When the RBI granted small finance bank (SFB) licences in 2015, the vision was clear: create a new category of banks focused on financial inclusion, serving unbanked and underbanked populations with savings products and small loans. Eleven years later, that vision has partially materialised — but the economics are proving difficult for several players.

Of the ten SFBs that launched between 2016 and 2018, at least three face persistent profitability challenges. Two have reported net losses in recent quarters. And industry conversations increasingly turn to a question that was once taboo: should some of these banks merge, be acquired, or convert to a different structure?

The Profitability Squeeze

SFBs operate in an inherently difficult segment. Their lending is concentrated in microfinance, small business loans, and affordable housing — categories with higher credit costs than corporate or prime retail lending. Their deposit costs tend to be higher than large banks because they lack the brand recognition and branch networks that attract low-cost CASA deposits.

The result is compressed net interest margins. While large private banks operate with NIMs of 4-5%, several SFBs have reported NIMs below 3.5% in recent quarters. Layer in higher credit costs and the fixed costs of maintaining a banking infrastructure, and the profitability math becomes challenging.

RBI financial stability data shows that the average return on assets for SFBs has been below 1% for the past two years, compared to 1.1-1.3% for scheduled commercial banks overall. Some individual SFBs perform well — AU Small Finance Bank and Equitas SFB have established themselves as credible, growing institutions. But the performance gap within the category is widening.

Scale Is the Underlying Problem

Banking is a scale business. Larger banks spread technology, compliance, and infrastructure costs across a bigger asset base. SFBs that haven’t grown quickly enough are caught in a bind: they need to invest in technology and branch expansion to compete, but lack the revenue base to fund those investments comfortably. Growing the loan book aggressively carries credit risk. Growing deposits requires offering rates that compress margins further.

The minimum net worth requirement for SFBs is Rs 200 crore, but the practical minimum to operate competitively is much higher. Banks with assets below Rs 20,000-25,000 crore struggle to achieve the scale economics needed for sustainable profitability.

Regulatory Signals

The RBI hasn’t explicitly encouraged SFB consolidation, but it has created pathways that make it possible.

The 2021 guidelines allowing SFBs to transition to universal banks after five years opened one route. An SFB meeting the criteria — including Rs 1,000 crore net worth and a profitability track record — can apply for universal bank status. The stronger SFBs can effectively graduate out of the category.

For weaker SFBs, the more relevant pathway is acquisition by a larger bank or merger with another SFB. The RBI’s framework for consolidation provides the regulatory mechanism, though each transaction requires specific RBI approval.

In December 2025, the RBI Governor’s statement included language about “right-sizing the banking landscape” — widely interpreted as a signal that consolidation among SFBs would not be opposed.

Possible Scenarios

SFB-to-SFB mergers. Two smaller SFBs in overlapping geographies could merge for scale. The combined entity would have a larger branch network and better cost economics. The challenge: merging two struggling entities doesn’t automatically create a healthy one.

Acquisition by universal banks. A large private bank looking to expand its microfinance presence could acquire an SFB, providing capital, technology, and brand strength. Kotak Mahindra Bank’s 2014 absorption of ING Vysya Bank provides a template.

NBFC conversion. Some SFBs might find that operating as an NBFC better suits their business model. The compliance burden of being a bank — CRR, SLR, priority sector lending targets — is substantial. An NBFC-MFI structure offers more operational flexibility.

Private equity recapitalisation. Rather than merger, some SFBs could bring in fresh capital from PE investors. A recapitalised SFB with new management could potentially be turned around without losing its independent identity.

The Financial Inclusion Question

The most important question isn’t about shareholder value. It’s about whether financial inclusion goals are still being met.

SFBs serve approximately 7-8 crore customers, many of whom had no formal banking relationship before. If consolidation reduces the number of SFBs but surviving entities continue to serve these customers effectively, the outcome is positive. If it leads to branch closures in remote areas or withdrawal from unprofitable micro-lending segments, it defeats the purpose.

The RBI will need to evaluate consolidation proposals not just on financial viability but on financial inclusion impact. An SFB merger that creates a stronger institution but abandons rural branches in Jharkhand or Odisha isn’t serving the mandate.

What to Watch

Over the next 12-18 months, watch for quarterly results showing consecutive losses, RBI commentary on SFB regulation in supervisory feedback, PE firms circling weaker SFBs, and universal bank licence applications from stronger players like AU or Equitas.

The SFB experiment isn’t a failure. Several institutions have genuinely expanded banking access. But the category may have too many players for the available market. Some form of consolidation — managed thoughtfully, with financial inclusion safeguards — seems increasingly likely.