When the RBI issued the first batch of small finance bank (SFB) licences in 2016, the theory was elegant: convert successful microfinance institutions into deposit-taking banks that serve the underbanked. Ten years later, the theory is colliding with economics that weren’t fully anticipated.

AU Small Finance Bank’s Q3 FY2026 results told part of the story: net interest margin compressed to 5.2% from 6.1% a year ago. Equitas SFB reported similar pressure, with NIMs down 85 basis points year-on-year. The pattern is consistent across the sector, and the causes are structural rather than cyclical.

The Deposit Cost Problem

SFBs were supposed to fund themselves with low-cost deposits from the communities they serve. That hasn’t happened at scale. Most SFBs have a CASA (current account, savings account) ratio between 25-35%, compared to 40-45% for large private banks. The rest of their funding comes from term deposits, and they’re paying 7.5-8.5% for those—150-200 basis points more than HDFC Bank or SBI.

Why? Brand trust. A farmer in Rajasthan or a small shopkeeper in Tamil Nadu will put their savings in SBI because their father did and their grandfather did. SFBs can offer higher rates, but the perception gap on safety persists.

The deposit insurance limit of ₹5 lakh helps, but most SFB customers don’t fully understand DICGC coverage. They see a smaller bank with fewer branches and draw their own conclusions about safety.

Some SFBs have tried wholesale deposit routes—bulk deposits from corporate treasuries and cooperative societies—but these are expensive and volatile. When interest rates shift, wholesale depositors move their money instantly. A ₹500 crore deposit that walks out in a quarter can crater an SFB’s liquidity position.

Priority Sector Requirements Are Double-Edged

SFBs must maintain 75% of their loans as priority sector advances, with at least 50% in loans below ₹25 lakh. This was the point of the licence—serve the underbanked. But it also constrains where SFBs can grow.

Personal loans and credit cards are the highest-margin retail products in Indian banking right now. SFBs can’t meaningfully participate because their balance sheets are locked into small-ticket lending. When Bajaj Finance can offer personal loans at 12% and earn 800 basis points of spread, SFBs are stuck making ₹3 lakh loans at 18% to borrowers with thin credit files, earning similar spreads but with much higher credit costs.

The credit cost difference is the killer. SFBs are reporting gross NPA ratios of 3-5%, compared to 1.5-2.5% for large private banks. When your cost of deposits is higher AND your credit costs are higher, the margin squeeze becomes obvious.

Fintech Competition From Above and Below

SFBs now face competition on both sides. From above, large banks have finally gotten serious about financial inclusion—SBI’s YONO platform, HDFC Bank’s SmartHub, and ICICI Bank’s iMobile Pay have all expanded their reach into tier-3 and tier-4 cities.

From below, fintechs are cherry-picking the most profitable micro-segments. Lending fintechs like KreditBee, MoneyTap, and Slice are doing small-ticket personal loans with faster disbursement than any SFB. Payment fintechs handle the transaction layer. Neo-banks offer savings products with better UX.

What’s left for SFBs? The customers that nobody else wants—the ones too small for big banks, too risky for fintechs, and too scattered for cost-effective digital-only service. These are viable customers, but serving them requires physical presence, which means high operating costs, which means thin margins.

The Technology Deficit

Most SFBs are running core banking systems that were adequate for their microfinance incarnation but insufficient for a full-service bank. Upgrading costs money they don’t have. The gap shows up in basic capabilities—real-time credit decisioning, automated collection workflows, integrated treasury management.

AU SFB and Ujjivan are exceptions, having invested early in modern platforms. The rest are playing catch-up with constrained budgets. A core banking migration for a mid-size SFB runs ₹200-400 crore including implementation, data migration, and staff retraining. For a bank with net profits of ₹500-800 crore, that’s a huge bite.

What’s the Path Forward?

Consolidation seems inevitable. The RBI’s guidelines on universal bank conversion require SFBs to maintain a net worth of ₹1,000 crore for five consecutive years. Only AU SFB is close to meeting this threshold. The others need to either merge, find investors, or accept their current scale limitations.

Some SFBs are exploring partnership models—handling the last-mile customer relationship while larger institutions provide the balance sheet. This is essentially going back to the business correspondent model that existed before SFB licences, which raises the question of whether the licensing exercise achieved its goals.

The more innovative SFBs are looking at becoming embedded finance platforms—providing the regulated banking layer for fintech apps and e-commerce platforms. This is capital-light and scale-friendly, but it also means becoming invisible infrastructure rather than customer-facing brands.

The Uncomfortable Question

Were SFB licences the right policy tool for financial inclusion? The evidence is mixed. SFBs have collectively opened about 50 million accounts, which is meaningful. But the deposit mobilisation and profitability models haven’t worked as intended, and several SFBs are now struggling to justify their cost of capital.

The next two years will determine whether SFBs find a sustainable model or whether the experiment gets quietly wound down through mergers and conversions. Either way, the 2016 optimism about a new banking category serving India’s underbanked has met the reality of banking economics.