Small Is Not Always Beautiful In The World Of Banking

In the wake of the PPBL imbroglio, regulators and investors have started scanning the books of the SFBs while taking stock of how compliance-related issues are being solved in these lending banks.

Given the myriad difficulties these small banks have in accessing low-cost deposits, the rising cost of operations as well as a plethora of unsecured loans that have the potential to turn risky, analysts expect a significant shakeout in this segment with a few exits and some mergers coming up on the horizon.

Earlier this month, the Reserve Bank of India (RBI) approved the merger of Fincare Small Finance Bank with AU Small Finance Bank. Following the regulatory nod, all branches of Fincare Small Finance Bank Ltd will function as AU Small Finance Bank Ltd branches from April 1, though the actual integration process will take about nine months. 

This is the second merger of an SFB. Last year, the RBI approved the merger of fintech major Slice with North East Small Finance Bank.

Though AU Small Finance Bank’s CEO Sanjay Agarwal said that now the bank aims to become a full-fledged lender in the next three to five years, challenges are rising for a host of other SFBs.

An ICRA report issued last year said, “Cost of funds for SFBs remains higher than universal banks as SFBs have been offering higher rates on term deposits and have a lower (albeit improving) CASA (current account and savings account) deposit base.”

While the SFBs, with about 6,589 domestic branches across the country as of end-June 2023, have made significant progress since they came into existence less than a decade ago, issues relating to regulatory compliance, access to low-cost funds, and adoption of technology could pose serious challenges for some of the lenders in this category. Besides, these lenders face more than stiff competition from the larger and better-entrenched scheduled commercial banks.

What Are The Limitations For SFBs?

Since the SFBs were set up to boost financial inclusion, the lenders are mandated to provide at least 75 per cent of their Adjusted Net Bank Credit (ANBC) to priority sectors as compared to 40 per cent in the case of other scheduled commercial banks. ANBC refers to net bank credit plus investments in non-statutory liquidity ratio (SLR) bonds.

Priority sector loans include lending to agriculture, micro, small and medium enterprises (MSMEs), education, housing, social infrastructure, and renewable energy.

Also, at least 50 per cent of SFB loan portfolio should be of loans of up to Rs 25 lakh, according to RBI directives. “These restrictions will continue to cause considerable pain for the SFBs as they gear up for the next phase of growth,” said, Ashwin Parekh, a financial services sector analyst.

He added that the challenges for payment banks as well as SFBs “are quite similar”.

Though a payments bank is different from an SFB—the latter can accept deposits as well as extend credit while the former is restricted from lending—both essentially have been created to serve the unbanked and underbanked segments and were granted licenses to deepen financial inclusion.

So far, these banks have had a good run. According to RBI data, the profit before tax for SFBs stood at Rs 5,417 crore in FY 2023 compared to Rs 1,283 crore in FY 2022. This was of course a vast improvement over FY 2019 when SFBs taken together had posted a net loss of Rs 727 crore.

The Red Flags For SFBs

The RBI in its report pointed out that many SFBs have low current account and savings account (CASA) deposits and a greater reliance on bulk term deposits, often acquired at high rates, especially from cooperative banks. This suggests a high degree of inter-connectedness of SFBs with cooperative banks, with the possibility of any shock to the latter sector spilling over to the former, the regulator pointed out.

The operating expenses of these banks have risen too. Operating expenses related to inventories, payroll, and rent, among other things, which were less than Rs 10,000 crore in March-end 2022 increased to over Rs 13,000 crore as of March-end 2023. 

Compared to public sector banks, SFBs had more manageable gross and net non-performing assets (NPAs), according to the RBI data. However, compared to Indian private banks and foreign banks, the SFB reported far higher NPA levels.  

Luring Customers With Higher Interest Rates

The SFBs, in a bid to shore up their deposit base, have been luring customers with higher interest rates. Depending on the tenure of fixed deposits, many of these banks including AU SFB, Equitas SFB, and Suryoday SFB offer an interest rate of more than 7 per cent on the fixed deposits. In several cases, the interest rate is upward of 8 per cent. 

