Small Finance Banks- Big profits?(Part 2)

..continuing the article from the earlier post here

Let us begin the next part by looking at the current list of small finance banks in India

Source: RBI website

The Banking and Financial services space in India is fast-changing. The emergence of startups and Fintech companies has simply increased the rate of developments happening in this sector multi-fold. The agility of SFBs may put them in an advantageous position to leverage the power of digital by partnering with some of these high growth startups. This again means more activity in mergers & acquisitions is likely in this high growth area. Consolidation is pretty much the rule of high growth areas in which customer acquisition is involved. Acquisitions generally provide synergies to both the parties. In the banking space, we have witnessed a couple of such deals in the recent past namely IDFC Bank and Capital First. IndusInd Bank-Bharat Financial Inclusion. These mergers help the banks by providing them with a wider customer base. The NBFC scores by getting a more stable source of funding in the form of CASA deposits. We may exaggerate the synergies a bit more and say that some of these are marriages made in heaven.

Such M&A activity is likely to happen in the SFB space in the coming future. The RBI has clearly expressed its intention of encouraging microfinance institutions, co-operative banks, NBFCs, and payments banks to convert themselves into SFBs. The requirements for this conversion are clearly laid down and looking at the trend, it looks like the picture will get clearer. Does that mean are we looking at mergers where SFBs would acquire smaller payments banks or NBFCs? Or does it mean that SFBs would get acquired by the commercial banks? At this point, it is difficult to comment. Honestly, the M&A activity in this space is tightly regulated by multiple regulators. Deals are announced and overnight they fall-off (Many traders burn their fingers by trading such news items). Let me stop speculating here regarding companies getting acquired, but definitely the space is hot and is likely to witness good action in the future!

Why am I speaking all good about Small Finance Banks? Are there no risks involved in this business? Well, there are, and in fact not one, but many risks! Let us talk about them here:

Small Finance Banks are required to lend 75% of their funds to sectors classified under priority sector lending (PSL). 40% of the total lending should be allocated to different sub-sectors within the PSL, the remaining 35% is at the bank's discretion to identify the sub-sector in order to stay competitive.

When we speak of scheduled commercial banks, the RBI mandated requirement for priority sector lending is 40%. The table below will discuss further on the difference between the requirements for both SCBs and SFBs. Let us look at the sectors covered under priority sector lending:

  • Agriculture

  • Micro, small & medium enterprises

  • Export credit

  • Education

  • Housing

  • Social Infrastructure

  • Renewable Energy

Here is the summary of the difference between PSL targets for scheduled commercial banks and small finance banks:

While the sub-sector targets are the same, the overall targets for SFBs are much higher than those for SCBs. Does this make a lot of difference, significant enough to prohibit SFBs from competing against their bigger and established peers?

We need to analyze the NPAs in priority and non-priority lending on two fronts:

  1. Priority sector NPAs as a percentage of total NPAs

  2. Absolute NPA percentage in the priority sector over a period of time

Source: RBI data

From the face of this, it appears that the priority sector NPAs as a percentage of total NPAs in the country is coming down. In a way, this looks good for SFBs. However, this does not necessarily mean that NPAs in the priority sector aren't increasing. In the last few years, the NPAs in non-priority sectors have been increasing at a faster pace. This makes the percentage of priority sector NPAs a smaller number!

Let's look at the actual growth in priority and non-priority sector NPAs. From the below figures, the CAGR of NPAs in public sector banks stands as below:

  • Priority sector: 18%

  • Non-priority sector: 28%

  • Total: 24%

Here's the data for your reference:

Source: RBI data

18% CAGR growth rate is definitely better than a 28% CAGR, but in absolute terms, 18% CAGR is high. And mind you, this percentage number is likely to increase when the lending in priority sectors increases further.

The growth rate in priority sectors NPAs may increase when aggressive lending picks up in this area owing to emergence of small finance banks

Here's a chart of NPAs in three important segments: Private banks, public banks, and small finance banks

It is time to summarize the discussion we have had thus far:

  • We started with the history of co-operative banks and understood the RBI classification of various banks.

  • Co-operative banks continue to have a problem of dual regulations. The existence of state Governments as regulators brings in a clear conflict of interest. The process of nominating Board of Directors is full of conflict of interest.

  • RBI has been encouraging co-operative banks, microfinance institutions, and other smaller banks to convert into small finance banks by increasing their paid-up capital. This encouragement from RBI clearly points to the intention of better-managed banks in the future.

  • In case co-operative banks are not ready to move to small finance banks, the RBI requires them to appoint a fit and proper board. In the current scheme of things, big borrowers nominate the board of directors in co-operative banks.

  • The law mandates small finance banks to have a minimum 75% lending target for small finance banks. This stands against the target of 40% for scheduled commercial banks. NPAs in any sector generally come like a wave. Since 2015, the NPA wave has grappled the big corporate loans space. This rise in NPAs in the industry makes the NPA rise for the priority sector looks relatively smaller.


In a country where the ideology of Governance changes frequently due to anti-incumbency, priority sector lending is a risk.
  • The very fact that sectoral NPAs are cyclical means that banks having large exposure to particular sectors are susceptible to the change in cycle. Now, in the case of small finance banks, 75% exposure to the priority sector is a risk and opportunity in itself.

  • The opportunity lies in the financial inclusion story of the Indian economy, whereas the threat lies in deteriorating macro-economic conditions which have a possibility of severely affecting the bottom of the pyramid.

  • Agricultural loans form a big chunk of advances given by small finance banks. These loans are susceptible to the vagaries of mother nature. Not just mother nature, but agri -loans are a big area of concern when there is a change in the Government.

  • In a country like ours where there is a strong tendency of anti-incumbency during elections, the possibility of we shuttling between the populist and capitalist ways of Governance is quite high. We have recently seen what happened in Karnataka in 2018.

  • Financials for small finance banks look good, but one needs to take it with a pinch of salt for the above-mentioned reasons.

  • On the positive side, small finance banks appear to be promising investment destinations considering the RBIs thrust on converting regional rural banks, NBFCs, co-operative banks and payments banks into small finance banks. The space is likely to witness a good amount of mergers & acquisitions activity in the future. M&A generally provides the opportunity to match synergies and identification of such opportunities is a good source of creating wealth.

No investment thesis is without risks and potential rewards- small finance banks are no exception. In my opinion, having a small exposure to small finance banks is worth considering. It is a high growth area in a country which is likely to grow in the next 10-15 years.

Thank you for your patience in reading this analysis. It became longer than intended. Questions/ suggestions/ feedback/ criticism most welcome!

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