What drove the recent recovery of small finance banks?

Small finance banks, instrumental in lending to small farmers and businesses, faced significant stress after the pandemic. Some of them even traded below their book value, grappling with high gross NPA levels. Many of them were even selling a portion of their loans to asset reconstruction companies. However, their recent share price performance indicates a shift.

What are small finance banks?

Set up to enhance financial inclusion, small finance banks cater to the un-served and underserved, providing essential banking services. They offer credit and deposit facilities to groups such as microfinancing recipients, small farmers, and MSMEs.

When the pandemic struck, it impacted the income of small businesses, as well as lower-and middle-class segments significantly, which are the primary clientele of small finance banks. As a result, the banks' asset quality took a hit, their NPAs shot up, and profits fell. But surprisingly, these banks have made a smart recovery with rising net profits and improving NPAs - trends mirrored in their stock prices.

We decided to explore the factors that led to their recovery and overall growth.

Expansion of net interest margins

The CASA ratio for small finance banks has seen an increasing trend over the past five years, significantly reducing their funding costs. A considerable part of their loan portfolio involves unsecured loans, where interest rates can reach up to 20 per cent for microfinance loans, enhancing their lending rate and bolstering net interest margins. This has further been a key contributor to higher net profits. According to the CRISIL MI&A research report, a 66 per cent CAGR increase in the industry's CASA ratio has been witnessed over the past five years.

The shift in industry dynamics

Previously, small finance banks used to allocate a huge part of their loan portfolio to microfinance loans. This made their assets significantly riskier as these loans were unsecured. However, recent trends show that these banks are slowly moving towards diversification of their loan portfolio, with a shift towards more secured offerings to decrease their microfinance exposure. According to CRISIL, the percentage of Microfinance loans to total loans stood at 33 per cent in FY22, as opposed to 41 per cent in FY18.

Expanded market presence

India's rural areas, typically underpenetrated regarding credit facilities, represent the classic target demographic for small finance banks. Over the past five years, these banks have captured a big chunk of this market with room to grow even further. This has assisted them in their growth trajectory and helped them grow their deposit base at a rate of 58 per cent annually in the last five years (as per Crisil MI&A report).

What lies ahead?

The outlook for small finance banks looks positive, with stronger asset quality, increasing interest margins and robust credit demand. Advancements in digital technology, coupled with the government's push for financial inclusion, are likely to propel their growth further. However, challenges like credit risk due to a substantial number of unsecured loans, and potential inflation-driven interest rate hikes might hurt the short-term margins. So, investors should exercise caution and conduct thorough diligence.

Also read: FDs of small finance banks are offering high interest rates