Small finance banks (SFBs) in India are facing a growing challenge as their credit-deposit (CD) ratios surge past comfort levels. This has prompted them to approach the Reserve Bank of India (RBI) seeking relief from the existing regulatory framework.

Recent news reports highlight this rising concern, with some SFBs reporting CD ratios exceeding 100 per cent, significantly higher than the 75 per cent generally seen as prudent for scheduled commercial banks. This surge in lending activity, while indicative of SFBs fulfilling their mandate of extending credit to underserved segments, raises concerns about their liquidity positions and ability to manage risks effectively.

CD ratio: The credit-deposit ratio (CD) provides insight into a bank’s lending practices and liquidity management. By indicating how much of the deposited funds are being used for loans, it helps assess the bank’s ability to generate income through interest on loans.

A higher CDR suggests that the bank is actively lending more relative to its deposits, which can lead to greater interest income. Conversely, a lower CDR might indicate a more cautious lending strategy, potentially leading to lower income.

This ratio is crucial for stakeholders, including regulators, investors, and the bank’s management, to evaluate the bank’s operational efficiency and risk management.

SFBs vs commercial banks: While both SFBs and commercial banks operate within the banking sector, they cater to distinct customer segments and have different operational focuses. Comparing them would be akin to comparing apples and oranges.

SFBs primarily focus on serving the unserved and underserved sections of society, including micro-enterprises, small farmers, and unorganised sector entities.

Commercial banks, on the other hand, cater to a wider range of customers, including individuals, large corporations, and government entities.

SFBs prioritise financial inclusion and developmental activities, providing customised financial products. Commercial banks, while also contributing to financial inclusion, have a broader mandate that includes corporate banking, investment banking, and international operations.

SFBs operate under a differentiated regulatory framework that recognises their unique mandate and provides them with certain relaxations.

The rationale

SFBs were originally set up with an aim to promote financial inclusion by providing banking services to underserved population. They often focus in niche lending like microfinance and agriculture.

Exemption could provide them with greater flexibility to manage capital and liquidity, allowing them to lend more effectively based on demand rather than being constrained by regulatory ratios. Without the pressure of maintaining a certain CD ratio, SFBs can focus on expanding their lending portfolios and growing their customer base.

By easing CD ratio requirements, SFBs can increase funding for small businesses and entrepreneurs in rural and semi-urban areas, contributing to job creation and growth. Exempting SFBs from strict CD ratio requirements similar to that of commercial banks could be a significant step toward enhancing their ability to promote financial inclusion.

Further, SFBs have generally maintained a healthy CD ratio. In recent years, there has been an increasing trend in the CD ratio of SFBs, indicating their growing confidence in lending to their target segments and their ability to manage liquidity effectively.

It is essential, however, to balance this flexibility with robust oversight to ensure that these institutions remain solvent and effective in their mission. The case for exemption can certainly be considered alongside a framework that emphasises responsible lending and risk management.

Saravanan is a Professor of Finance and Accounting at IIM Tiruchirappalli and Williams is the Head of India at Sernova Financial