Microfinance comes crashing again. Two stocks could buck the trend

Since FY17, microfinance loans outstanding have grown at a CAGR of 23%, from less than ₹1 trillion to nearly ₹4.3 trillion in June 2024. At no point during this period was year-on-year growth less than 10%. Yet, the two largest players–Bandhan Bank and IndusInd Bank (IIB in chart) –have faced big challenges in this segment. Over the last two years, a happy-go-lucky period for the sector, these two largest players have grown profits by 13% CAGR and -3% CAGR, respectively. That’s disappointing, at the very least.

Last week, the IndusInd Bank stock plunged, falling by as much as 20% in a day. This was on account of increased provisioning and higher than expected NPAs in the Microfinance segment.

Even the stock prices of small finance banks and top NBFC-MFIs have been in a downtrend since January 2024. What’s happening here?

 

Two years ago, in April 2022, RBI ‘harmonized’ regulations created an even playing field for NBFC-MFIs with banks and NBFCs. By this time, the pandemic was ending, stress in the segment was obviously high, profitability had decimated for nearly every player. Against this backdrop, RBI wanted to make changes for the better.

Among the major changes were:

⦁ Removal of interest caps. Lenders could charge no more than 10% above their cost of funds before this change.

⦁ Definition of MFI loans changed from unsecured loans to Households with Income of up to Rs. 1.25 Lac rural, Rs. 2 Lac Urban to Household Income under Rs. 3 Lacs. Increasing the so called “TAM – Total Addressable Market" for Microfinance.

⦁ The maximum cap of two NBFC-MFI lenders per borrower were removed

⦁ All members’ income should be includedas household income. Previously only borrows income was considered for assessment and gold, kisan credit card were excluded from assessment, resulting in higher fixed obligations as total income.

⦁ FOIR – Fixed obligation to Income ratio to be restricted to under 50%.

This was seen as a huge positive. Two years later, these changes seemed to have not played out as expected.

Portfolio at risk or PAR, the percentage of total loans that remains unpaid fully has been rising. While banks, such as IndusInd Bank and Bandhan Bank are repeat offenders in this segment, small finance banks have been especially vulnerable to this trend. Their provisioning requirements have increased, and profitability has been hit.

In recent regulatory actions, the Reserve Bank of India (RBI) imposed restrictions on four microfinance institutions (MFIs) to address concerns regarding over-indebtedness, improper calculation of household income and ‘usurious’ interest rates. These were Asirvad Microfinance (Manappuram subsidiary), Navi Finserv (Sachin Bansal), Arohan financial services, DMI finance.

Despite the best intentions of the central bank, second order effects of changes made just two years ago seem to be hurting borrowers instead of helping them. 

Also Read: Manappuram Finance: A falling knife or a mouth-watering opportunity?

According to the MicroLend Report by CRIF Highmark for June 2024, of the 8.6 crore unique borrowers availing microfinance loans, about 55 lakh have at least four or more active lender associations. Here’s the kicker, in the June quarter, about 67% of the incremental PAR 31-180 bucket (yoy) came from borrowers with more than four active lender associations. This means more than half of incremental stress (measured as PAR 31-180) comes from over-levered borrowers. A significant jump in the percentage of borrowers having more than four lender associations is a direct consequence of the removal of the lender per borrower cap in April 2022.

The percentage of borrowers with more than four lenders has increased in each of the top 10 states, but the increase has been especially dramatic in Bihar and Odisha followed by Uttar Pradesh and Karnataka.

Around 57% of the outstanding microfinance portfolio is concentrated in five states: Bihar, Tamil Nadu, Uttar Pradesh, Karnataka and West Bengal.

The gross loan portfolio (GLP) or the total outstanding loans in four of the top five states have grown at a CAGR of over 20%, with Bihar and Uttar Pradesh growing north of 30% CAGR. High growth in any loan segment usually raises question, in microfinance its usually a predictor of impending stress.

