Tech is the Best Way

Startup Small Banks loves Microfinance for a reason

Who or what is Equitas anyway?

Equitas, its peers Ujjivan, AU Small Finance, Suryoday and Jana Small Finance all belong to a class of banks called Small Finance Banks created by the financial regulator Reserve Bank of India in 2014. Along with their infamous cousin, payments banks. Unlike payments banks, that have a shaky business model to start with as they can’t lend, small finance banks don’t suffer structurally. They can lend and accept deposits, with the caveat that 50% of the loans should be upto Rs 25 lakh ($34,680).

Both payments banks and small finance banks were created with one intention in mind. Financial inclusion. While payments banks are mired in regulatory tangles, small finance banks are looking to ride the micro, small and medium enterprises (MSME) wave that the government is keen on driving. The banks have started well. In fact, they’ve even taken analysts by surprise. In the last two years alone, the top three banks—AU Finance, Equitas and Ujjivan—have deposits worth over Rs 15,000 crore ($2 billion). And they’ve lent over Rs 25,000 crore ($3.4 billion) in two years. In comparison, payments banks only had deposits worth Rs 540 crore ($74.9 million) in these two years. And AU Finance has already become the world’s most expensive banking stock, as of October.

One of the biggest reasons for this early success has been the interest rates on the deposits they offer. Small banks’ savings account interest rates are a good three percentage points above other banks. The reason they are able to do this is because of their golden goose—the microfinance portfolio (MFI). What’s not to love about giving small ticket-sized loans to low-income households that earns the banks upto 24% interest rates?





But just a few months after demonetisation came unannounced, the small banks gave their MFI portfolio the short shrift. As 86% of the notes became invalid overnight in November 2016, the MFI segment felt severe pain as most of the repayments and loan disbursals are made through cash. Equitas, in 2017, struck down its MFI exposure from 50% to 27%. Ujjivan is now focused on reducing its exposure from 80% to 50% over the next few years. Suryoday has a 90% exposure to MFIs and wants to bring it down to 60% in three years.

What this eventually boils down to is the banks’ continued ability to give high interest rates on deposits. As it is, even with high deposit interest rates, only few open an account. “If we reach out to a 200, only one or two may finally open an account,” said PN Vasudevan, founder of Equitas, without batting an eyelid.

So how will the small banks fill that MFI-sized hole?

The MFI yo-yo


Of the nine Non-Banking Financial Companies (NBFCs) that were given licenses to be small finance banks, eight were microfinance institutions. The idea was since they already have experience lending to those who find it tough to access banks for credit, they would be in a position to drive financial inclusivity. So Equitas, Ujjivan, Suryoday, Jana were all NBFCs that lent to MFIs and gave loans worth Rs 25,000-Rs 50,000 ($347-$695) at a 24% interest rate and collecting it back in 1-2 years. They perfected the art of giving risky loans at efficient operating costs, a skill fintech lenders such as Capital Float, Lendingkart will kill for. The only thing holding them back, as NBFCs lending to MFI, was the cost of funding. Since they borrowed from banks to lend to MFIs, their cost of funds was at 11-12%. But now as a bank themselves, this was down to 8%, and that made MFIs a highly profitable product.

Resilient


Despite repeated crises like the one in Andhra Pradesh and demonetisation, MFIs had better repayment rates than banks. And their write-offs are on average less than 0.5% of assets, says Eric Savage, co-founder of Unitus Capital which raised money for most MFIs, including Bandhan and Janalakshmi

It is this high exposure to MFI that allowed them to pass on the profits from this segment to depositors in the form of higher interest rates. This, in turn, became a crucial factor to build their Current Account Savings Account (CASA) pot. And they started off well. “Small finance banks’ CASA ratio in their first year looked much better than what it did for banks like Yes Bank when it started,” said Nidesh Jain, research analyst at financial advisory firm Investec. Just like with any bank, higher CASA balances are crucial for sustenance and success. It is the best available low-cost source of fund for a bank. CASA deposits are all the more important for small banks that incur mounting costs associated with setting up and early expansion.

So starting off with a heavy MFI skew, these small banks could afford to give market-beating interest rates on fixed deposits of 8.5%-9%, a full 200 basis points (100 basis points =1%) over banks. And a higher interest rate on fixed deposits (FDs) has trigger value, especially among senior citizens, who love a high-interest paying FD to grow their nest eggs.

“For a few basis points difference, customers will leave. So usually banks won’t let FDs have much difference. 25 basis points at best is the difference among banks’ fixed deposits,” says Puneet Kapoor, senior VP at Kotak Mahindra Bank. But because small finance banks account for less than 0.01% of the total deposits flowing into the banking sector, big banks didn’t bother to respond with rate changes.

