The Small Finance Banks (SFB)s has reported a 17% growth in FY2018 with assets under management (AUM) of Rs 514.98 billion as on March 31, 2018 (26% AUM growth in FY2017). Though the pace of growth slowed down in the last two years, the primary reason was the focus SFBs on the migration process-from NBFCs to SFBs. As per a report released by ICRA on SFBS, all the SFBs were operational by June 2018 and most of the players (NBFCs) have managed the transition well with respect to the initial challenges identified earlier such as raising of capital, diversification of liability profile, identifying and converting branches as well as diversifying the product portfolio and recruiting staff.

Supreeta Nijjar, Vice President, ICRA Ratings says, ''Apart from the migration process, SFBs growth was also affected by the demonetisation related impact on the microfinance sector. While microfinance dominates the asset mix of SFBs, focus on product diversification has led to a reduction in the share of microfinance to 51% as on March 31, 2018 from 61% as on March 31, 2017 with the SFBs establishing their presence in retail asset classes such as vehicle loans, loans against property (LAP) and housing finance. However, the share of microfinance for the erstwhile Non-Banking Finance Companies (NBFC-MFIs), which converted to SFBs, stood higher at 79% as on March 31, 2018 (84% as on March 31, 2017).''

On the deposit mobilisation front, SFBs have made good progress with deposits forming 43% of the borrowings as on March 31, 2018. Nevertheless, most of the deposits are bulk deposits/certificates of deposit as the retail deposit franchise will be developed over some time. Further, funding from refinance institutions accounted for 20% of the borrowings, while the share of bank funding and debentures declined due to the repayment of older borrowings. The cost of funds for SFBs has reduced on the back of a higher share of funding from financial institutions (FIs) and deposits, despite the rate offered on deposits being 50-100 bps higher than that offered by other full-service banks. Overall, ICRA expects the SFBs' cost of funds to decline by an additional 60-80 bps pursuant to the repayment of legacy higher-cost borrowings and further deepening of their liability franchise.

Demonetisation severely impacted the asset quality of SFBs largely driven by slippages in the microfinance loans, with gross NPA at 8.95% as on March 31, 2018. Incrementally, while on a consolidated basis, asset quality for SFBs is likely to be supported by diversification into relatively lower risk products and providing for/writing-off legacy NPAs; performance of individual SFBs could vary depending on the robustness of credit underwriting norms and collection framework of these SFBs.

The overall capitalisation levels for the SFBs have been good (net worth/managed advances of 20% as on March 31, 2018) supported by regular capital infusion by most of the entities. The SFBs raised Rs 60 billion during FY2016 to FY2018 for meeting the regulatory norms on shareholding as well as for future growth. ICRA estimates that the SFBs would require external capital of Rs 40-60 billion (40%-60% of present networth) till FY2022 for meeting the growth requirements while growing at a CAGR of 25-30%.  Part of this requirement could also be met through Initial Public offerings.

Owing to the focus of the SFBs on higher-yielding asset classes, portfolio yields and net interest margins continue to be higher than those for scheduled commercial banks (SCBs). However, interest reversals on the delinquent portfolio (mostly the microfinance portfolio that was impacted by demonetisation) led to a reduction in the yields and net interest margins of the SFBs in FY2018. This was despite a dip in the cost of funds. At the same time, SFBs were able to earn significant non-interest income from trading in priority sector lending certificates in FY2018. The setting up as well as upgradation of existing branches, systems upgradation, and hiring of manpower led to an increase in the operating expense ratios though they are likely to moderate as the SFBs' operations stabilise over the medium term. The overall profitability of the SFBs was impacted in FY2018 by higher demonetisation related credit costs. ''Going forward, ICRA expects SFBs to report RoE of 8-12% till FY2020, supported by some reduction in the cost of funds as well as the operating expense ratios. Focus on product diversification would enable the SFBs to deepen their relationship with existing customers and manage concentration risk better. Over the medium term, we expect the SFBs’ loan portfolio to grow at 25-30% with the share of microfinance to decline to around 40% by March 2020,'' concludes, Nijjar.