GLP growth in Bihar, for example, was more than 31% CAGR over since FY21. According to an HDFC Securities report on microfinance sector, Bihar also has an MFI penetration of over 80%. And now with floods affecting nearly 1.5 million people across 17 districts, lenders with excessive exposure to Bihar might see some stress in coming quarters.

West Bengal (WB) and Odisha (OR) have also shown high growth in the >=5 category. The 99% year-over-year growth (on a small base) in West Bengal for borrowers with >=5 associations, for example, highlights a potential asset quality concern.

In short, the top five states with the highest market share of total microfinance loans are well penetrated, account for nearly 57% of total microfinance loans (concentrated), have grown at rapid rates since FY21 and account for a significant share of growth borrowers with over four lenders.

It’s not looking good.

The RBI mandated that a few large private banks increase the risk weights on microfinance loans from75% to 125%, effectively treating them as high-risk unsecured loans. This decision was driven by signs of overheating in the MFI sector. 

Also Read: Could the Nifty lose another 1,000 points? A market veteran explains.

How bad is it, really?

Amongst the four types of players that operate in the microfinance segment, NBFCs fare the best from an asset quality perspective and small finance banks the worst.

 

The stock price of all small finance banks is in a downtrend. According to Sadaf Sayeed, CEO of Muthoot Microfin, there could be three reasons. One, the average ticket size of SFB’s is higher compared to NBFCs & NBFC-MFIs. Second, SFBs MFI portfolios could be slightly more concentrated in states showing signs of stress. Third, since SFB are focusing on growing its secured book, their MFI book is not growing at the same pace, which means NPAs as a percentage of loan book appear higher.

We also believe that the overall stress in the Microfinance sector is a result of a larger macroeconomic phenomenon – Inflation. While do not have hard data to verify correlations between Inflation and Microfinance NPAs, we are of the opinion that inflation, and therefore higher rates, therefore higher stress in the MFI is correlated. Given this context, we believe that stress in Microfinance is not surprising at all.

RBI raised rates to curb inflation, it also cautioned against a deposit crunch, in response to which banks have slowed down their credit growth. All this leads to the perfect cocktail for creating stress at the so called ‘bottom of the pyramid’, how can it not?

For more such analysis, read Profit Pulse.

The opportunity?

It's a bleak outlook for the sector but it also has all the makings of an opportunity. You see Microfinance is a cyclical Industry(duh). Very few players have exhibited the ability to manage stress, as is the case in any loan segment.

The five best-performing lenders (by asset quality) have asset quality significantly better than the industry average. The dispersion between the five best and worst players is staggering. While there’s no debating that NPAs are likely to deteriorate significantly from here for all players, it’s these players we want to keep an eye on. At some point, the best MFIs are going to scrape through.

Indeed, “this time it could be different" for the microfinance industry compared to previous cycles. According to Sadaf Sayeed, CEO, Muthoot Microfin, capital adequacy ratio of some players is as high 25-30%, unlike in previous cycles. During stress periods, better-capitalized players should be able to get through imminent crises relatively unscathed.

For now, most players are feeling the pain. The market has started discounting it into stock prices. For example, CreditAccessGrameen (CAG) and Arman Financial, two of the better-run MFIs, are already trading at valuations as low as they were during the March 20 crash, based on the price-to-book ratio, a common valuation metric used for lenders.

It’ll be worth watching how the industry, and particularly these two players, perform in relation to competition.

Note: We have relied on data from www.Screener.in and www.tijorifinance.com throughout this article. Only in cases where the data was not available, have we used an alternate, but widely used and accepted source of information.

The purpose of this article is only to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly advised to consult your advisor. This article is strictly for educational purposes only.

Rahul Rao has been Investing since 2014. He has helped conduct financial literacy programs for over 1,50,000 investors. He helped start a family office for a 50-year-old conglomerate and worked at an AIF, focusing on small and mid-cap opportunities. He evaluates stocks using an evidence-based, first-principles approach as opposed to comforting narratives.

Disclosure: The writer and his dependents do not hold the stocks/commodities/cryptos/any other asset discussed in this article.