While these banks knew relying on MFI is something that they would need to stop eventually, they didn’t expect to turn off the tap this soon. The small banks are now expanding their lending portfolio to segments like used commercial vehicles, affordable housing, loans against property etc. These are secured loans, which typically yield lesser interest rates of about 12-18%.

Tallying costs


The operating expense to secure MFI loans is about 6-7% of loan book while expenses towards secured loans are close to 3-4% of assets

“This realignment will eventually lead to a stress in their ability to maintain high interest rates on deposits as on the other side the secured assets attract lesser interest rates and thus a lesser income,” said MS Sriram, faculty at Indian Institute of Management Bangalore. “Small finance banks’ expertise lies in giving risky loans and charging a premium for it.”

Jain, of Investec, agrees. “Over the long term, as yields reduce and share of MFIs comes down, they will have to lower their interest rates. Before that happens, small finance banks will have to make customers sticky and transactional rather than customers just chasing highest rates.”

PN Vasudevan at Equitas though, argues that realigning their loan portfolio will not impact their ability to give high interest rates. The cost of acquiring customers from other segments is not as high as MFIs, so the spreads in different segments ends up looking similar, he said. And also that they can afford to charge a slightly higher interest rate to the segment they are lending to and pass that benefit to depositors.

It is not just their exposure to MFIs, but a whole set of levers that the bank will need to pull to continue to give higher interest rates.

Interest rate tightrope walk


There are about 1.57 billion bank accounts already in India, and when banking services are highly commoditised, it is tough to stand out. Except through interest rates. While every bank starts off with it and gradually eases on its interest rate stance, small finance banks may not have the luxury of doing so. At least not in the coming years.

“In the next 3-5 years, it is important to build deposit franchise, so they still have to offer high interest rate,” said Jain of Investec.

Why, even banks like Kotak Mahindra, after 15 years of existence, continue to rely on interest rates to draw customers. “Having an interest rate above market has delivered its value. But it needs to be accompanied by an accelerated deposit growth that we will have to deliver, to justify the high interest rate,” said Kapoor of Kotak.

Kotak has been growing its deposits at 40% year-on-year, more than double the industry growth rate. It now gives 5% interest rate on savings accounts with balances up to Rs 1 lakh ($1,387.5) and 6% on interest rates over a lakh and up to a crore ($0.1 million).

But it is not just deposit growth and asset growth that makes it worth a bank’s while to pay higher interest rates. It is also the number of transactions and the ability to sell other products that justify the interest rate paid to a customer. And the small finance banks agree that is an area they need to work on. “We have a target to sell at least a few more products in the 90-day window. Typically, if a customer doesn’t engage even after 90 days, you have lost them,” says PN Vasudevan.

And he candidly admits that right now, that number for Equitas is very low. Right now, all the 380,000 accounts they have are either the third or fourth bank account for users. Without transactions, they suffer from not earning fee income, which account for nearly 20-25% of banks’ income. While two years is too early to judge the number of transactions on these accounts, it is this ability of theirs, that will determine if they can grow to be a real bank.

After all, that is the underlying aim for most of the founders of these banks. To shed the ‘small’ moniker. But what doesn’t help their cause is that there is no uniform messaging on what small finance banks stand for.

Searching for the right path


In the lending side of the business, small finance banks have a uniform target—SMEs, MSMEs and low-income retail borrowers. This is driven partly by regulation and their own orientation. On the deposit side though, each one is pulling different tricks from the bag.

Jaipur-based AU Finance Bank lends to small businesses and takes deposits from a spectrum of retail borrowers including high net-worth individuals.

Then there is Bengaluru-based Ujjivan and Mumbai-based Suryoday, both of which lend to and take deposits from low-income households. “We want to target the entire MFI household so that we can grow our customer base from current 4 million to 20 million customers,” said Samit Ghosh, founder of Ujjivan. The banks tend to operate in a certain way – they target the same customer for deposits and assets. The company approaches customers who want loans and opens accounts for them at the same time so that the loan flows into those accounts. A two birds-one stone strategy. But cross-selling to this customer base is going to be difficult as they don’t have enough income to spare for deposits. So getting them to take a recurring or fixed deposit is not an easy sell.

Chennai-headquartered Equitas has a different strategy. It believes in tapping the mass affluent for opening deposits. “This is the only segment that has enough disposable income to save,” says PN Vasudevan. For this, it has invested in separate branches for assets and others to attract liabilities. “We spend lesser on asset branches and more on liability branches.”

All these different strategies have been taken with one goal in mind. More deposits. While doing it without falling back on an MFI portfolio will be challenging, it also marks the beginning of an aspiration coming to fruition – that of small finance banks slowly disentangling themselves from MFI and stepping into the big shoes of a bank, without the “small” tag holding them back.
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