PremiumMUMBAI : When Govind Singh quit his 20-year-long career as a bank employee in 2009, he was ready to take the plunge and follow his passion. At 43, he set up a microfinance firm, Shree Pathrakali Finance. It lent primarily to women. Operating under the Utkarsh brand, the firm targeted Varanasi’s small business owners with micro loans (ticket size of ₹100-5,000).
Just a decade since his humble beginning, Singh is now preparing to launch a ₹1,350 crore initial public offering (IPO). Utkarsh SFB is among the five small finance banks or SFBs that are expected to launch an IPO over the next 2 months. The other four are Fincare Small Finance Bank ( ₹1,330 crore), Jana Small Finance Bank Ltd, formerly known as Janalakshmi Financial Services Ltd, ( ₹ 700 crore), Capital Small Finance Bank Ltd ( ₹1,000 crore) and ESAF Small Finance Bank ( ₹1,000 crore).
These IPOs come at a time when the external environment is not particularly conducive for the listing of these banks. With the lending business getting severely disrupted by covid-19, SFBs have been working hard to get things back on track. In some ways, these banking upstarts have been victims of their own success. According to the Reserve Bank of India (RBI), which carved out a new category called a ‘small bank’ in India’s financial universe just half a decade ago, small finance banks need to list on the public stock exchange within three years of attaining a net worth of ₹500 crore. And SFBs have been in a tearing hurry to grow. In the five years since new SFB licenses were issued, their loan books have swiftly grown to account for roughly 10% of all small loan accounts.
The idea behind SFBs can be traced back to 2013 when an internal group of the RBI recommended that much like microfinance institutions (MFIs), banks should begin viewing the poor as profitable customers. Based on its observations, the panel proposed the establishment of a set of new private, well-governed, deposit-taking SFBs that could operate in a contiguous (small) area.
The proposal, however, became a reality when Raghuram Rajan became the governor of the RBI, and the term ‘small finance’ was introduced—indicating not the size of the bank but the size of the loan or the economic status of the potential borrower.
In a country where banking innovations are a dime a dozen—from payments banks and e-wallets to neo-banks—the nascent universe of 11 SFBs is a domain of hope, an innovation that has worked to some extent. The success of these SFBs could also serve a larger public purpose. Although the share of Indians with bank accounts has swiftly expanded over the past decade, most of these accounts are rarely used. A majority of Indians still remain outside the reach of formal financial institutions. Without assured access to credit, small entrepreneurs can’t flourish, and innovation cannot take root. This is exactly the problem that these new banks were meant to solve.
“It’s early to say if the concept of SFBs is a success story. So far, they have done reasonably well," said R. Gandhi, former deputy governor of RBI. “We need to see how they are able to manage one full business cycle."
While it is still early days, there are also a few detractors who question the performance of SFBs, particularly on the financial inclusion plank. Most of the new small banks operate in urban and semi-urban areas and a large part of their deposit portfolio consists of large borrowers. Naturally, some experts believe that these banks have already moved away from “small finance" in their pursuit of quick growth.
“This is a wrong model for financial inclusion. When you have given (SFBs) the ability to give a loan of ₹25 lakh, do you think they will (give) a ₹40,000 loan? This is an appropriate design for MSME finance. They are only catering to the missing middle-income market," said an industry expert on the condition of anonymity. MSME refers to micro, small and medium enterprise.
The SFB lending rate also continues to be fairly high despite their transition into a bank—a throwback to their past avatar as MFIs. Ultimately, the evolution of these SFBs will depend on how quickly these banks manage to find a stable and profitable business model. So far, only AU SFB and Equitas SFB have managed to achieve a well-diversified loan book.
What’s in a name?
One of the initial challenges that SFBs faced was with the “small finance" moniker. Most customers were not aware what a small finance bank was and how it was different from a mainstream bank.
Suryoday Small Finance Bank’s managing director and chief executive officer Bhaskar Babu says that it was a challenge to convince his mother-in-law that a small finance bank is different from a cooperative bank. Others like P.N.Vasudevan, managing director & chief executive officer of Equitas SFB, admitted that brand acknowledgment among customers was a worry initially. “Early on, we had reached out to RBI with a request that we drop the words ‘small finance’ from our name. However, they were not able to accede to it since this was part of the licensing guidelines," Vasudevan said.
“We had to (generate awareness) and (build) outreach at the branch level. It was a challenge initially to even get new staff from other banks…because they were not sure whether we were a proper bank" he added.
However, as SFBs opened new branches, more and more customers began to recognize their existence. Over the past five years, SFBs have expanded their branch presence rapidly—rising to 4,307 branches by March 2020. However, most of these branches have been opened in the relatively well-banked regions or states. As of March 2020, about 39% of all SFB branches were in semi-urban areas and 26% in urban centres. In the case of only three SFBs did the share of rural branches stand at more than 25%, while for the others, the share ranged from 10-22%.
