In the post-April 2024 Monetary Policy press conference, RBI Deputy Governor M Rajeshwar Rao, had reportedly stated, “SFBs have been conceptualised as differentiated banks with specific objectives. The tag of having an SFB after their name is a key part of that differentiator. So, I do not think there is any requirement to modify that at this point of time.”

At March-end 2023, there were 12 operating Small Finance Banks (SFBs) (now reduced to 11). SFBs are apparently not happy with the ‘Small Bank’ tag in their names, as according to them, it inhibits trust of the customers (existing and potential) to deposit their savings with them. Therefore, they want the tag to be removed, which, however, has been turned down by the regulator.

Another issue in the SFB space today is that some of them want to convert into universal banks as they have completed the mandatory five years of operations. The current licensing norms for SFBs do not have any additional requirements or conditions to be met to convert to universal bank except that “paid-up voting equity capital” should be ₹500 crore. Such aspiring SFBs argue that a universal bank licence would reduce their cost of funds and consequently borrowing cost to the borrowers.

Before we discuss the two issues, it will be in order to look at a few key performance indicators relevant to our discussion. We focus on the performance of SFBs at March-end 2023 (unless otherwise mentioned), the latest year-end data available in the RBI’s annual publication The Report on Trend and Progress of Banking in India, 2022-23 (hereinafter referred to as The Report).

SFBs’ Performance

In June 2023, there were nearly 7,000 SFB branches, comprising 55 per cent Rural and Semi-urban (RUSU) and 45 per cent Urban and Metropolitan branches. Except in the northern and western regions, in the other four regions (central, eastern, north-eastern and southern), individually, the shares of RUSU branches were above 50 per cent of the total number of branches in the respective regions.

Population group-wise distribution of SFB branches as well as ATMs reveals that, by and large, their presence in under-served areas and among unbanked people has been increasing, which is in consonance with their mandate.

The ‘smallness’ of SFBs can be judged from the fact that the average balance sheet size per SFB was ₹22,293 crore, constituting 5.5 per cent of that of private banks (PvBs).

The Current and Savings Account deposits, which are low-cost and stable, of SFBs accounted for 32.5 per cent of their total deposits, much below PvBs’ 44.1 per cent. According to The Report, many SFBs sourced bulk deposits at higher rates especially from co-operative banks, which exacerbated the contagion risk due to interconnectedness between the two banking segments.

Term loans dominated the loan portfolio of SFBs (89.2 per cent) as against PvBs’ 65.8 per cent. Moreover, the credit-deposit ratio for the former at 93.0 per cent exceeded PvBs’ at 85.2 per cent.

The Priority Sector Loans of SFBs stood at 88.2 per cent of their ‘Adjusted Net Bank Credit’, exceeding the target at 75.0 per cent.

In the sub-segments also, SFBs crossed the stipulated sub-targets.

Apparently, there were mismatches in the maturity profile of deposits and loans by SFBs, potentially inducing Asset-Liability Management risk. However, this requires a detailed study.

SFBs adopted a ‘high cost-high return-high spread’ business model. While ‘cost of funds’ for them was 6.1 per cent (PvBs = 4.1 per cent) due to higher cost of deposits plus borrowings, ‘return on funds’ was equally higher at 14.2 per cent (PvBs = 8.4 per cent) mainly due to higher rates on loans. Thus, SFBs reaped a spread of 8.1 per cent as against PvBs at 4.3 per cent.

Gross Non-Performing Assets (NPAs) of SFBs stood at 4.7 per cent as against 2.3 per cent for PvBs. The corresponding Net NPAs were 0.9 per cent and 0.5 per cent.

The Capital to Risk-Weighted Assets Ratio (CRAR) for SFBs stood at 24.1 per cent out of which Core CRAR was 20.5 per cent.

Per The Report, the share of unsecured lending in the portfolios of SFBs, especially to microfinance and Joint Liability Group borrowers, was high. This lack of asset diversification, often coupled with geographical concentration, implied high concentration risk. In a way, niche banking and concentration risks are twins.

Financial inclusion

Banks are ‘special’, and SFBs are more special as their principal task is to foster financial inclusion. Though SFBs came into existence after a lot of discussions, their healthy continuance today is challenged by the enormous capacity of FinTech entities to serve the un- and under-served population.

Since a majority of SFBs were earlier micro-finance institutions, they could continue to harness their relationship with the small depositors through dedicated deposit mobilisation strategies — both physical and digital.

They need to emulate the Pradhan Mantri Jan-Dhan Yojana strategy. The public sector banks in the 1980s and 1990s faced similar problems which they overcame through widened and deepened low-cost and stable deposit mobilisation. Mobilisation of retail deposits is more effort-elastic than anything else.

On the issue of converting SFBs, which have completed five years, to universal banks, the first question to be examined is whether India needs more universal banks today or say, in the next decade.

Do we need more banks or more banking? Today’s emphasis on consolidation of existing banks needs to be continued. The list of PSBs was pruned to 12. So is the case with Regional Rural Banks which are also ‘specialised’ banks focusing on the rural economy. PvBs which were set up in the 1990s also went through a process of consolidation via mergers and acquisitions.

In sum, SFBs need consolidation and proper management of risks (some of which are mentioned earlier) first, and then one could think of giving them the universal banking status. The consolidation could be within the SFBs group or one or some SFBs merging with a universal bank or the latter acquiring SFB/s. The process has already begun. Eventually, the country should have fewer categories of banks thereby decluttering the banking space and removing confusion from the public mind.

Das is a former senior economist, SBI. Rath is a central banker. Views expressed are personal.