year is enough to cover the customer acquisition cost of new users.
Low Cost of Customer Service：Nubank's cost of serving customers is significantly lower because it does not incur the various expenses associated with physical bank branches. It operates with a very lean staff and does not have the extensive payroll expenses associated with branch networks. Consequently, the cost of serving users is 85% lower than that of traditional banks. Currently, Nubank has 7,700 employees serving 93.9 million users, averaging 12,194 users per employee. In contrast, Itau Bank has 95,000 employees serving 65 million individual users, averaging 684 users per employee. This means Nubank's labor efficiency is 17.8 times higher than that of Itau Bank.
Low Risk Cost： Various policies implemented by the Brazilian government have broken the absolute monopoly once held by traditional banks, gradually shifting the market towards digital competition. Data analysis and financial system development are areas where Nubank excels compared to other companies. By leveraging credit, credit scoring, and other financial information, Nubank possesses industry-leading risk control capabilities. This is evident from the NPL (Non-Performing Loan) ratios, which show that Nubank has better control over selecting mortgage clients and determining loan amounts. This capability has enabled Nubank to reduce credit provisions and improve gross profit margins.
Low financing cost: Nubank's financing cost is only 85% of the interbank loan rate. This is because Nubank has a certain deposit-absorbing capacity, which reduces part of the financing cost.
Nubank has established a positive feedback loop, which is its most crucial advantage. When a company's algorithms are strong enough, the risk cost of credit defaults can be significantly reduced. This allows Nubank to offer lower pricing compared to competitors, given its ample profit margins. Initially, Nubank attracted users by offering lower loan interest rates than traditional banks. Naturally, users tend to prefer platforms with lower loan costs. For other digital banks, if they lack robust data analysis and operational capabilities, they might attract users in the short term by sacrificing profits to offer lower loan rates. However, they will not have long-term competitiveness.
Runway Analysis
We predict that Nubank will exhibit significant trends in capturing market share in three main areas: payroll loans, credit cards, and personal loans.
1. Payroll Loans:
With the government opening up the binding of payroll accounts to traditional banks, Nubank can also cater to the payroll account needs of some customers in the future. This will naturally lead to a portion of these customers requiring payroll loans. We estimate that by 2036, Nubank's market share in payroll loans will reach 7.3%.
2. Credit Cards:
Credit card revenue is roughly equal to the scale of credit card receivables multiplied by the proportion of interest-bearing assets and the credit card interest rate. Historically, the proportion of interest-bearing assets in credit cards has been rapidly increasing, leading to a swift rise in credit card revenues. This trend is due to users not utilizing a significant amount of interest-bearing installment services in the early stages. As users become more mature, this proportion will increase quickly.
3. Personal Loans:
While traditionally a stronghold for conventional banks, personal loans are seeing a strong growth trend from Nubank. An increasing number of people prefer obtaining personal loans from digital banks like Nubank due to their convenience over traditional banks. We anticipate Nubank's market share in personal loans to grow from 6.4% to 18.6%.
The assessment of interest rates comprises two parts: the policy rate (Selic) and the premium based on the policy rate. Given that the policy rate closely aligns with financing costs, it can also be understood as the interest rate spread. The policy rate has shown a downward trend over the past six months. During the pandemic, the government raised rates rapidly to control inflation, but now that inflation is within the Central Bank's target range, rates are being reduced. Thus, the policy rate is expected to return to pre-pandemic levels, indicating further room for reduction.
Regarding the interest rate spread, as mentioned earlier, we believe the primary drivers include increased industry competition, higher household savings rates, more effective control of inflation and foreign exchange, and more efficient government governance. Historically, a decline in the policy rate has also been accompanied by a reduction in the interest rate spread. This is because the spread compensates for risk; a lower policy rate implies reduced default risk, thus lowering the need for risk compensation.
In the long term, we expect the high Return on Assets (ROA) in the Brazilian banking sector to gradually align with the global average. Considering factors like trade protection, the current interest rates still have significant room for reduction. Therefore, based on our ROA assumptions, we have back-calculated future reasonable interest rate levels to use as our baseline scenario assumptions.
Another portion of revenue comes from transactions. This part is mainly forecasted based on the number of consumers multiplied by the TPV (Total Payment Volume) as a percentage of per capita GDP. We predict that as users become more mature, the proportion of TPV to per capita GDP will gradually increase, and the number of consumers will grow as penetration rates rise. However, due to the establishment of new payment systems such as PIX, banks' take rate from payments has been generally declining. We maintain the same assumptions as the industry, expecting this take rate to decrease.
In summary, we believe that Nubank, as a disruptor in the Latin American banking sector, possesses strong competitiveness in the wave of digital banking in the region. Due to historical reasons, the Latin American banking industry has significantly higher interest rate spreads compared to other regions, resulting in extremely high profit margins. Additionally, the Latin American market is large enough, with a young population that is highly receptive to new technologies. The penetration rate and per capita consumption are expected to increase significantly, especially in the Mexican market, which is currently in a state of urgent development. This positions Nubank for continuous and rapid growth in the future.
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