Further reading
A year ago, the return on equity of Brazilian digital lender Nubank was zero (or 0.001% to be precise). Today, it is 23%.
Similarly, a year ago the RoE of another digital firm, Banco Inter, was -0.2%, while today it is 8.5%, having grown by two percentage points in each of the past three quarters. Inter’s chief executive, João Menin, is targeting a RoE of 30% by 2028 and believes that the longer-term sustainable RoE is somewhere above that number.
Meanwhile Banco Pan reported 11% RoE in the fourth quarter of 2023, and chief executive Carlos Eduardo Guimarães tells Euromoney it will be between 20% and 22% in two years’ time.
What is happening to drive such profit growth at the digital banks? Is it simply the evolution of a business model that always promised to generate cash at some point or has the increase in interest rates and the refocusing of investors on profits rather than user growth prompted this transformation?
What is clear is that whatever is happening, it is not happening at the incumbent banks.
Bradesco reported RoE of 10% in the fourth quarter of 2023, down from 23.7% in the fourth quarter of 2019, before the pandemic.
Santander isn’t faring much better. Its latest quarter’s RoE was 11.8%, down from 21.3% in the fourth quarter of 2019.
Even Itaú, the poster child of a well-run traditional bank – one that is churning out dividends as it struggles to find organic and acquisitive growth opportunities – is on a downward trajectory. In the fourth quarter of 2023, it reported RoE of 21.7%, down 250 basis points versus the same period in 2019. Above 20% is still good, but is it sustainable? And even if it is, how will it look relative to the neobanks in five years’ times if they are reporting 30%-plus?
Brazilian banking, it seems, is at a tipping point.
Reality
“What I can say is that the digital banking models are no longer a promise, they’re a reality,” says Santiago Stel, chief financial officer of Inter, based in Belo Horizonte.
What I can say is that the digital banking models are no longer a promise, they’re a reality
Santiago Stel, Banco Inter
“If you look at the largest digital banks in Brazil, there is critical mass – it’s not debatable anymore. And the size of these banks will be even larger in five years, 10 years. Also, the profitability of these banks was also a question mark two years ago and now it no longer is. We have certain competitive advantages like cost-to-serve, which is insanely cheaper and, in our case, the cost of funding as well.”
According to Stel, questions around the digital banks business models have evolved as their competitive advantage has become more entrenched.
“The question mark now is what is the sustainable RoE of these banks? Is it 20%, 30% or even higher? And what is the total size of the pie that the large five [incumbent] banks in Brazil will own when we fast forward five years? Today, they still have a 70% to 80% market share of any metric you want to choose. But in the future, this will not be the case because we’re growing so much more than them. And so how will the landscape look if our growth continues to compound?”
Inter’s commitment to 30% RoE by 2028 is inextricably linked to two other key metrics – continued growth of its user base (to 60 million from 30 million today) and an improvement in its efficiency ratio to 30% from 51.4%.
The bank’s main competitor, Nubank, just delivered a masterclass in how these factors interplay so powerfully for the digital banking model. It is all about scalability.
At some point if banks continue to grow active clients, the revenues they generate will dilute the fixed costs. And with low-to-no additional variable costs, operational leverage kicks in. All that added revenue lowers cost-to-serve and flows into the income column.
In the fourth quarter of 2023, Nubank’s revenues rose 57% year on year to $2.4 billion, while gross profit jumped 87% to more than $1.1 billion, with net income up 229% year on year. The efficiency ratio fell to 36% from 47.4% in the fourth quarter of 2022.
Stel says that Inter has seen the same phenomenon.
“We built profitability of around two percentage points of extra RoE consistently during the four quarters of the year, and that was the product of several initiatives,” says Stel. “But the most meaningful – or the most visible – was on the cost side. The efficiency ratio moved the most. We were at 70% and now we’re at 50%.
“Half of the progress that we want to do in five years was done in year one. We kept costs flat – the total for January 2023 and 2024 is exactly the same – and we grew revenues by 40%. So, there was a big increase in operational leverage, and now in 2024 the driver will be a combination of many factors, and not so much focus on one. We think the efficiency ratio will be around 40% at the end of 2024.”
Cost to acquire
But while digital banks may be able to keep fixed costs steady, surely there are some variable costs that need to grow with scale? Not all additional revenues can flow to the bottom line.
