To Sustain Growth, India's Small Finance Banks Look To Shed 'Small' Tag

Some of India’s small finance banks that took roots in the past decade now want to shed the “small finance” tag from their names, as they have grown big enough and now want to grow bigger. But their plea with the Reserve Bank of India (RBI) for the same has not evoked a positive response. 

The central bank would rather want the small finace banks (SFBs) to tick all the right boxes in order to get into universal banking. The 'small' tag would then just drop off, with its repositioning as a full-fledged lender. Any SFB can apply for a universal lender's license after five years of operation, provided it matches the requirements set by the RBI.

“The broader roadmap for these SFBs’ transition into universal banks has already been given. So as and when these banks are ready to become full banks, they are free to apply for a licence. If the RBI gives its nod, these SFBs become universal banks,” a person with familiar with the matter said. “Therefore, there is no need to rebrand them and remove the tag ‘small’.”

Before going into the conditions and assessing the prospects of any of the small finance banks getting into universal banking, it is also important to bear in mind the context and rationale for setting up these entities.

Context And Rationale

Small Finance Banks (SFBs) were set up with a specific mandate—to expand financial inclusion, cater to the unbanked segment and increase lending to the priority sector including the micro, small and medium enterprises and agriculture.

The RBI set stringent guidelines that act as safeguards and boost the credibility and performance of the SFBs. These niche banks are required to direct 75 per cent of their loans to the priority sector, while the same for other scheduled commercial banks is pegged at 40 per cent. At least 50 per cent of the SFBs’ credit portfolio should comprise loans of up to Rs 25 lakh.

The SFBs are also required to go public within three years of reaching a net worth of Rs 500 crore, as per the RBI guidelines, first issued in 2014.

In return, the SFBs, which come under the ambit of private sector banking enjoy concessions or easier norms. As set by RBI, the minimum capital requirement for these banks currently is Rs 200 crore as against Rs 100 crore set in the initial phase. The amount is Rs 1,000 crore for licensing new full banks now, though it was Rs 500 crore earlier—a move apparently designed to discourage industrial houses from entering the banking space.

Therefore, the SFB route provided a relatively easier way for many entities wishing to enter the banking space.

Performance So Far

A dozen small finance banks have come up over the past decade. As a pack, the SFBs have had a good run so far, driven by strong credit and deposit growth. The Covid-19 pandemic hit just when these newly set-up banks were finding their feet. While most of them managed to overcome the challenge, the road ahead continues to be uncertain for some.

An RBI report shows the combined profit of the SFBs in FY2022-23 rose to Rs 4,162 crore, more than four-fold from Rs 973 crore in FY2021-22. Their non-performing asset level—loans that do not fetch returns—also stood at a reasonable 4.8 per cent for FY 2022-23.

But a closer scrutiny points (see table above) to uneven performance across the SFBs. A few of them, such as the AU Small Finance Bank and Equitas Small Finance Bank, have grown at an exponential pace and are now keen to become full-fledged lenders.

However, there are quite a few, such as the Unity Small Finance Bank, which took over the beleaguered Punjab and Maharashtra Cooperative Bank, could face uncertainties, especially amid higher cost of funds despite registering impressive profits. In the third quarter of 2023-24, Unity recorded a net profit of Rs 110 crore, a jump of 79 per cent. But that was on a low base.

One of the main challenges for these banks is boosting the CASA ratio, which is the share of current and savings accounts in total deposit. The higher the ratio, the lower is cost of funds for a bank.

Diversifying portfolios and client base will, therefore, be key for all SFBs as they reset their strategies. Access to low-cost funds and the adoption of technology will be crucial. And the “small” tag is not helping the cause.

The largest chunk of the SFBs’ loan book is directed towards microfinance, which is unsecured. This raises a cause for concern. Though these banks have somewhat started the diversification process with a focus on secured products like home, vehicle and gold loans, they need to up the game to stay afloat.

The relatively more successful SFBs are now looking to bring in premium customers as well. But there are limits to it, unless their status changes.

The Perception Battle

The SFBs, much like full-fledged banks, carry out banking activities that include accepting deposits and extending credit. The scale of operation, however, is much smaller.

“Regular commercial banks have the advantage of brand and size, which elicits some sense of trust. Small banks on the other hand are differentiated banks and for the lay person may not necessarily equal the same levels of service that they would expect from regular banks. This is a perception problem,” Nirupaman Soudararajan, economist and former CEO of Pahle India Foundation said.

Challenges for these banks are now rising as they set bigger targets. These banks have been typically considered riskier due to their limitations, leading to trust deficit.

“For SFBs, challenges will rise as they compete with bigger and well-established lenders. But RBI’s prime objective is to safeguard the interests of the depositors, many of whom have remained outside the banking net till not very long ago,” Ashvin Parekh, financial services sector analyst and managing partner APA Services said.

In a bid to woo customers, the SFBs are offering higher rates of interest on deposits. This has also set an alarm bell among investors. Since SFBs’ are typically focused on serving the underserved compared to the scheduled commercial lenders that have the advantage of a much-diversified portfolio, several questions have come up.

The transition for SFBs into universal banking will not be automatic. They not only need to adhere to requirements pertaining to minimum paid-up capital and net worth as applicable to universal banks, but their track record of performance as small finance banks will also be taken into consideration.

Most of the SFBs have a net worth of more than Rs 1,000 crore and are qualified as per current RBI norms to operate as universal banks. But their problems may continue for some time for these banks even after the transition, primarily because of perception issues and branding of small.

Currently, the SFBs need to maintain a capital adequacy ratio of 15 per cent, while the mandatory level for a scheduled commercial bank is 9 per cent.

According to news reports, the RBI may come up with fresh guidelines for SFBs seeking to become universal banks.

Future Of Small Finance Banks

While a host of SFBs are eying to convert to full banks, a few others are looking at mergers. Last month, the RBI approved the merger of Fincare Small Finance Bank with AU Small Finance Bank. From April 1, all branches of Fincare Small Finance Bank Ltd have started to function as AU Small Finance Bank Ltd branches.

Prior to the merger, 12 SFBs were in operation. Interestingly, Bengaluru-based Ujjivan Small Finance Bank is headed for a reverse merger with holding company Ujjivan Financial Services. Not just that, fintech firm Slice also got the regulatory nod to merge with North East Small Finance Bank. Earlier, the RBI had also given its nod to fintech major Slice’s proposal to acquire North East Small Finance Bank.

As SFBs fight perception challenges and look at mergers to expand their scale of operations or gear up to become universal banks, the big question is: Can the small finance bank experiment be termed a success story?

(The writer is a New Delhi-based independent journalist. Views expressed are personal)