What symptoms do merger talks between Clix and Suryoday SFB represent?

Last October, Clix Capital made an attempt to acquire the doddering Lakshmi Vilas Bank (LVB), but lost out to the Singapore-based DBS Bank. Almost a year on, it is in talks to merge with Suryoday Small Finance Bank (SSFB), a listed entity. As platforms, LVB and SSFB could not have been further apart. The point is that Clix, somehow, wants to be part of a banking story — it’s about survival; and is symptomatic of the concerns facing many second-rung shadow banks.

The playfield changed for non-banking financial companies (NBFCs) after the blowout at the Infrastructure Leasing & Financial Services. The Reserve Bank of India (RBI) reduced the elbowroom for regulatory arbitrage between NBFCs and banks. And the latter turned extremely selective in vending credit to shadow banks. The bigger NBFCs rode out the crisis, but the plot for the smaller players has become complicated. Post-pandemic, they have found it difficult to restructure the loans given out by them — because the banks from which they sourced funds in the first place were reluctant to follow suit.

The RBI had announced targeted long-term repo operations (TLTRO) to up the flow of credit from banks to NBFCs. But data on TLTRO 1.0 shows that around 88 per cent of the funds raised by banks through this window were invested in or advanced to NBFCs with a credit rating of AA and above. Even under TLTRO 2.0, when it was mandated by the banking regulator that at least 50 per cent of the funds raised by banks be given to small and mediums-sized NBFCs, the response from banks was tepid.

So what’s in store for them? Many of the smaller NBFCs that are expected to be in play now may not hold much attraction for the larger, full-service commercial banks. So, is merging with a small finance bank (SFB) the solution as in the case of Clix Capital-SSFB? The RBI’s Report on Trend and Pro­gress of Banking (T&P:2019-20) makes an interesting observation that has not got the attention it deserves.

It says that SFBs, which were earlier micro-finance institutions (a class of NBFCs), continue to have significant exposure to unsecured ad­van­ces even as they strive to diversify their portfolio. That these banks have smaller low-cost current and saving account deposits. They may rely on the prevailing easy liquidity conditions that facilitate borrowings and refinance, but SFBs may need to focus on the bottom-line as and when financial conditions tighten. The ability to absorb risks in the form of provision coverage ratio is also low in some SFBs, impacting their ability to withstand adverse shocks.

In a nutshell, what this implies is as follows: SFBs’ focus is on the bottom of the pyramid. They have to extend 75 per cent of their net credit to the “priority sector”; and, at least 50 per cent of their loans are to be of ticket size of only up to Rs 25 lakh. On the liabilities side, they raise costlier deposits. In turn, this implies they have to price their loans accordingly and their assets are riskier.

In a downturn, it is folks at the bottom of the food chain who are the worst hit. The distribution of moratorium sought by micro, small and medium enterprises indicates that urban co-operative banks bore the brunt of it, but this held true of SFBs in the case of individual loans. All this will call for higher provisioning and put pressure on capital. And in such a situation, depositors may well decide to shift to state-run or the better private banks.

This could be why there have been few takers for SFB licences even when they have been made “on-tap”. The SFB licence issued recently to the Centrum-BharatPe combine falls into a different category — it was to clean up the Punjab and Maharashtra Co-operative Bank mess.

It is clear that given the stress on the books of the smaller shadow banks, it may not bring any great advantage to SFBs by acquiring them. Of course, there could be outlier transactions. And there are some new-age NBFCs, which are to be watched out for: Five Star Business Capital, backed by Sequoia Capital and KKR, which plans to raise $400 million; Aptus Value Housing Finance; or a Home Credit.

That said, why don’t smaller legacy NBFCs apply for an SFB licence and start life anew? They can, after all, at least build a deposit franchise, and hope to do better than an NBFC.

It could be due to the reputational risks involved. The guidelines for on-tap SFB licences have it that an applicant not found suitable for a licence will not be eligible to apply again for three years. Those aggrieved by the decision of the Committee of the Central Board (CCB) of the RBI can prefer an appeal against the decision to the Central Board of Directors (CBD). This is a departure from the first round of SFB licences (not “on-tap”) when there was nothing by way of redressal (November 27, 2014). But the point is: Can there ever be a situation where a CCB decision is overturned by the RBI’s CBD?

So, what symptoms do the merger talks between Clix and SSFB represent?

It is clear that investors in level-two NBFC are seeking an exit route. And merging with an SFB is a good option for now. It is entirely possible that the SFB they merge into may get acquired by a universal bank, or become a recipient of such a licence (they can apply for one after five years of life as an SFB). Basically, it is about switching trains to reach your El Dorado.