Banking Trends: Is small beautiful?

The impressive stock market debut of both Ujjivan Financial services and Equitas Holdings seems to have enthused analysts and investors about the arrival of small finance banks (SFBs), but that could be a premature celebration, considering that these entities are still micro finance institutions (MFIs) and have been riding what have been exceptionally good times for the microfinance sector. The real test will be next year as full fledged banks. With most of the new licensees being MFIs, the issue of customer acquisition or banking infrastructure may not be problematic, but their real challenges will be in three key areas, viz funding, credit pricing and business models.

On funding, currently MFIs are almost exclusively dependant on bank loans which, in turn, is driven by their classification as priority sector credit; with the SFBs themselves having to meet priority sector targets, bank lending may lose its sheen and SFBs would need to explore alternate avenues. As for deposits, the challenge will be not so much of competing for low-cost deposits, but tapping into a completely different client segment than what they now have.

On the flip side, they are well capitalised and their lower leverage gives them more leeway for additional borrowings, but then the real issues are availability and cost of funds. The limits to future growth in microfinance lending may well be set by their deposit-taking abilities. And then there are the known issues in capital re-structuring that will be required to comply with RBI regulations on promoter and foreign holdings. But as of now, the high capital base should help the cause of capital adequacy well. Another key aspect of the liability side that is bound to change is their asset-liability maturity profile; currently MFIs enjoy a positive mismatch (shorter assets and longer liabilities), which is bound to change with a larger deposit base and changes on the asset portfolio.

Credit pricing has been a key factor behind the high return on assets (ROAs) of MFIs; their large interest spreads together with low cost of risk (that flow from low non-performing assets) are in stark contrast to banks (with low net interest spreads and high credit risk premiums).

One wonders whether the transition to banks would impact any of this — for one, they will now be subject to the credit pricing norms under MCLR; with most MFIs currently charging 20 per cent plus rates with the maximum capped by RBI rules for NBFC-MFIs, it remains to be seen how new loans will be priced under MCLR. In all likelihood, net interest spreads would come down.

The saving grace would be low credit risk premiums, given their low bad debt portfolio. While prudential norms for asset quality and income recognition have been made applicable for SFBs, their business model of short term loans (weighted average maturity of loans is less than 12 months) and focused lending have helped them restrict bad loans to insignificant levels.

Finally, their business models could change significantly, not only on account of the changes discussed above on the liabilities side, but also due to the new rules for asset allocation (75 per cent of adjusted net bank credit to priority sector, of which 40 per cent to be dispersed across existing priority sector sub-sectors). This leaves fewer resources for micro financing business itself, their core competence. When we consider that MFI clientele have been largely weaned on repeat loans year on year that keep the cash cycle flowing, it will be a matter of concern if microfinance growth drops as a result of their transition to banks.

The rationale for encouraging MFIs to convert to banks apparently derives from giving them a chance to get over the constraints they face, such as inadequate finance, unclear regulatory environment, or low technology and management bandwidth.

Although, as the RBI discussion paper itself acknowledged, earlier experiments with specialised small banks such as LAB were not successful, the driving force now is financial inclusion with the twin initiatives — namely, small finance banks aiming at credit outreach and payments banks at filling gaps in access to formal payments and remittances system.

This is a time to pause and watch how the SFBs adapt and how the microfinance sector itself adapts, in the event of any shift in focus of the SFBs on account of their becoming banks.

The writer is an independent consultant

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