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In 2014, the Reserve Bank of India (RBI) announced a framework for developing “small finance banks,” a new class of bank that would cater to low-income and underserved customers. In a country where more than 200 million people do not have a bank account and many more rely day-to-day on cash or informal financing, the RBI move signaled recognition that India’s financial system needed to do more to promote financial inclusion.

India is the largest microfinance market in the world, and although microfinance in India is restricted to simple, unsophisticated loans, the sector has thrived, lending to hundreds of millions of unbanked citizens. In 2016, the final year before India’s small finance banks began operating, microfinance institutions (MFIs) in India had a collective loan book of 639 billion rupees ($9.4 billion).

Why Customers Need More than Microfinance

But the proliferation of microfinance in India has been a double-edged sword. On the one hand, microfinance institutions have developed deep community ties and reached customers that most mainstream financial institutions have overlooked. On the other hand, the sector lacks clear regulation and oversight, an issue that has had devastating consequences for borrowers.

At the height of the microfinance market in 2010, a wave of borrower suicides exposed what was happening behind the scenes: Many of India’s microfinance customers had become over-burdened by debt. In response, the state of Andhra Pradesh imposed stricter lending parameters and greater oversight over microfinance institutions, causing such a shock to providers that the sector collapsed. The RBI responded shortly thereafter with its own regulations on microfinance.

The regulator’s more recent creation of small finance banks signified its recognition that overdependence on microfinance was not an adequate model for meaningful financial inclusion. “We have been trying for decades to expand credit. We have focused much less on easing payments and remittances, on expanding remunerative savings vehicles, or on providing easy-to-obtain insurance against crop failures,” reflected the RBI’s Governor Raghuram Rajan shortly after the first small finance bank licenses were granted.

“In the emerging financial inclusion paradigm,” Rajan continued, “the government and the RBI are trying to expand inclusion by encouraging these other products, allowing credit to follow them rather than lead.”

Elevating financial inclusion

Nevertheless, of the 10 organizations approved in 2015 to become India’s first small finance banks, eight were microfinance institutions. This suggests that the RBI recognized MFIs’ role and capacity for delivering services to the unbanked and financially underserved, and saw their potential in helping build the foundation of a more inclusive financial system.

The “small finance bank” designation requires 75 percent of bank credit and 50 percent of loan portfolios to serve low-income customers, small businesses and other priority sectors like farmers and students. It also gives institutions license to develop a wider range of products to fit customers’ financial needs, providing an opportunity for deeper social impact than microfinance institutions have.

Having the license to operate as a bank will also mitigate institutional risk and improve credibility because, unlike microfinance, the banking sector is very clearly (and heavily) regulated by the Reserve Bank of India.

Financial risk and social impact are two issues Venky Natarajan knows well in the world of financial inclusion. His firm, Lok Capital, has been investing in India’s socially-focused businesses since 2004, particularly those emphasizing financial inclusion. (Disclosure: Our firm, Sonanz, has invested in a private equity fund managed by Lok Capital in India.) Indeed, when the small finance banking licenses were granted in 2015, Lok was already an investor in five of the eight microfinance organizations that were approved. It continues to hold shares in two of those organizations today: Mumbai-based Suryoday Bank and Varanasi-based Utkarsh Small Finance Bank.

The transition from MFI to bank

Realizing financial and social gains as small finance bank shareholders requires a long-term mindset. Lok’s approach here has been similar to its approach to early-stage startup investments. “The business model is entirely new, so we have to look at the investment from a long-term perspective,” Natarajan says.

Lok anticipated that the transition process from microfinance institution to bank would be slow and costly, and that the immediate capital investment required for regulatory compliance, technology upgrades and human resources would negatively impact profits in the short-term.

Now, nearly two years since Suryoday and Utkarsh started the transition, Natarajan says the two companies are “back on track” profit-wise and should fully regain their peak profitability in 18 to 24 months. But both companies’ executives say that upgrading back-end functions has so far been the primary focus.

“As a microfinance institution, we had compliance, risk, auditing and human resources departments, but we have had to upgrade all of them to comply with the significant requirements of becoming a bank,” recalls Govind Singh, CEO of Utkarsh.

Baskar Babu, CEO of Suryoday, has also made significant investments in Suryoday’s immediate regulatory, technology and human resource needs. “Compliance and technology are expensive,” he notes. “But it is a short-term sacrifice on the bottom line.”

A slowly shifting model

Now in their second year of operation as small finance banks, both Suryoday and Utkarsh say that network expansion, customer conversion and product development are their main business priorities. But the banks’ executives acknowledge that for now, microfinance lending continues to represent the largest share of business.

“Gradually the share of microfinance loans will come down, but it will remain a large part of our business,” Singh says. The deposit, or “liability”, account clients that both Utkarsh and Suryoday have developed have largely been institutional clients and high net worth individuals, rather than existing microfinance customers.

Long-term, Utkarsh and Suryoday will primarily focus on low-income, unbanked and underserved customers, and both banks have already started adapting their products and services to cater to their target customers’ unique needs:

First, this target customer base – which includes Suryoday and Utkarsh’s microfinance customers – has savings, but typically only small amounts, which need to be highly liquid to cover unexpected expenses.

Second, many microfinance customers are unaccustomed to or unable to deal with formal institutions with fixed hours and rigid processes. Owners of tailoring shops or vegetable stands, for instance, have daily cash flows and would require almost daily access to a bank account.

Third, most customers do not live in close proximity to a bank branch. Establishing a network of brick and mortar branches is expensive for banking institutions. While mobile and online banking are alternative options, India’s financial services customers are not adopting digital banking as quickly as customers in other emerging markets.

Suryoday’s solution involves converting its 215 existing microfinance outlets into formal bank branches, says Babu. “This is easier in cities than more remote areas,” he notes.

Natarajan is aware of the challenges in the market: “As a bank, to succeed you need savings, but it will take effort to convince any segment of the population to join a new bank,” he says. He adds that he has been impressed with Suryoday and Utkarsh’s early and “innovative” efforts to expand their products and services for microfinance customers, such as offering non-standard business hours and taking account deposits in person, door-to-door.

The social impact of small finance banks

Even if only a small share of Suryoday’s and Utkarsh’s microfinance customers ultimately become account holders, as small finance banks, they can still offer their customers a wider range of products and services than they could as microfinance institutions. This on its own could have a profound impact on financial inclusion, says Natarajan.

“Low-income borrowers can only get one limited-size loan product from a microfinance institution. But they also want to do remittances, or get insurance, or apply for home or vehicle loans,” he explains.

By addressing low-income and rural Indians’ financial needs and aspirations more comprehensively, small finance banks can influence how India’s broader financial sector thinks about financial inclusion. Lok, for instance, has shifted its own thinking about social impact, thanks to its work with Suryoday and Utkarsh. The firm is now looking beyond the simple metric of “income improvement” to other indicators of positive social impact, like customer employment characteristics, customer distribution between urban and rural markets and women’s engagement.

“When Suryoday and Utkarsh were only doing microfinance, impact assessment was easy: 100 percent of their borrowers fit within our target impact market,” Natarajan says. “But now as banks, they’re building trust and bridging other gaps. And our view of impact has changed in light of them.”

It will take time for small finance banks to demonstrate their full potential in India’s new model for financial inclusion. But like Babu, Natarajan believes that the costs associated with the transition will be a good investment. Long-term, operating as banks will put these businesses on a stronger risk, profit and impact trajectory.

Andreas Nilsson is the founder and managing director of Sonanz.

Nina Freudenberg is an investment manager at Sonanz.

Photo courtesy of Utkarsh Small Finance Bank.