The most obvious variable cost is client acquisition cost (CAC). Even if the bank can achieve a low CAC, as it grows, it is logical that this cost will increase. Guimarães challenges this assumption.
“Sometimes we have a positive cost of acquisition,” he says. “For example, when we originate a payroll transaction with a broker, that has a positive CAC. It’s a client that we bring to the bank while having profit in the first transaction. So, we’re trying to integrate these different channels, different products and direct then to our app because the app is the best way to keep in touch with our clients.”
We’ve digested some higher delinquencies and we have been investing a lot in our digital platform; and we still almost reached the same profit as the year before despite this tough environment
Carlos Eduardo Guimarães, Banco Pan
Guimarães says that Pan should be generating RoE of between 20% and 22% due in large part to the increased credit appetite as Brazil’s credit cycle turns. He explains that the bank was hit by a “mini-bomb” at the end of the pandemic.
“The government injected a lot of money into individuals and they didn’t have anything to spend their money on, so delinquency rates at the beginning of 2021 were at an all-time low,” he says. “Then inflation rocketed as people were spending heavily after all that time stuck at home. The government removed its cash injection and, on top of that, there were many banks offering credit to those individuals – and many of them didn’t know how to deal with these credit offers.”
Pan saw its non-performing loans begin to rise from the second quarter of 2022 and then increase quite sharply from 6.7% in that quarter to a peak of 8% a year later before beginning to trend down. In the most recent quarter delinquencies had fallen back to 7.3%.
Others such as Bradesco and Santander Brasil also got burned by credit losses as this financial bomb went off in the system. Even Itaú saw some credit-card losses, but these were largely offset by the bank’s other businesses.
“We’ve digested some higher delinquencies and we have been investing a lot in our digital platform; and we still almost reached the same profit as the year before despite this tough environment,” says Guimarães. “Now we can increase our credit portfolio by 30% because we have been increasing our unsecured lending portfolio. In particular, we want to increase our personal loans portfolio – it’s a high margin business. Only 4% of our loan portfolio is unsecured, and that’s far from the optimal point.”
However, Guimarães notes that Pan’s shift to risk-on will only flow through to markedly better RoE from 2025 and 2026 due the accounting impact of the bank selling a large portion of its credit portfolio this year – a process that brings forward the present value of those loans for reporting purposes.
Meet in the middle
Pan’s emphasis on higher margin credit is a good reminder that the profitability of the digital banks varies widely.
For example, Nubank has a done a good job of growing its personal loans portfolio, a product that can have a return on assets of over 9% given the very high interest rates they attract. That is a lot more profitable than payroll lending, for example. However, in time the digital banks business may converge with their legacy rivals.
“Nubank is already signalling that it’s going to try to grow its payroll loans, its [length-of-service guarantee fund] FGTS loans – all these will lower the sustainable RoE,” says one analyst. “Over time the models will merge; they’ll all meet in the middle of the credit spectrum.”
Stel says that Inter is also planning to increase its payroll and FGTS lending, as well as boost its home equity products, but says that the RoE impact won’t curb long-term sustainable RoE too dramatically – with interest rates around 20% a year and with almost zero risk, the dilution to RoE will be minimal if at all.
Meanwhile, Inter’s app-based shopping functionality – the Inter Shop super app – gives it strategic differentiation, but experts argue that it doesn’t add to the bank’s RoE. They say it is a positive in terms of engagement but not profitability.
Stel argues that view is outdated.
“At the beginning [the shopping part of the app] grew engagement, but from 2024 we have been growing GMV [gross merchandising volumes] again,” he says. “And since the Americanas event [a high-profile retail bankruptcy] in Brazil, the retailers have been happy to bypass the middlemen and sell directly through Inter Shop. We can control the process – improve our take rates – do cross-selling at checkout through selling insurance of buy-now-pay-later financing. So, increasingly, Inter Shop is both engagement and profitability.”
To what extent the differences in operating strategy between Brazil’s digital banks will lead to different long-term sustainable RoE outcomes remains to be seen – as does just how high those sustainable RoEs might be.
These questions are important for the broader financial sector, but for the senior management of Brazil’s traditional large banks they are starting to feel existential.
