Small Finance Banks- Big profits? (Part 1)

Banking & Financial Services in India is a high growth area, and why not, after all, we are (or were until recently) one of the fastest-growing economies in the world. There is little point in debating the role that banks and financial institutions play in the development of a country. I believe we all will agree that India has the potential to develop from the current state. We may have slowed down owing to various structural changes like demonetization & GST rollout, but in my opinion, it is too early to say that the long term India growth story is in danger.

Dependence of the economy on Banks & Financial institutions was recently tested once again in the aftermath of IL&FS crisis. For a few months, credit was frozen and banks were in a state of hyper risk aversion. We may not have completely recovered from that shock of IL&FS default, but yes the liquidity situation is improving, perhaps at a rate lower than desired.

The Reserve Bank of India categorizes banking institutions under various heads namely:

Private Sector Banks, Local Area Banks, Payments Banks, Public Sector Banks, Regional Rural Banks, Foreign Banks, NBFCs and Small Finance Banks. The reason behind creating various categories is to have a pre-defined objective for each type of bank. Today, we will discuss Small Finance Banks in detail- their origin, purpose of existence and finally how good an idea it is to invest in Small Finance Banks.

Small Finance Banks have their roots in scheduled co-operative banks.

In order to understand more about Small Finance Banks, we have to go back in time- almost 20 years. We have to revisit some scary stories of Urban Cooperative Banks to understand the reason for the existence of Small Finance banks. There are close to 1500 Urban Cooperative Banks in India. What separates UCBs from the gamut of other categories is the regulator. Urban co-operative banks in India are jointly regulated by RBI and the respective State Governments. This leads to dual-regulation and naturally, the consequences of dual regulations have not been pleasant. Let us discuss one such story of Madhavpura Mercantile Bank.

Madhavpura Bank was established in the year 1968 in Ahmedabad and became a scheduled co-operative Bank in 1994. In 1999, the bank started providing financing to stockbrokers, one among whom was Ketan Parekh (Yes, the same Ketan Parekh who made many investors lose their trust in the capital markets forever). Stockbrokers used these funds for speculative trading. On the liability side, Madhavpura Bank owed money not just to the depositors, but also to other banks. It is outside the purview of this article to discuss the implications of allowing SCBs to accept deposits from other SCBs.

In 2001, the problem behind the scenes came to light. RBI's inspection revealed:

  • The entire capital & reserves and 91 percent of deposits were eroded for Madhavpura Mercantile Bank

  • Net worth was -Rs. 1150 crores (Negative net worth!)

  • Gross non-performing assets stood at 88 percent of gross advances

  • The total loss for the year was more than Rs. 1000 crores.

Now, that really sounds horrific, doesn't it? What happened to the depositor's money? Immediately after the uncovering of the scam, the RBI decided to reconstruct the bank and placed it under a special scheme for 10 years. Unfortunately, none of that worked and in 2012 finally, RBI decided to cancel the bank's license. The nightmare for depositors continued until the year 2018 when the Gujarat Urban Cooperative Banks Federation issued a statement that up to Rs. 2 lakh per depositor would be compensated back.

That story of Madhavpura Bank is truly scary. Something similar (Not as worse as Madhavpura) has happened in the recent past when RBI imposed restrictions on the withdrawal of deposits from Punjab and Maharashtra Cooperative Bank. There was a state of panic and helter-skelter. The poor depositors could just wait for RBI to speak more! RBI's scrutiny revealed that the Bank's management had lent 73% of their assets to a single lender i.e. the HDIL group. RBI's regulations do not allow such a large concentration of borrowings to a single borrower. Then how exactly did this take place? Was the RBI kept in complete darkness until the scam was uncovered?

Precisely, Yes! The PMC Bank board decided to hide the loans given to HDIL promoters under the mask of retail borrowers. Around 21000 fake borrower accounts were created and loans given to the HDIL group were portrayed as borrowings by these fake account holders. That is another scary story, maybe not as scary as Madhavpura Bank, but definitely worth losing trust in the way cooperative banks function!

Where exactly does the problem lie? Has nothing really changed since the Madhavpura Bank scam? Is RBI as a regulator incompetent to handle 1500 banks? In my opinion, the influence that state Governments have on Urban Cooperative Banks is the problem. The process of appointing the Board of Directors for UCBs is full of conflict of interest. Directors are nominated by members of the banks. Members essentially mean borrowers of the bank. If borrowers can nominate directors, can we really expect clean governance? Can we not compare this to a robber having the keys to a Bank's gate?

