Small Finance Banks (SFBs) in India are on the cusp of a significant profitability rebound, with their Return on Assets (RoA) expected to more than double by fiscal year 2027. According to Crisil Ratings, RoA is projected to rise to 1.3–1.5% in FY2027, a substantial improvement from the sub-0.6% levels observed over the past two fiscals.
This optimistic outlook is primarily driven by an anticipated easing of stress within the microfinance sector, which will lead to reduced credit costs and improved lending margins for SFBs. The sector had previously faced a sharp deterioration in earnings, largely due to rising delinquencies in microfinance portfolios, which necessitated higher provisioning and triggered interest income reversals.
Easing Microfinance Stress Drives Recovery
Crisil Ratings anticipates that better loan collections, a reduction in new defaults, and improved performance of recently originated microfinance loans will underpin this recovery. Credit costs, which had been elevated at 2.3-2.5% over the previous two fiscals, are now projected to decline to around 1.5% in FY2027.
Aparna Kirubakaran, a director at Crisil Ratings, highlighted that "higher collection efficiencies, lower incremental slippages, and the stabilisation of recently originated microfinance loans are expected to materially reduce provisioning requirements and support a meaningful recovery in profitability." Banks have proactively strengthened their underwriting practices, leading to a moderation in delinquencies for newer loans issued under revised frameworks, thereby easing the provisioning burden.
Despite the positive projections, Crisil Ratings cautioned about potential risks. El Niño-related weather disruptions and drought conditions could negatively impact the cash flows of microfinance borrowers, potentially affecting their repayment capacity.
Net Interest Margins Set to Improve
Another crucial factor contributing to the profitability surge is the expected recovery in Net Interest Margins (NIMs). SFBs experienced a nearly 200-basis-point contraction in NIMs between FY2024 and FY2026, primarily due to interest income reversals linked to the higher microfinance delinquencies.
NIMs are now forecast to rebound to 7.1–7.3% in FY2027, up from approximately 6.2% in FY2026. Vani Ojasvi, an associate director at Crisil Ratings, noted that this improvement will be fueled by "significantly lower interest income reversals as microfinance slippages moderate, alongside healthy advances growth, including a measured revival in the high-yielding microfinance portfolio." Ojasvi also emphasized that efficient liability management will be key to sustaining profitability in the medium term.
Deposit Competition and Diversification Challenges
Despite the improving outlook, SFBs continue to face competitive pressures, particularly in attracting deposits. Retail deposits constitute over 70% of SFBs' total deposits, and relying solely on higher interest rates to attract funds is becoming increasingly challenging. A recent FCNR(B) deposit mobilization drive saw SFBs offering rates 50–100 basis points higher than universal banks, yet they accounted for less than 1% of the total deposits raised through this channel.
The sector's ability to maintain profitability while navigating funding costs, diversifying its portfolio, and managing asset quality through various credit cycles will define its next phase of growth. The gradual shift towards relatively lower-yielding, secured assets also presents a challenge that SFBs must address.