Small is beautiful, but not always

All small finance banks are running two banks within one – an SFB for assets and a universal bank for liabilities

Published in 1973, EF Schumacher's bestseller, Small is Beautiful, challenges what were then the prevailing economic assumptions and offers an alternative perspective on sustainable development, social justice, and human well-being. 

The German Rhodes scholar, who taught at Oxford University and was chief economist of Britain's National Coal Board, drew from his wide experience to offer a thorough argument in favour of small-scale, human-centred, beautiful work as a superior alternative to the mainstream ethos of “bigger is better”.

Close to a dozen founders/promoters of small finance banks (SFBs) also probably felt the same way when they applied to the Reserve Bank of India (RBI) for a licence about a decade ago to set up such banks. Barring two (one got merged with the biggest small finance bank and another is being merged with a fintech), all have got themselves listed on bourses. If we ask them now how their journey has been, hand on heart, most of them would probably say they want to get rid of the small tag. They would like to become universal banks.

We could practically hear their collective sigh of relief at the RBI’s decision to open the door for small finance banks to become big universal banks.

The RBI experimented with the SFB idea to reach out to those borrowers who have not been served by universal banks. SFBs, most of whom were microfinance institutions before they donned this avatar, have done well to serve these borrowers, but when it comes to collecting deposits, they have been struggling since they compete with universal banks for this.

What is the eligibility criteria for an SFB to become a universal bank?

# Scheduled status with a satisfactory track record of performance for a minimum period of five years.

#  Shares of the bank should be listed on a recognised stock exchange.

# A minimum net worth of Rs 1,000 crore.

# 15 per cent capital adequacy ratio.

# Net profits in the last two financial years.

# Maximum 3 per cent gross non-performing assets (NPAs) and, post-provisioning, 1 per cent net NPAs in the last two financial years.

# A diversified loan portfolio.
 

Of all SFBs, only one – AU Small Finance Bank Ltd, which is the largest – meets each of these conditions. Among others, barring Ujjivan Small Finance Bank Ltd, none meets the NPA criterion. But Ujjivan SFB doesn’t have a diversified loan book, which Equitas Small Finance Bank Ltd, Jana Small Finance Bank Ltd and probably one more have.
 

The RBI has made its stance clear on the shareholding pattern of the SFB that wants to transform into a universal bank.

@ There is no mandatory requirement for an eligible SFB to have an identified promoter. However, the existing promoters of the eligible SFB, if any, will continue as promoters on the transition to universal bank.

@ Addition of new promoters or change in promoters will not be permitted for an eligible SFB while transitioning to universal bank.

@ There will be no new mandatory lock-in requirement of minimum shareholding for existing promoters in the transitioned universal bank.

@ Finally, there will be no change to the promoter shareholding dilution plan already approved by the RBI.

 

The eligible small finance bank will have to furnish a detailed rationale for such transition. Once that is done, the RBI will scrutinise its application through the lens of on-tap licensing norms of universal banks.  

The rationale of the transition is clear: All SFBs are running two banks within one – an SFB for assets and a universal bank for liabilities. While they are giving loans to people and enterprises who are not typically served by universal banks, for deposits, they are competing with universal banks in metro markets. The only way they can garner deposits is by offering higher rates.

Even there, the “small” prefix in their name is a big disadvantage. Prospective depositors think twice before keeping money in such banks as they always wonder why they are called small. Even though all of them enjoy the scheduled bank status, depositors sometimes wonder whether small banks are safe for keeping money.

Simply put, the biggest challenge before the SFBs is garnering deposits. As they need to pay higher rates, their cost of money is higher than universal banks. They can still manage and run profitably as typically they charge higher rates from small borrowers.

The moment the “small” prefix is dropped from their names, their cost of funds will drop. A recent note by Investec Bank plc says post the transition to a universal bank, the cost of funds can come down by 20 basis points, leading to a 60 basis points rise in the return on equity. One basis point is a hundredth of a percentage point.

There are other benefits as well. An SFB needs to serve the so-called priority sector to the extent of 75 per cent of the loan book. For universal banks, the priority loan requirement is far lower – 40 per cent. A lower credit flow to the priority sector will help an SFB-turned-universal bank to manage the loan assets better in a more profitable way.

Finally, there will be a dramatic drop in the capital requirement. An SFB needs a 15 per cent capital adequacy ratio. In other worlds, for every Rs 100 worth of loan, it needs to have a capital of Rs 15. (This is presuming a 100 per cent capital requirement. For certain loans such as personal loans, the capital requirement is higher – 125 per cent.) For a universal bank, the requirement is far less – just 11.5 per cent (9 per cent plus 2.5 per cent in the form of the capital conservation buffer).

Lower capital requirement will lead to higher leverage. Earlier, they needed Rs 15 for giving a Rs 100 loan. Once they become a universal bank, they would need just Rs 11.5 to give a Rs 100 loan.

Overall, they will become more profitable with higher return on equity.

The Indian banking system, which is dominated by universal banks, has different kinds of banks – cooperative banks, regional rural banks, local area banks and payments banks, besides SFBs. Both SFBs and payments banks are relatively new animals on the banking turf, having made their appearance in the second half of the previous decade.

It's now fairly well known that the payments banks genre is a failure. After all, what can a payments bank do that a universal bank cannot? What’s the business model of a bank that operates only in the payments space? SFBs, in contrast, are a different story. By and large, they have done reasonably well. Incidents like demonetisation and the Covid pandemic have taught them to diversify the loan portfolio as small unsecured loans are always vulnerable to external shocks.

Apart from the challenge of garnering deposits, SFBs have also felt the heat of the cost of compliance. In private, a few promoters admit that had they known earlier, they would not have applied for a banking licence; the NBFC (non-banking financial company) days were far better.

Things will not change even after they become universal banks as the RBI has changed its approach towards inspection and supervision. That’s a different story.

For most SFBs, being a small bank is part of their journey, not the destination. While many of them will be eager to become universal banks as and when they are eligible, I suspect the RBI will also welcome new entities as SFBs to carry on the task of financial inclusion. From now on, this will be the architecture of Indian banking – matured SFBs migrating to universal banks and new SFBs being ushered in through a turnstile gate.

Writes Banker's Trust every Monday in Business Standard. 

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