CRISIL Ratings projects gross non-performing assets at small finance banks will drop to 2.6-2.8% by March 2027, driven by a strategic pivot toward secured lending. While this shift reflects a cleaner balance sheet, investors should remain cautious about lingering stress in MSME and unsecured retail portfolios. Understanding these structural changes is essential for assessing the sector's long-term stability and risk profile.
Small finance banks are undergoing a clear transformation in their lending strategy, aiming to reduce bad loans and improve overall asset quality. According to projections by CRISIL Ratings, the sector is expected to see its gross non-performing assets drop to a range of 2.6-2.8% by March 2027. This anticipated improvement is not accidental but follows a deliberate effort by these institutions to lower their reliance on high-risk microfinance and increase their exposure to more stable, secured lending products.
The Shift to Secured Lending
The most significant change in the business model of small finance banks is the diversification of their loan books. In fiscal 2022, non-microfinance products made up about 50% of their total advances. By 2026, this figure rose to approximately 70%. This pivot helps these banks avoid the boom-and-bust cycles often associated with micro-lending. While these banks are pulling back from direct microfinance—evidenced by a 28.5% year-on-year decline in direct microfinance portfolios to Rs 83,080 crore as of June 2026—they continue to play a major role in the financial ecosystem. They remain the primary funding partners for NBFC-MFIs, providing 80.4% of the fresh debt funding for these lenders in the first quarter of fiscal 2027.
Risks in the New Portfolio
While the reduction in microfinance exposure is a positive step for stability, investors must be aware of new risks emerging in the banks' portfolios. The transition to non-microfinance lending often involves expanding into MSME loans and unsecured retail credit. Data indicates that these specific segments could become new structural fault lines. Increased volatility in MSME performance, driven by rising input costs and potential trade disruptions from geopolitical events, may lead to higher slippage rates. Unlike state-owned banks, some private and small finance lenders face a higher probability of stress in these unsecured portfolios, which requires careful monitoring.
What Investors Should Monitor
The path to improved asset quality by 2027 depends on several moving parts. Beyond just tracking the headline NPA numbers, the ability of these banks to mobilize deposits and maintain a healthy credit-deposit ratio will be crucial for managing liquidity. Furthermore, any changes in state-specific microfinance regulations or shifts in government policy regarding loan waivers could alter recovery expectations. As these banks continue to reclassify older micro-loans into retail portfolios, the actual performance of these reclassified assets will be a key indicator of whether the quality improvement is genuine or merely a result of bookkeeping changes. Investors should keep a close eye on quarterly updates regarding credit cost and the health of the non-microfinance book to see if the planned asset quality turnaround remains on track.