Is the Reserve Bank of India (RBI) priming some of the small finance banks (SFBs) to convert into universal banks? The central bank’s recent incremental liberalisation for SFBs, making them eligible for Authorised Dealer (AD) category-I licence so that they have more flexibility to meet their customers’ foreign exchange business requirements, seems to suggest so.

So, now an AD Category-I Bank can carry out all permissible current and capital account transactions. Hitherto, SFBs could only get AD Category-II licence, which allowed them to carry out specified non-trade related current account transactions and all activities permitted to Full Fledged Money Changers.

It may be pertinent to note that the RBI, in its December 2019 guidelines for ‘on tap’ licensing of SFBs in the private sector, had clearly mentioned that after the initial stabilisation period of five years, and after a review, it may liberalise the scope of activities of SFBs.

Notwithstanding asset quality pressures and dent in their bottomline during the last two years due to Covid-related impact, SFBs seem to have bounced back, and given a good account of themselves, otherwise the RBI would not have effected the aforementioned liberalisation.

According to the December 2019 guidelines, if an SFB aspires to transit into a universal bank, it has to have satisfactory track record of performance for a minimum period of five years.

The transition will not be automatic, but would be subject to an SFB applying to the RBI for such conversion, fulfilling minimum paid-up voting equity capital/ net worth requirement as applicable to universal banks, and the outcome of the central bank’s due diligence exercise.

Of the 10 applicants who were granted in-principle approval in 2015 to set up SFBs, nine have already completed five years of operations and Jana SFB will be completing it in March 2023. Two other entities (Shivalik SFB and Unity SFB) commenced operations only in 2021.

Among the 12 SFBs, Jaipur-headquartered AU SFB, which is the biggest SFB with deposits and advances of ₹54,631 crore and ₹48,654 crore, respectively, as of June-end 2022, has already disclosed its plans to convert into universal bank.

In AU SFB’s FY21 annual report, Raj Vikash Verma, Chairman, said: “We are looking far and beyond the current status of the bank in the SFB space; we are propelling the bank’s journey to the next important milestone in the bigger banking space with an aspiration to serve all sectors and segments of the economy under the larger agenda of national development and growth.”

If this happens, it will be the second transition for the lender. Before it converted into an SFB in 2017, AU was a non-banking finance company – Au Financiers (India) Ltd.

SFBs are niche banks. Their scope of activities is restricted to undertaking basic banking activities of acceptance of deposits and lending to unserved and underserved sections, including small business units, small and marginal farmers, micro and small industries and unorganised sector entities. Universal Banks’ scope of activities is much wider, spanning RAM (retail, agriculture and micro, small and medium enterprises) banking, wholesale (corporate) banking and infrastructure/project financing. Karthik Srinivasan, Senior Vice-President & Group Head, Financial Sector Ratings, ICRA, said: “There is a roadmap for conversion [of an SFB into Universal Bank]…I guess, you can say that it [SFBs becoming eligible for AD Category-I licence] is a precursor to that.

“There will always be an aspiration that I want to go to the next level. That will be a commercial call that each SFB will have take.”

He noted that there are inherent advantages in converting into a universal bank, including undertaking larger ticket transactions, lower capital adequacy and priority sector lending (PSL) target. Moreover, SFBs, which plan to convert, don’t have to do anything additional to meet PSL target.

SFBs are expected to deploy 75 per cent of their loans in priority sectors (agriculture and allied activities; micro, small and medium enterprises; education; housing; others), with at least 50 per cent of loans below ₹25 lakh. The PSL threshold for a universal bank is lower at 40 per cent.

The minimum capital adequacy ratio that an SFB has to maintain is 15 per cent (against 9 per cent for universal banks).

“SFBs have done pretty well on the liabilities side as they have been able to build a fairly good retail franchise in the last five-odd years. The risk granularity in deposits is coming in.

“Assets side still remains a challenge. Most of them were primarily into microfinance. So, they all wanted to diversify outside of microfinance and started building the non-microfinance book...the last couple of years have been challenging on the assets side, with Covid hitting MSME sector more compared to other sectors,” opined Srinivasan.

So, all these entities have had challenges on the asset quality front not only on the microfinance book but also on the non-microfinance book.

“If we are expecting that possibly the worst on the asset quality is behind us, things should start stabilising. The collection numbers are improving for all SFBs.

“So, we should see some improvement in overall profitability and asset quality. Going forward, things should stabilise in FY23 before they start improving next year onwards,” he said.

Market experts say over the last five years, AU SFB has been able to scale up and is in a different league in the SFB space. Other SFBs, which started off as microfinance institutions (MFIs), have also scaled up, but not to that extent. AU SFB has the advantage of originally being a Commercial Vehicle and SME financier. The other entities that got SFB licence along with AU SFB were primarily MFIs. Therefore, as they scale up, they need to diversify.

The average loan tenure of AU SFB is 3-4 years, whereas its peers have (microfinance) assets of 1-2 years tenure. So, SFBs with a large proportion of microfinance loans, have to run faster to remain where they are.

While AU SFB may currently be the most eligible SFB for converting into universal bank, the others are leaving no stone unturned to catch up with it. They are gradually diversifying away from microfinance loans so that their balance sheets gain heft.

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