Small Finance Banks, once positioned as high-growth and high-yield lenders, turned into underperformers for the shareholders last year. With negative returns of 3% to 58%, the entire small finance bank pack has underperformed broader markets by a wide margin.
The correction reflects a structural headwinds like shrinking net interest margins, elevated credit costs, deteriorating asset quality, and slowing advances growth momentum. In the last one year, the stock performance of small finance banks has been dismal.
Utkarsh Small Finance Bank is down 58%, Suryoday SFB has fallen 38%, ESAF SFB dropped 44%, and Equitas SFB is down 38%. Even relatively better performers like Jana SFB and Ujjivan failed to deliver positive returns. The entire sector has underperformed sharply, driven by fundamental challenges.
NIMs Under Pressure
The sharpest pain point for SFBs has been the decline in net interest margins (NIMs). Utkarsh saw a 350 basis points (bps) fall, Suryoday lost 280 bps, and better-positioned banks like Equitas and Ujjivan reported a 140–160 bps decline.
The main reason for the contraction in NIMs is the fall in lending rates. Lending rate is the rate at which banks lend to corporates and individuals. With the banks shifting away from high-yield unsecured microfinance loans toward secured products like affordable housing and vehicle finance, the yields see a wider contraction.
While the shift improves banks portfolio stability, it comes at the cost of lower spreads. For instance, ESAF lending rates fell by 400 bps, Utkarsh by 380 bps, and Suryoday by 330 bps, in last one year, directly dragging down the bank’s profitability.
Shift From Unsecured To Secured Lending
A key structural shift for SFBs over the last few years has been the move from unsecured microfinance loans to secured lending. While unsecured loans typically deliver higher yields, asset quality worries have forced SFBs to rebalance portfolios. As a result, the share of secured advances has risen significantly. The transition has improved balance sheet resilience but has also led to NIM compression, given secured loans yield lower returns compared to microfinance.
Slowing Advances Growth Momentum
After a phase of strong double-digit loan growth between FY22–FY24, SFBs are now showing a visible slowdown in FY25 and Q1FY26. All SFBs have seen a deceleration. The deceleration is driven by a high base effect, tighter funding conditions amid deposit competition, and regulatory nudges towards stronger capital and liability management. Sustaining the earlier growth momentum has therefore become increasingly difficult.
Rising Credit Cost
Credit cost trends point to rising stress across several SFBs, with Equitas, Utkarsh, Ujjivan, and Suryoday witnessing a visible uptick. Utkarsh has seen a structural spike, sustaining credit cost levels above 8%, far higher than peers. On the other hand, Jana is an outlier in a positive sense, as its sharp decline in credit costs suggests improving recovery and controlled slippage. ESAF and Capital SFB remain stable at relatively lower levels, though growth moderation is visible.
Deteriorating Asset Quality
Asset quality paints a similar picture of divergence. Utkarsh and Suryoday have seen sharp deterioration, with GNPA ratios surging to 11.4% and 8.5% respectively by Q1FY26, alongside NNPA rising above 5%. Equitas and Ujjivan remain in the 2.5–3% GNPA range, signaling manageable but rising pressure. Jana continues to perform better, keeping GNPA at sub-3% and NNPA around 1%, while ESAF and Capital SFB are relatively steady with contained slippages. Overall, asset quality remains a key differentiator, with a few banks showing structural stress while others maintain stability through prudent credit practices.
Pressure On Profitability
In Q1FY26, profitability across SFBs took a notable hit, with ROAs declining sharply for most players due to compressed margins and rising credit costs. Ujjivan SFB saw its ROA drop steeply to 0.80% from 2.9% a year ago, while Equitas SFB's ROA plunged from 1.91% to just 0.32%. Utkarsh SFB reported a reversal in ROA, slipping from a positive 2.30% to a negative -3.40%. In contrast, Capital SFB and ESAF showed relative stability, with only marginal declines.
Outlook For Small Finance Banks
The Q3 of FY26 is poised to mark a turning point for the microfinance segment, particularly benefiting SFBs, as early indicators point a gradual improvement in credit quality. Ease in credit costs, improving collection efficiency, and regulatory support are creating a more favourable environment for lenders operating in the high-yield, high-risk microfinance space.
One of the key tailwinds is the stabilisation of asset quality, especially in rural and semi-urban pockets, where stress levels had peaked in prior quarters. As borrower behavior normalises, GNPA are expected to moderate, leading to lower incremental provisioning requirements.
Further, regulatory tailwinds are strengthening the funding profile of SFBs. Liquidity in the system remains comfortable, helping banks manage cost of funds despite a generally tight interest rate environment.
However, NIMs are likely to remain under pressure in Q3 due to a combination of factors: elevated competition in certain lending segments, gradual transmission of higher deposit costs, and slower yield expansion on the asset side.
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