Are small finance banks a good deposit option?

In these days of easy money when interest rates on savings accounts and term deposits are either below the rate of inflation or just about match it, small finance banks (SFBs) offer a slightly better option for risk-averse savers.

Fixed deposits of companies rated the safest are as attractive but they don’t have deposit insurance. As scheduled commercial banks (SCBs), SFBs are overseen by the Reserve Bank of India. And deposits in them up to Rs 5 lakh will be insured, if the Finance Minister makes amendments to the law she promised in her Budget speech.

Ten SFBs are in operation of which the first two started in 2016 and the last in 2018. Four of them pay 3.5% on savings bank account balances of Rs 1 lakh. An equal number pay 4%. One offers a minimum of 5%. In some SFBs, the interest rate rises in slabs and all but three of them pay 7% on savings bank balances of Rs 10 lakh and above. On fixed deposits of 366 days, the SFBs pay between 6% and 7%. All except one pay senior citizens at least half a percentage point extra.

In comparison, HDFC Bank pays 4.9% on 366 day deposits while senior citizens get 5.4%. On savings bank account, balances of up to Rs 50 lakh, it pays 3%. State Bank of India’s respective rates are 5%, 5.5% and 2.7%.

Except one SFB which was a Jalandhar-based local area bank, the rest were erstwhile microfinance institutions (MFIs) which could not raise deposits. They lent money borrowed from banks. They chose to become SFBs to access lower cost funds though current and savings bank accounts (CASA) and term deposits. As MFIs, they had a well-developed base of middle- and low-income customers.

Unlike large public and private sector banks which need Rs 500 crore as capital to begin with, SFBs could be established with Rs 100 crore. Since SFB licenses are on-tap now, the capital requirement has been doubled to Rs 200 crore. They are mandatorily required go public upon crossing certain milestones. Unlike conventional banks, SFBs have to lend at least 75% of their advances to the priority sector – small farmers and businesses, migrant workers and other low income groups. For other SCBs, the mandate is 40% and 50% of the loans have to be of Rs 25 lakh or less.

The need for SFBs was articulated in 2009 by a committee chaired by former Reserve Bank of India Governor Raghuram Rajan. The guidelines were published in 2014 and licenses issued thereafter. The objective was financial inclusion and service of customers in unbanked areas by leveraging digital technology to keep costs down. At least 25% of their branches had to be in places with no or few banks.

An analysis by Richa Saraf and Pallavi Chavan from RBI’s Department of Supervision shows that the SFBs have abided by their mandate. They have lent above their requirement to the priority sectors. Agriculture, trade and professional services accounted for 65% of their total credit as compared to other SCBs which lent as much to industry or individuals. Micro, small and medium enterprises had a 40% share of their total credit compared to 17% of other SCBs. They met the size-wise mandate too: almost all their loan accounts and 83% of the loan amounts were up to the credit limit of Rs 25 lakh. In fact, 96% of the loan accounts and 48% of the loan amounts were of Rs 2 lakh or less.

The branch network of SFBs has expanded to 4,300 or 3.5% of the total SCB branch network. This is mostly in well-banked southern, western and northern regions. Madhya Pradesh and Rajasthan have got a look in, but they are concentrated in Tamil Nadu, Maharashtra, Karnataka, Kerala and Punjab.

Rural branches had an 18% share compared to 39% share of semi-urban areas and 26% of urban centres. Thirty-one percent of the branches were in tier-1 and tier-2 centres with population of less than one lakh. Only three SFBs had a quarter of their branches in rural areas. In this respect, SFBs mimic private banks, 32% of whose branches are in semi-urban centres and 21% in rural areas.

Depositors concerned about the health of SFBs would be glad to know that before the pandemic, they reported lower bad loans because of better management and supervision of their credit portfolio. Net interest margins, that is the different between interest charged and interest paid was 8.34%. This compared with 2.37% for public sector banks and 3.42% for private banks, albeit on a comparatively miniscule asset base.

Their cost of deposits on average was 8.2%, compared with 5.26% for large private banks. Their return on funds in the last fiscal was the highest at 17.32% as was their return on assets. But there is enormous concentration too: the top three had 60 percent of total SFB assets. Their return on equity was a healthy 15%.

Due to exposure to economically-vulnerable customers and geographical concentration, the business of SFBs tends to be risky and volatile. This pandemic year would be a real test of their grit.