Enough said about co-operative banks. Let us move away from this topic and focus on the intended topic of Small Finance Banks. Having identified the problem at hand, the RBI has given 2 options to Urban Cooperative Banks:

  1. Appoint a board of fit and proper management as per the RBI code of conduct (The RBI is hopeful that change in the Board will help improve Governance at these banks.

  2. Convert Urban Cooperative Banks into Small Finance Banks

Now, what exactly is a Small Finance Bank? A UCB may convert itself into a Small Finance Bank by having a capital of more than Rs. 100 crores and capital adequacy of more than 15%. The bank is required by law to increase its capital base to Rs. 200 crores within 5 years from the date of conversion into a Small Finance Bank. In the present state, UCBs have a restriction on raising capital. Once these banks convert to Small Finance Banks, they may raise more capital by issuing shares at a premium to the par value. This means that Small Finance Banks would not have the biggest problem that Urban Cooperatives faced: capital raising. So far, so good!

Looks like the RBI too is fed up with the Cooperative Bank business and wants to move towards a more robust option: Small Finance Banks.

It is now time to look at the financials and the business model of Small Finance Banks. The objective of setting up small finance banks looks pretty much the same as that of UCBs: financial inclusion. In a growing economy, it is important for the unorganized sector to have access to capital. In a capitalistic democracy, capital is an important raw material for financial success. From a business standpoint, Small Finance Banks(SFBs) are competing with Scheduled Commercial Banks(SCBs) and NBFCs. In the remaining part of this article, we will compare a few SCBs, SFBs and NBFCs. This comparison will give us a fair idea about where do SFBs stand when compared with the bigger established players.

Looking at this comparison gives us some clues about small finance banks viz-a-viz commercial banks and microfinance institutions. Like I have mentioned earlier, in the eyes of RBI, each bank/ financial institution has a specific role to play. While the broader goal for all these banks and institutions is financial inclusion, there are some differentiating factors on the basis of ticket size, the target market being addressed, the requirements of minimum capital, etc. Let us discuss some strengths and weaknesses of these institutions relative to each other:

Micro Finance NBFCs vs. Small Finance Banks:

  • The biggest differentiating factor comes into the picture regarding the ability to raise deposits from the masses. Microfinance institutions are not allowed to accept deposits. This leaves 2 options for these institutions to raise money: Banks and raising funds from the primary capital markets. While these 2 are a good source for raising money, but it can get really difficult to raise funds at affordable costs during times of liquidity crunch. This may directly affect the Net Interest Margins for these institutions.

  • Small Finance Banks, on the other hand, are allowed to accept deposits. Not just the lower cost of raising funds, but the bigger advantage of raising funds from the people is the reliability of the funding source. As the country progresses, the financialization of savings is very likely to keep growing. This means more funds available to banks and deposit-taking NBFCs, which eventually means more scale to their business!

Scheduled co-operative Banks vs.Small Finance Banks:

  • Scheduled co-operative banks have the biggest restriction in the form of raising capital. These banks are not allowed to sell shares at a price more than their face value. Now, that certainly places restrictions on the banks to raise growth capital. Deposits are just one source, but what about the risk capital that banks and microfinance institutions generate by raising funds through primary capital markets? This means scheduled co-operative banks that do a job of financial inclusion for the masses are excluded from the capital markets! In the aftermath of PMC bank fraud, co-operative banks have requested RBI's permission to float bonds. The proceeds of these bonds would be included in the Tier I capital of these banks. The discussion is in the initial stages and may take time to be made. The survival of many co-operative banks is dependent on their ability to raise funds during these conditions of tight liquidity.

  • Small Finance Banks, on the other hand, are allowed to raise capital. Not just allowed, but the RBI makes it mandatory for these banks to list on achieving scale in business. This directly gives and edge to Small Finance Banks as their valuation is done by market forces. This freedom of price discovery also motivates the management to be competitive in business and performance is likely to be positively influenced.

Co-operative banks, which work towards financial inclusion, are excluded from the capital markets

Scheduled Commercial banks vs. Small Finance Banks:

  • Scheduled Commercial Banks are a more stable version of Small Finance Banks. Why am I saying more stable? Does that mean Small Finance Banks are vulnerable to some forces? Yes, they may be. We will talk about it soon.

  • On the positive side, Small Finance Banks score over Commercial Banks on the agility front. The ticket size that SFBs deal with is much smaller than SCBs. While this affects the cost-income ratio negatively, it allows SFBs to focus on areas where growth rates are high. If fortune really lies at the bottom of the pyramid, SFBs are perhaps hitting the nail on the head!

Thank you for being with me thus far, we will continue this article in the next part here.

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