What Happens to Small Firms When Big Banks Go Digital

In Latin America and the Caribbean, a region historically marked by financial exclusion, a rapid shift to digital banking in the last decade has created new opportunities for credit provision to underserved populations. But the transformation, accompanied by a reduction in traditional banking infrastructure, such as physical branches, is not without its risks and challenges.

According to an IDB report, the fintech ecosystem in the region grew 112% between 2018 and 2021, with especially strong growth in South America, which alongside the digital transformation of banks, has significantly expanded access to credit. This shift in financial technology has been critically important. New digital banking platforms have enabled financial institutions to reach people in remote and low-income areas who were traditionally excluded from formal credit markets. For example, in Brazil, digital lenders have started using alternative credit scoring models based on non-traditional data, such as mobile phone usage and social media activity, to assess creditworthiness. This has allowed consumers and microentrepreneurs without traditional credit histories to access loans, effectively broadening the pool of potential borrowers and fostering greater financial inclusion.

Cost of Credit in a Digital Age

The transition to digital banking has also influenced the cost structure of credit in Latin America. In a sector with significant concentration of market share at the top, the decline in local outlets of the large banks has affected the cost of credit, particularly for small and medium-sized enterprises (SMEs). The reduction in physical branches has led to decreased local banking competition, potentially increasing borrowing costs for SMEs. On the other hand, the rise of digital banking has countered this trend by reducing operational costs for lenders, enabling them to offer more competitive interest rates, especially in countries like Mexico and Colombia where fintech innovation is robust.

But while digital finance has on balance helped expand access to credit in certain market segments, it has also introduced new challenges in assessing risk and creditworthiness. As we point out in a recent IDB study, the closure of physical bank branches can lead to a decline in the availability of credit for local businesses, as these branches often play a critical role in collecting "soft" information about borrowers, based on personal relationships and interactions, which can be extremely valuable for assessing credit risk. This is particularly problematic for micro and small enterprises, which rely heavily on local banking relationships. In contrast, digital lenders tend to use automated and data-driven methods for credit assessment, which may overlook nuanced local knowledge. The World Bank also emphasizes that while digital credit scoring models are efficient in collecting and analyzing data, they can inadvertently exclude individuals with limited digital footprints, leading to potential biases and inequalities in credit distribution.

Risks of Bank Digital Transformation

The decline in physical bank branches due to digital transformation can also negatively impact local economies. Our study examined firm data from municipalities in Brazil where the only local branch, typically owned by one of the five large banks, closed during the 2010s. We found that such closures led to significant reductions in firm activity, employment, and wages in affected municipalities. Roughly one percent of firm establishments become inactive three years after a bank branch closure, and the share of inactive establishments increases from 1.2 percent to 8.4 percent four to seven years after the closure. Average wages also register a decline, by 1.5 to 1.7 percent in the first three years. For employment there is no significant short-term effect but a potentially negative effect in the longer term. The types of firms most affected are micro firms in sectors such as trade, services, and agriculture.

These results imply a significant downside of the digital shift: as digital banking expands access in some areas, it may simultaneously erode the local economic fabric by reducing the availability of personalized financial services. Another potential risk comes from the handling of client data through digital channels. The World Bank warns of the risks associated with data privacy and cybersecurity in the digital banking era, which could undermine trust in digital financial services if not properly managed. Government regulations need to adapt to the new technological reality to mitigate these problems.

Balancing Digital Innovation with Local Needs

The digital transformation of banking in Latin America has brought about significant changes in access to credit, enabling financial inclusion while generating challenges related to creditworthiness assessment and local economic impacts. As the IDB and World Bank research suggests, the key to harnessing its benefits lies in balancing innovation with the preservation of essential local banking services based on relational knowledge that digital data has difficulty capturing. Policymakers must ensure that digital transformation does not come at the expense of local communities' economic health and that the benefits of increased access to credit are equitably distributed across all segments of society.

The ongoing evolution of banking in Latin America will require continuous adaptation, both from financial institutions and regulatory bodies. It is crucial to ensuring that the promise of digital financial inclusion is fully realized without unintended negative consequences.

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