Does Investing in Small finance banks Make Sense?

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Utkarsh Coreinvest Ltd, Fincare Small finance Bank and Capital Small finance Bank are the three Small finance banks available in Pre-IPO space to invest, but before that let us first understand what exactly is a SFB and how does it work?

Small Finance Banks (SFB) are institutions that were founded primarily to focus on financial inclusion. In our examination this week, we attempted to look at how SFBs have fared and whether they have a profitable model.

An overview of small finance banks

Small financing banks (SFBs) are a relatively new type of bank, having been regulated by the RBI in the 2016-17 fiscal year. This category was established with the goal of focusing on financial inclusion – 1) SFBs have a 75% priority sector lending limit, compared to 40% for other scheduled banks; and 2) 50% of their loans must have a ticket size of less than Rs. 25 lakhs.

Today, there are 10 Small finance banks, most of whom were erstwhile MFI-NBFCs – except the largest SFB, AU Bank, which was an NBFC catering to underserved/ informal segments. In addition, all these institutions were built and managed by fantastic entrepreneurs and management teams.
So SFBs have historically built their businesses around financial inclusion, positioning them well to capitalize on the inclusion problem. With that context, let’s look at the size of SFBs today.

SFBs constitute less than 1% of the overall deposits and advances in the banking system.

NBFC – Non Banking Financial Companies, SFB – Small Finance Banks, PSB – Public Sector Banks, Private/ PB – Private Banks, FB – Foreign Banks
NBFC – Non Banking Financial Companies, SFB – Small Finance Banks, PSB – Public Sector Banks, Private/ PB – Private Banks, FB – Foreign Banks

While they are still small relative to other banks, SFBs have grown rapidly over the last few years. Note that SFBs transitioned from being an NBFC to a Bank, which allowed them to take deposits and reduce their cost of borrowing.

Let’s break down SFBs further and look at the size of the players. AU, Equitas and Ujjivan are the 3 largest SFBs with ~60% market share.

What are the economics of the Small finance banks business model?

SFBs target underserved segments and have higher pricing power v/s SCBs and other banks that target highly served segments. This has translated into much higher yields for SFBs…

… which has also translated into higher NIMs.

But has the lending to underserved segments translated into higher risk for SFBs?
The chart below tells us the answer is no – however, vertical losses are expected to be low on a fast growing portfolio such as that of an SFB. In addition, we will assess the resiliency of lending to underserved segments in a macro worsening environment in the next section.

Looking at the cost side though – this business comes with higher operating expenses (opex) than those for other banks.

Do the higher NIMs compensate for higher Opex and credit costs?

Let’s start with opex and layout why opex costs are higher for SFBs v/s other banks:

1. Average ticket sizes for SFBs are lower due to underserved segment focus, as well as Priority Sector lending mandates of >=50% loans of less than 25 lakhs.
2. Banks have been around longer and built deeper relationships with customers – i.e. products cross sold are likely much higher, thereby increasing retention and reducing operating costs over the long run. 3. Higher collections costs for SFBs given the underserved customer profile needing a “Feet on street” collections approach, which is likely to worsen far more in downturns.

To evaluate the opex difference, let’s zoom into a few players across public and private banks and SFBs. Clearly, opex costs are higher for SFBs like AU and Equitas v/s private sector banks like Kotak and HDFC – however, they have gone down over the last few years for SFBs.

Looking at the components of opex, looks like employee expenses are a significant driver of the opex disparity between SFBs and others. Two call outs –
1. With increasing digitization in underserved lending, this gap can be reduced further.
2. Average branch employee pay structure is likely to be lower in SFBs v/s banks, but SFBs are likely to have a higher number of employees.

AU, the largest SFB, is potentially the benchmark for what other players like Equitas can get to – they’ve managed to bridge this disparity to 100-150 bps.

As a next step, let’s compare losses for SFBs (AU, Equitas) v/s private banks Kotak and HDFC. While losses for the two business models have been comparable, two points to note –
1. Calendar loss rates are bound to be low for SFB’s fast growing portfolio due to the denominator effect – cohort loss rates will likely be higher for AU and Equitas.
2. SFBs are likely to see much higher loss worsening v/s private banks during downturns – the FY’21 loss numbers below demonstrate this.

Let’s finally compare NIMs – today SFBs have a NIM upside of 100-400 bps relative to private banks, but this gap is likely to widen even more as their CASA ratio improves.

SFBs should be able to handle the additional opex and increasing credit costs with a NIM upside of 300-400 bps. Finally, the SFB business model appears to be rather appealing.

Utkarsh Coreinvest Ltd:

Utkarsh Micro Finance Limited (UMFL) is a Varanasi-based micro-finance company registered with RBI (Reserve Bank of India) as a non-deposit accepting NBFC (Non-Banking Financial Company)-MFI (Micro Finance Institutions). It offers group loans, micro enterprise loans, and housing loans. It also provides pension services. The company’s operations spread across nine states, namely, Uttar Pradesh, Bihar, Madhya Pradesh, Haryana, Uttarakhand, Maharashtra, Delhi, Himachal Pradesh, Chattisgarh, and Jharkhand. The company was incorporated in 1990 and has its registered office located in Varanasi, Uttar Pradesh.

Utkarsh Coreinvest share price: Rs 160/Share (as on Sept. ’22)

Market Capital: Rs 1562.34 Cr

Fincare small Finance Bank:

Fincare Small Finance Bank Ltd is a private sector bank in india. It has headquarter in Bengaluru. Fincare Small Finance Bank Ltd was founded on 21-07-2017. It has 1 branches and It provides all the financial services to its customers like saving deposit, fixed deposit, recurring deposit, loans, personal loan, NEFT, IMPS, E-Wallet.  Atal Pension YojanaPradhan Mantri Jeevan Jyoti Bima Yojana and many more.

Fincare small Finance Bank share price: Rs 185/Share (as on Sept. ’22)

Market Capital: Rs 4084.42 Cr

Capital Small finance Bank:

Capital Small Finance Bank Limited started operations as India’s 1st SFB on April 24 2016 after conversion from Capital Local Area Bank. Prior to conversion to a Small Finance Bank. Capital Local Area Bank was operating as India’s largest local area bank since January 14, 2000.

Capital Small finance Bank share price: Rs 185/Share (as on Sept. ’22)

Market Capital: Rs 4084.42 Cr

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