Even as SFBs kept opening new branches, deposits did not come in easily as a majority of these entities had some experience in doling out loans but not in collecting deposits. The share of current and savings accounts (CASA) in total deposits for SFBs stood at 15% in March 2020, as compared to 41% for banks. This is despite SFBs offering a higher interest rate to woo depositors. Utkarsh SFB, for instance, offers 5% on savings accounts with a minimum balance of up to ₹1 lakh and 7% on a balance above ₹25 lakh.
N. Vasudevan, managing director and chief executive officer of Equitas SFB, believes that it is not possible to fund low-ticket loans with low-ticket deposits. “SFBs can’t fund their growth by taking deposits from the borrowing communities unlike a regular bank. Their (borrowers’) income is not steady as they are self-employed. You will have to access the affluent and upper middle-income category of customers… only through them can we fund the low-income category," said Vasudevan.
One by-product of this difficulty with raising deposits is the interest rate on loans. In some cases, the lending rate could be as high as 30%, even when the loan is secured and is for a business purpose. According to RBI data, SFBs have outstanding loans of ₹83,441 crore as of March 2021. These had been given at an interest rate of 13% and above, as per the central bank’s data. Bankers say that the RBI is aware of these high lending rates and has expressed its displeasure on several occasions. In one meeting with the heads of SFBs, RBI governor Shaktikanta Das is said to have reprimanded these bankers for charging obnoxious interest rates on small borrowers, which goes against their very purpose of such institutions, that is to enable enhanced financial inclusion.
According to an analyst who spoke on the condition of anonymity, these banks have taken a lot of time to switch to a low interest rate regime. “The idea of giving them a banking licence is to lend at lower rates. But these banks continue to charge rates similar to the ones they charged when they were an MFI," the analyst said.
But Equitas SFB’s Vasudevan explains the math behind these high rates and predicts that it will take at least another five years to bring down the cost for borrowers. “Most SFBs’ interest cost on deposits is anywhere around 7%. When we add the cost of SLR/CRR (reserves that a bank has to keep to satisfy statutory requirements), we are talking of a landed cost of money at about 9%. In a few more years, as the bank’s brand recall goes up and the customer base increases, we should be able to reduce our rate of interest on deposits. The cost of acquiring deposits would also come down. Then, the real benefit of transmission of lower cost to borrowers would be realized," he said.
Swift growth
Despite the borrowing rates, SFBs continue to be the fastest-growing segment within the banking sector, given the small size of their current loan book, strong distribution and exposure to underserved segments where competition is generally low. According to a recent analyst report prepared by Investec, three listed SFBs—Ujjivan, AU SFB and Equitas—saw their advances grow at 50% compound annual growth rate (CAGR) between March 2018 and December 2020. During the same period, private sector banks grew at 12.7% CAGR. While nearly all the SFBs started off with a large concentration of microfinance loans, many have diversified into other segments such as MSME lending. In fact, SFBs have been lowering their exposure to microfinance customers to reduce the risk from income shocks, and political and operational risks inherent in the microfinance business.
Over the past four years, SFBs have also had to face two big risk events demonetization and the covid-19 pandemic. These events have resulted in immediate delinquency accompanied by liquidity stress. Post-demonetization, two small banks ended up with a loss in 2017–2018 and one bank had incurred a loss in 2018–2019. The NPA (non-performing asset) ratio for the sector touched a high of 5% compared to the sub 1% mark earlier.
Demonetization forced many SFBs to reduce their concentration to the microfinance sector and undertake a massive write-off of bad loans. The pandemic’s impact on the asset quality of SFBs is still not fully reflected in the reported numbers as many banks had availed of the moratorium benefit.
The way forward
Five years after the experiment began, the RBI is now gearing up to issue another set of SFB licences to new players. Centrum Financial Services has also received the go-ahead to set up an SFB after its merger with the distressed Punjab & Maharashtra Cooperative (PMC) bank.
While the central bank is getting ready to issue new licences, several SFBs continue to view the license as a mere plank to attain what is still an elusive tag in the Indian context—a ‘regular commercial bank’. But doesn’t this defeat the very purpose of creating a separate SFB category?
“SFBs want to become like HDFC Bank," said Samit Ghosh, founder, Ujjivan Small Finance Bank. “A lot of regulations are liberal for universal banks. Becoming a universal bank is less capital intensive. That’s why most of them want to become a universal bank."
As more players enter the SFB space, a stiff competition is expected to break out in the segment alongside a rise in innovation and digitalization. What is at stake is not merely the success or failure of a five-year-old banking innovation, but the financial future of India’s unbanked millions.
