India’s small finance banks have a few major problems

Shares of Ujjivan Small Finance Bank Ltd, AU Small Finance Bank Ltd and Suryoday Small Finance Bank Ltd have been hit the hardest in FY22. The shares have dropped 34%, 7.4% and 21%, respectively, since April. Equitas Small Finance Bank Ltd’s shares have largely remained flat, minus any misgivings on governance.

AU Small Finance Bank and Ujjivan Small Finance Bank have been at the receiving end of concerns over governance. The quick exits of key executives from the management have made investors uneasy, especially when expectations are that stress on the balance sheet would only increase. In the case of the former, the exit of the chief risk officer raised eyebrows. Last month, Ujjivan Small Finance Bank’s chief executive officer Nitin Chugh resigned after several other mid-level exits. Chugh’s exit came at a time when the bank was struggling with a spike in bad loans in the wake of the pandemic.

In a 23 August note, analysts at Emkay Global Financial Services Ltd said: “In our view, apart from the bank’s underperformance, some niggling issues with the old management and his incompatible new-age management style in the still MFI-dominated old school bank, could also have contributed to the resignation."

While these concerns are legitimate, the larger trouble for lenders is the sharp deceleration in loan growth since the pandemic struck last year. “These banks are in a tight spot because of the pandemic. The pressure of growing the balance sheet is immense, but at the same time, high attrition level is definitely a big worry," said an analyst requesting anonymity.

As the adjoining chart shows, small finance banks saw a sharper deceleration in loan growth over the past few quarters compared to the industry wide performance. The pain on asset quality has only worsened this even more.

For instance, Ujjivan’s stressed loan book, including bad and restructured loans, is nearly 30% of its total book. AU Small Finance Bank’s gross bad loan ratio rose to 4.3% as of June. Suryoday Small Finance Bank’s default loans were 9.52% of its book. Considering that the lenders service the most vulnerable segments of borrowers, the stress is unlikely to reduce immediately, analysts said.

This brings us to the strategies for growth of small finance banks. Most of the lenders have capital ratios far in excess of regulatory requirements and therefore may not require fundraising exercises. That said, small finance banks are looking at various tie-ups and avenues to fuel growth.

According to media reports, Suryoday Small Finance Bank may be exploring a merger with non-banking financial company Clix Capital. The immediate outcome of a merger is an increase in balance sheet size and expansion into non-micro loans for Suryoday. Another benefit would be the reduction in gross bad loan ratio from the current 9.5%. The 20% surge in the bank’s shares on Monday shows that investors see the merger as beneficial.

As organic growth seems a slow and tough path, the inorganic route may seem beneficial. For now, a boost to valuations from business growth seems to be a tall ask.