Small finance banks' profitability set to more than double in FY27 as microfinance stress eases

Small finance banks (SFBs) are poised for a recovery in profitability in FY2027 as easing microfinance stress reduces credit costs and improves lending margins, according to Crisil Ratings. Return on assets (RoA) is projected to rise to 1.3–1.5% in the current fiscal, compared with levels below 0.6% over the previous two fiscals.

The improvement follows a sharp deterioration in earnings as rising delinquencies in microfinance portfolios increased provisioning requirements and triggered interest income reversals. Crisil Ratings expects better loan collections, fewer fresh defaults and improving performance of recently originated microfinance loans to support the recovery.

“Credit costs are projected to decline to around 1.5% this fiscal from 2.3-2.5% over the previous two fiscals,” said Aparna Kirubakaran, director at Crisil Ratings.

“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,” she added.

Lower credit costs to support earnings

SFB profitability weakened significantly over the past two fiscals after reaching a healthy RoA of 2.3% in FY2024. Elevated stress in microfinance increased credit costs, while banks moderated lending in the segment to contain risks. This also reduced portfolio yields because microfinance loans typically generate higher returns than several other asset classes.

Banks have since strengthened underwriting practices, and the performance of newer loans originated under revised lending frameworks has improved. The resulting moderation in delinquencies is expected to ease the provisioning burden and support earnings.

However, Crisil Ratings flagged potential risks from El Niño-related weather disruptions and drought, which could weaken cash flows among microfinance borrowers and affect repayment capacity.

Net interest margins expected to recover

Improving net interest margins (NIMs) are expected to provide another boost to profitability. SFBs' NIMs contracted by nearly 200 basis points between FY2024 and FY2026, primarily because of interest income reversals linked to higher microfinance delinquencies.

NIMs are projected to recover to 7.1–7.3% in FY2027, from around 6.2% in FY2026.

“The improvement will be driven by significantly lower interest income reversals as microfinance slippages moderate, alongside healthy advances growth, including a measured revival in the high-yielding microfinance portfolio,” said Vani Ojasvi, associate director at Crisil Ratings.

She added that “efficient liability management will be critical to sustaining profitability over the medium term”.

Deposit competition remains a key risk

Despite the improving outlook, SFBs face pressure from competition for deposits and the gradual shift towards secured, relatively lower-yielding assets.

Retail deposits account for more than 70% of SFBs' total deposits. However, relying on higher interest rates to attract funds may become increasingly difficult. During the recent FCNR(B) deposit mobilisation drive, SFBs offered rates 50–100 basis points above universal banks but accounted for less than 1% of total deposits mobilised through the route.

Crisil Ratings said the sector's next phase will depend on its ability to sustain profitability while balancing funding costs, portfolio diversification and asset quality through credit cycles.