Small Finance Banks (SFBs) were introduced by the Reserve Bank of India in 2019 to make formal banking accessible to underserved segments such as small borrowers, farmers, and informal workers. Today, India has 12 public sector banks, 21 private sector banks, and 11 small finance banks forming a diverse and expanding banking landscape.
Since their launch, SFBs have grown at a remarkable pace. They have weathered major disruptions, including demonetisation, the NBFC liquidity crisis, and the pandemic, yet continued to outpace the broader banking system.
After years of operations, SFBs are entering a more mature phase. Let us understand the sector in detail and explore whether there is a meaningful investment opportunity.
Current State of India’s Small Finance Banks
Small Finance Banks continue to expand their presence in India’s lending ecosystem. Their market share in total banking credit has risen steadily from just 0.4% in FY18 to about 1.5% in FY25. Even though they still form a small portion of the overall system, their pace of growth has been far stronger than larger banks.
Since 2018, SFBs have consistently delivered double-digit growth in their loan books. Their advances have increased at a remarkable 35% CAGR between FY18 and FY25. In comparison, public sector banks grew at 8.5%, private banks at 16.6% and the overall banking system at 11.5% during the same period.
Another important indicator of their rising influence is their share in incremental credit. Every year, SFBs have secured between 2% and 6% of the new credit added to the system. In FY25 alone, they captured around 2.1%. This steady traction highlights how SFBs are carving out space for themselves despite operating in a highly competitive and challenging environment.
SFBs Universal Bank Conversion
The Reserve Bank of India (RBI) introduced clear norms in FY25 to enable eligible SFBs to convert into universal banks. The aim is to encourage those who have matured in risk management, asset quality, and scale to transition into broader banking, with reduced regulatory burdens and expanded business opportunities.
Recent Example: In August 2025, AU SFB became the first SFB to receive RBI in-principle approval for conversion, driven by its large scale, healthy asset quality, and diversified lending.
RB has laid some guidelines, such as only listing SFBs with scheduled bank status, a minimum net worth of Rs 1,000 crore, and at least five years of profitable, satisfactory operations may apply. It should also consistently maintain GNPA below 3% and NNPA below 1% for the preceding two years.
Additionally, SFBs are encouraged to diversify their loan books as a preference for conversion. Those retaining a high share of unsecured microfinance loans are less likely to qualify.
Conversion benefits
The move to a universal bank license offers several clear advantages.
PSL Requirement: PSL norms would come down from 60% to 40%, which helps SFBs earn more PSL income and gives them more room to lend beyond PSL categories. This can add stability to credit costs.
Cost of Deposits: A universal bank license improves brand strength and trust. Over time, this can help reduce the overall funding cost.
Better Leverage: Capital adequacy needs would fall to 11% compared to 15% now. This improves balance sheet efficiency and supports better return ratios through higher leverage.
No Cap on Loan Size: The rule that required more than half of the loans to be below Rs 2.5 million would end. This gives SFBs more freedom in choosing customers and designing products.
Growth Triggers for India’s Small Finance Banks
Portfolio Diversification: SFBs are declining dependence on microfinance, with the MFI share falling from 35% in FY22 to 24% in FY25. Growth in secured segments like MSME, vehicle finance, affordable housing, and corporate loans has supported better portfolio quality.
Deposit Mobilisation & Branch Expansion: The branch network expanded 1.3x to 7,641 branches by March 2025, largely in rural and semi-urban areas, deepening customer penetration and broadening the deposit base. Deposits grew at a 28% CAGR between FY22 and FY25, reaching Rs 3.2 lakh crore.
Regulatory Support: RBI reduced the priority sector lending (PSL) norms for SFBs from 75% to 60% of adjusted net bank credit (ANBC) in June 2025, enabling greater flexibility for credit diversification and portfolio risk mitigation.
Improved Liability Profile: Shift to a deposit-led liability base with the credit-to-deposit ratio moderating from 92.5% in FY22 to 86.3% in FY25, reducing dependence on expensive borrowings.
Financial Inclusion Focus: Penetration into underserved rural and semi-urban markets targeting small traders, MSMEs, and self-employed individuals has driven strong credit growth (25% CAGR in advances between FY22 and FY25). This aligns with India’s larger goal of financial inclusion.
Product Innovation & Technology Investments: Adoption of digital technologies and evolving product offerings in MSME, vehicle finance, housing, and other secured loans support competitive positioning and customer retention.
Challenges in India’s Small Finance Banks
Asset Quality Stress: The microfinance portfolio, accounting for nearly one-third of advances, has been volatile. The gross non-performing assets (GNPA) ratio in microfinance spiked to 6.8% in FY25 from 3.2% in FY24, which is higher than the broader microfinance industry by over 60 basis points. Elevated slippages from overleveraged rural borrowers and uneven economic recovery contributed to this stress.
Profitability Pressure: Despite growth, profitability has been constrained by high credit costs and elevated operating expenses. Net interest margins (NIMs) declined from 7.4% in FY24 to 6.6% in FY25 and are expected to fall further. The return on average assets (ROTA) dropped sharply from 2.1% in FY24 to 1.0% in FY25.
High Operating Costs: SFBs maintain a branch-intensive operating model with a mandated rural presence and ongoing technology investments. Operating expenses were 5.5% of assets in FY25, compared to about 2% for the broader banking sector.
Moderate CASA Ratio: The CASA ratio stood at 26.2% as of March 2025, which is modest compared to peers, leading to a higher cost of funds (7.3% for SFBs vs ~5.3% for the broader sector).
Elevated Provisioning: Higher provisioning requirements due to stressed microfinance portfolios keep credit costs high, further pressuring profitability.
Balance Sheet & Concentration Risks: Though overall asset quality improved from a GNPA peak of 7.2% in FY22 to 3.8% in FY25, stress in microfinance loans remains a key concern. Portfolio concentration in microfinance adds risk.
Stocks to Add to Watchlist
What’s Next?
SFBs are entering a phase of steady but disciplined growth. As per CareEdge Ratings, their deposits are Rs 3.15 lakh crore, and advances reached Rs 2.72 lakh crore in FY25 and are expected to rise further to Rs 3.77 lakh crore and Rs 3.23 lakh crore in FY26. Crisil says the momentum is likely to be supported by stronger traction in non-microfinance segments along with a gradual recovery in the microfinance portfolio, which had contracted last year.
According to Sanjay Agarwal, Senior Director, CareEdge Ratings, profitability pressures persist in FY26, but they also note that the revised PSL norms offer more lending flexibility and help reduce portfolio risk over time.
SFBs have also requested the RBI to relax the rule that requires half of their loans to be below Rs 25 lakh and to allow them to participate in co-lending. These changes would enable them to widen their customer base, especially among MSMEs, and improve overall loan mix quality. Additionally, the move by leading players such as AU Small Finance Bank toward universal bank status reflects the sector’s evolution.
*The companies mentioned in the article are for information purposes only. This is not investment advice.
*Disclaimer: Teji Mandi Disclaimer
