Challenges Ahead for Small Finance Banks

Small finance banks (SFBs) have experienced remarkable growth in recent years. However, projections for FY2025 indicate a slowdown in this momentum. According to a report from credit rating agency ICRA, growth for SFBs is expected to moderate to 18-20 percent. This is a significant decline from the 24 percent growth recorded in FY2024. As the sector faces rising delinquencies and asset quality issues, the outlook for profitability appears challenging.

Projected Growth and Profitability Challenges

The growth trajectory of SFBs is set to face substantial hurdles in the coming fiscal year. ICRA’s report highlights that the gross non-performing asset (GNPA) ratio in the microfinance segment is anticipated to rise to between 2.6 and 2.8 percent by March 2025. This is an increase from 2.1 percent in FY2024. Such a rise in delinquencies poses a significant threat to the financial health of these institutions.

Moreover, the return on assets (RoA) is expected to decline to between 1.4 and 1.6 percent in FY2025, down from 2.1 percent in the previous fiscal year. This decline reflects the mounting pressures on SFBs as they navigate a challenging economic landscape. However, there is a glimmer of hope, as a modest recovery in RoA to between 1.6 and 1.8 percent is projected for FY2026.

The anticipated slowdown in growth and profitability underscores the need for SFBs to adapt to changing market conditions. As they face rising delinquencies, the focus will need to shift toward improving asset quality and managing risks effectively.

Asset Diversification Strategies

In response to the challenges posed by rising delinquencies, SFBs are increasingly diversifying their portfolios. Manushree Saggar, senior vice president and sector head at ICRA, notes that SFBs are placing greater emphasis on secured asset classes. This shift is crucial for mitigating risks associated with unsecured loans, particularly in the microfinance sector.

SFBs have expanded their product offerings to include various retail asset classes such as vehicle loans, business loans, loan against property (LAP), gold loans, and housing finance. This diversification strategy aims to reduce the share of unsecured loans in their overall portfolio. As the microfinance sector faces pressures, SFBs are expected to derive a larger portion of their incremental growth from secured asset classes. This strategic pivot is anticipated to be a key driver of growth in FY2026.

By focusing on secured loans, SFBs can enhance their resilience against economic fluctuations. This approach not only helps in managing risks but also positions them for sustainable growth in the long term.

Reversals in Asset Quality

While SFBs saw improvements in asset quality during FY2024, the trend has reversed in FY2025. By September 2024, the GNPA ratio had risen by 0.5 percent to reach 2.8 percent. This increase is primarily attributed to slippages in microfinance loans. ICRA anticipates further deterioration in asset quality in FY2025, with potential spillover risks affecting other secured asset classes.

The volatility in asset quality is concerning. It is driven by the seasoning of loans and the ongoing stress in the microfinance sector. As SFBs grapple with these challenges, maintaining asset quality will be critical for their financial stability.

To navigate these turbulent waters, SFBs must implement robust risk management practices. This includes closely monitoring loan performance and proactively addressing issues before they escalate. By doing so, SFBs can work towards stabilizing their asset quality and restoring investor confidence.

Funding and Profitability Pressures

Funding remains a critical concern for SFBs as they strive to maintain profitability. The share of current account and savings account (CASA) deposits for SFBs improved gradually, reaching 28 percent by September 2024. However, this figure is still significantly lower than that of universal banks.

The credit-deposit (CD) ratio has also seen a decline, dropping to 89 percent in September 2024 from 97 percent in March 2023. This trend is expected to continue, further complicating the funding landscape for SFBs. Increased competition for deposits may force SFBs to offer higher interest rates on term deposits, consequently raising their funding costs.

Moreover, operating expenses surged in FY2024 due to branch expansions and increased employee costs. While these expenses are expected to stabilize with a more cautious growth strategy, higher credit costs will continue to weigh on overall profitability.

 


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