AU SFB to Ujjivan SFB: Where do small finance banks go from here?

UCBs that aspire to become SFBs do not want the same limits on loan size and priority sector targets that SFBs have, especially when not many of them have sought to become SFBs

It does not depend so much on whom you ask but on whether you want them to speak on the record or off. On record, they say the correct things: Small finance banks (SFBs) are meant to enhance financial inclusion, act as savings vehicles, and be vendors of credit to small businesses, marginal farmers, and the unorganised sector through high-technology, low-cost operations.

Off the record, it is a different story.

Both the stories acquire relevance with recent developments. There is talk of one SFB being in preliminary talks to acquire another. Last year, Unity SFB, a joint venture between Centrum and BharatPe, acquired Punjab & Maharashtra Cooperative Bank in a rescue operation. 

More recently, albeit less momentous in impact, Ujjivan Small Finance Bank announced a strategic partnership with SMC Global Securities for online trading services, leading to a rise in share prices of both.

The developments show the various ways in which SFBs are trying to carve out a space for themselves. It is an arena that has to contend with their special circumstances.

Take the SFBs’ priority sector lending target — loans to the bottom of the pyramid, much of it unsecured — set at 75 per cent of the book. As the book gets bigger, so does the challenge of meeting this target. Other modes of making up the shortfall — securitisation, or co-lending with non-banking financial companies  —  are off the table.

For universal banks, the priority sector lending target is 42 per cent of the book. So, ask the off-the-record voices, why not keep it at 42 per cent for SFBs as well, and let them tap other routes just as universal banks can? This will help reduce the risk of concentration.

The counterargument is that there is no real concentration risk, that in a priority sector lending scenario the risk is spread over millions of customers. All of them cannot possibly default at the same time.

“That’s fine on paper,” says an SFB executive, “but, with climate change, floods and poor rainfall can upset calculations”.

He cites the Reserve Bank of India’s Report on Currency and Finance, which has a special edition on climate change. Its Chapter 1, entitled “The Climate Strikes Back”, says the difference between climate and non-climate issues is in the horizons. The former is for longer periods  — 30 to 80 years. Besides, it is difficult to rely on traditional risk quantification techniquesand past data may not be sufficiently representative of the extreme climate events that might lie ahead.

The other concern is the cost of deposits. SFBs pay higher interest on deposits than universal banks. This also holds true when they avail of refinance. The additional interest increases the overall cost of funds. The increased costs are passed on to borrowers.

What lies ahead

Many saw SFBs as a step towards a universal banking licence. The SFB operating guidelines (November 27, 2014) said they were eligible for transition to universal bank after five years of operations. This was subject to conditions. However, there is now a demand for a detailed road map for the application and conversion process.

Several big private equity names have stakes in the sector. Given the stock performance of SFBs, leaving out a couple of outliers, further supply of capital may not be easy to come by — even in the unlisted ones, whose valuation is influenced by their listed peers.

Fearing investor hesitance compounded by an oversupply of SFB stock, some sought an extension of the time limit for listing from six years to eight. They cited the “accepted recommendation 27” of the RBI’s Internal Working Group (IWG), which said: “Such banks should be listed ‘within six years from the date of reaching a net-worth equivalent to prevalent entry capital requirement prescribed for universal banks’, or ‘ten years from the date of commencement of operations’, whichever is earlier.”

The RBI, while accepting the recommendation, made a modification: “Such banks should be listed within ‘eight years from the date of commencement of operations’.” The RBI reasoned: “This has been stipulated considering the importance of listing and to provide sufficient time to these banks for stabilisation, consolidation of operations and to gain investors’ confidence.”

This was related to the IWG’s Recommendation 31, which said: “Whenever a new licensing guideline is issued, if the new rules are more relaxed, the benefits should be given to existing banks immediately… (if) the new rules are tougher, legacy banks should also conform to new tighter regulations, but a transition path may be finalised in consultation with affected banks to ensure compliance with new norms in a non-disruptive manner.”

Industry players say Recommendation 31 was for equal treatment of newly minted and existing SFBs. 

But when it came to listing, the new players were to do so in eight years while it was six years for the existing ones.

The RBI did not press for a listing in the sixth year as SFBs had faced the brunt of the after-effects of the demonetisation and, later, of the pandemic.

Parity with UCBs

Urban co-operative banks (UCBs) that aspire to become SFBs have urged the RBI and Ministry of Finance for more favourable entry norms. They do not want the same limits on loan size and priority sector targets that SFBs have, especially when not many of them have sought to become SFBs.

The RBI’s Report on the Trend and Progress of Banking in India noted that SFBs’ primary cash flows were adversely affected during the first phase of the pandemic. But structural problems had beset the sector even earlier. 

On the liabilities side, they had low savings and current accounts and relied heavily on bulk deposits and term deposits from cooperative banks. On the assets side, the share of unsecured microfinance loans was disproportionately large.

Many of these issues linger on. So, is the SFB model workable?

SFBs have been around for eight years. A paper on the “Performance of SFBs — An Early Reflection” in the RBI August bulletin 2021, authored by Nitin Kumar (assistant advisor, Department of Statistics and Information Management) and Sarita Sharma (manager, Department of Economic and Policy Research), said empirical results showed that micro-factors such as efficiency, leverage, liquidity and banking business were important in determining SFBs’ profitability during this early period of operations. 

The outcome could be because SFBs are established with the objective of serving a niche segment of under-privileged population instead of a purely profit-making intermediary. “Due to the limited time span available, the outcome of the analysis may be considered as indicative at this stage and needs to be substantiated with greater data,” the paper said.

Regardless, there is a steady stream of applications at the RBI’s on-tap window for SFB licences. Few make the cut.