Contrast this to the State Bank of India, the country’s biggest lender, which offers interest rates between 3.5 per cent and 7.1 per cent to the general public. 

Higher cost of funds mean the spreads are smaller, add to that the fact that most of the loans are small ticket unsecured, the risks consequently are higher.  

Rating agency ICRA said in its report, “SFBs are expected to continue offering higher rates of interest on deposits to support the envisaged growth in the near-to-medium term.”

These banks have been aggressively extending credit as well.

RBI governor Shaktikanta Das has already raised an alarm. He noted that these lenders must avoid over-exuberance when it comes to lending.

Last year, Finance Minister Nirmala Sitharaman too, while speaking at the Digital Acceleration & Transformation Expo 2023, underlined the need for SFBs as well as non-banking financial companies (NBFCs) to pay heed to RBI’s warning against over-expansion of their lending activities.

"The RBI has alerted NBFCs and SFBs to be careful so that they don't go too far, too soon, and (consequently) face downsides risks…We have (also) been after state-owned banks to focus on their core business, their banking business, which is to collect deposits, and lend, and make money out of lending, and giving more returns to people keeping their savings (with banks)," Sitharaman said.

In March 2020, the total advances of these banks stood at Rs 91,509 crore. In September 2021 it had increased to over Rs 2 lakh crore.

“As these banks expand aggressively, one may find cases where there have been lapses in terms of following the regulatory norms including the KYC (Know Your Customer) guidelines,” said a sectoral analyst, on condition of anonymity.

“The PPBL fiasco may affect these SFBs as the trust factor will weaken,” he added.

The problems for these banks may well become more pronounced as they switch to the next phase of growth.

“This is when they would be required to increase compliance and upgrade technology … that would mean increased costs,” the analyst explained.

NPA Woes

RBI has estimated the gross NPAs of these banks at 4.8 per cent during 2022-2023, a tad lower than 4.9 per cent in 2021-22. Though the NPA level for these banks at present does not reflect any immediate challenge, the aggressive expansion of loans is becoming a cause for concern.

Non-performing assets—assets that do not fetch returns—for some of these banks have started inching upward though overall figures are not alarming yet. 

Take the case of AU SFB. Its gross NPA has risen from Rs 470.14 crore in March 2019 to Rs 931.31 crore as on March 2023. However, its net NPA—the amount taking into account the provisioning, has come down from Rs 294.50 crore in March 2019 to Rs 245.16 crore in March 2023. 

Equitas’ gross NPA stands at Rs Rs 723.96 crore at end-March 2023, up from Rs 295.71 in end-March 2019. The bank’s net NPA in FY 2023 was Rs 312 crore, up from Rs 186.41 crore in FY 2019.

For Suryoday SFB, the gross NPA figure went up from Rs 49.62 crore in end-March 2019 touching a high of Rs 597.42 crore in end-March 2022 before coming down to Rs 191.40 crore in FY 2023. 

Similarly, for Ujjivan SFB, the gross NPA which was Rs 97.85 crore in end-March 2019, went up to Rs 630.61 crore in end-March 2023. 

Investor Confidence Shaken

Last month, Capital Small Finance Bank launched its initial public offering (IPO) but failed to make an impressive mark. Analysts claimed that though, in part, this could have been because of a lack of investor confidence in the bank’s growth prospects, it could also have been triggered by worries over the future roadmap of SFBs, especially after the PPBL scam.

Share prices of several of these small banks have taken a beating too. Though RBI had earlier said that the regulatory guidelines pertaining to SFBs will change as they progress, it is yet to relax the norms.

“The regulatory stipulations imposed at the time of grant of license have remained as they were. Though RBI said that it will relook and change the stipulations on some aspects, it is yet to do so,” Narasimhan Srinivasan, Development finance and livelihoods expert wrote in a LinkedIn post.

Going ahead, it would be survival of the fittest and to remain fit a few may have to rechart their plans as small may not always be beautiful in the banking business.

(The author is a New Delhi-based independent journalist with nearly three decades of experience in covering banking, finance and public policy. Views expressed are personal)