The coming-of-age dream of Indian small finance banks

Small finance banks, SFBs in short, are dreaming of coming of age. Be it AU SFB, Capital SFB, or Ujjivan SFB, they all are hungry to scale up to join the grown-ups of the banking system. The grown-ups are the large universal banks. SFBs have good reasons for seeking the coveted universal bank title that brings with it many strategic advantages that we will explain in a moment.

But before that, here's a quick rundown of the key criteria that SFBs are mandated to meet to attain the universal bank status:

• Asset quality: An SFB's gross NPAs, short for non-performing assets, must be under 3 per cent and net NPAs must be below 1 per cent for two years prior to applying for the universal bank licence.
  
• Performance record: SFBs need to meet at least five years of satisfactory performance as stipulated by the Reserve Bank of India. This is a subjective benchmark that differs for every bank based on factors like regulatory compliance, financial performance, governance standards, customer service, technology, and operations.
  
• Financial stability: SFBs must have a minimum net worth of Rs 1,000 crore and consistent profits for two years prior to applying for the universal bank licence.
  
• Public listing: An SFB has to be listed on exchanges in order to become a universal bank.

Why being a universal bank is better

Now coming to the advantages that universal banks enjoy over SFBs:

Wider array of services: A universal bank is a one-stop shop for all financial needs. They offer diversified services including regular banking solutions, investment, insurance, and asset management products to a larger and wider customer base. This allows them to generate better revenue streams than SFBs, whose basket of services and customers is much smaller. SFBs are primarily tasked with providing traditional banking and credit services to underserved and unserved markets.

Lower capital adequacy requirements: SFBs are required to maintain a capital adequacy ratio of 15 per cent, compared to only 11.5 per cent for universal banks. A lower capital adequacy ratio means the ability to lend more loans.

No mandates for priority sector lending: SFBs must keep 75 per cent of their lending book exposure to high-risk priority sectors like agriculture and affordable housing. This requirement drops to only 40 per cent for universal banks reducing their risk proposition.

No loan amount restrictions: SFBs are mandated to keep the loan amount of at least 50 per cent of their portfolio at not more than Rs 25 lakh. There are no such restrictions for universal banks, allowing them to lend to larger businesses and clients more freely.

No cap on branches: SFBs are required to keep 25 per cent of their branches in unbanked areas whereas universal banks have no such criteria.

Lower cost of funds: Since SFBs operate in high risk sectors, they offer higher interest rates and have relatively higher cost of funds than universal banks, whose economies of scale allow them to offer low rates.

The cost of going big

We now know the benefits of becoming a big bank, but there are some costs involved, at least initially.

• Transitioning into a universal bank entails higher costs pertaining to marketing and advertising, branch opening, and employee addition, all of which pressure their margins.
  
• Newly-minted universal banks have to tackle high competition in the sector from incumbent giants like HDFC Bank, SBI and ICICI Bank, among others.
  
• The traditional benefit of lower cost of funds enjoyed by universal banks is diminishing in the current market, where every bank is having to dole out higher interest rates to withstand the fierce competition of attracting deposits.
  
• This trend is leading to an increase in the cost of funds across the board, making net interest margins nearly similar for both SFBs and universal banks.

Also read: This small finance bank might be the next AU SFB