AU Small Finance Bank—weighed down by industry headwinds, but set for a turnaround

However, despite its solid fundamentals, AU’s stock has remained rangebound for nearly four years, weighed down by industry headwinds. Recent stress in unsecured lending has added to the challenges.

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Yet, the bank appears well-positioned for a turnaround now, aided by favourable macroeconomic conditions and regulatory support.

Unsecured loans have weighed on AU’s books

The merger of Fincare Small Finance Bank into AU in April 2024 expanded its geographical footprint into southern India and broadened its product portfolio to include microfinance loans. With yields exceeding 25%, these loans significantly outpace AU’s overall yield of 14.4%, enhancing its book yields.

Despite the higher credit costs associated with microfinance, the acquisition initially boosted AU’s net interest margin (NIM), which rose from 5.1% in Q4FY24 to 6% in Q1FY25—the first quarter post-merger.

However, indiscriminate lending over recent years in the unsecured segment has led to rising stress, particularly in unsecured retail lending. While asset quality concerns have emerged across the board, the most severe deterioration has been in the unsecured retail segment.

Gross non-performing assets (NPAs) in microfinance loans surged from 1.1% post-merger to 4.1% in Q3FY25. NPAs in AU’s credit card portfolio climbed from 2% in Q4FY24 to 4.4% in the latest reported quarter, and unsecured personal loan NPAs jumped from 4.5% to 6.3% over the same period.

These spikes pushed AU’s overall gross NPA from 1.67% in Q4FY24 to 2.3% by December 2024.

Slippages have eroded margins

Higher slippages have driven up credit costs.

In AU’s microfinance portfolio, credit costs stood at 5.41% for the nine months ended December 2024, up from 3.08% in H1FY25. Meanwhile, credit costs in its credit card business have worsened relative to the industry. While the industry average hovers at 6-7%, AU’s credit card credit costs climbed from 8.35% to 9.2%.

Although unsecured loans account for only about 12% of AU’s gross advances, the sharp rise in their credit costs has disproportionately impacted profitability. Nearly half of the bank’s overall credit cost, which jumped from a historically tight range of 20-60 basis points to 1.4% in Q3FY25, can be attributed to unsecured loans.

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Separately, AU’s NIM had already been under pressure due to rising interest rates affecting its largely fixed-rate loan book. While its aggressive deposit-growth strategy—registering a 34% CAGR between FY21 and FY24—improved its credit-deposit ratio from 96% to 84%, it further strained margins.

The Fincare acquisition in Q1FY25 provided a temporary reprieve, boosting AU’s high-yielding assets and moderating the credit-deposit ratio to 89%. However, renewed stress in unsecured lending has since caused NIM to decline again, dragging AU’s return on assets (ROA) in Q3FY25 to its lowest level since the pandemic.

RBI’s crackdown has hurt growth

After several months spent trying to sensitize lenders against the ongoing credit binge, the Reserve Bank of India (RBI) in November 2023 raised risk weights on unsecured retail loans and loans to non-banking financial companies (NBFCs) by 25 percentage points. The move tightened capital requirements, effectively slowing credit growth.

AU’s microfinance portfolio has contracted by 10% in FY25 so far, while new credit card issuances have declined 9% sequentially. As a result, overall credit growth has decelerated from 46% in FY24 to approximately 20% in FY25. Reflecting these challenges, AU’s management recently revised its FY25 credit growth guidance downward to 20% from 25%.

Better positioned to withstand the stress

Despite these setbacks, AU’s diverse customer base and geographical spread have helped cushion the impact of retail lending stress.

Unique borrowers make up 39% of its customer base—higher than peers—while no single state accounts for more than 12% of its microfinance book, and no district exceeds 3%. Additionally, about 20% of its microfinance portfolio is covered under the Credit Guarantee Fund for Micro Units (CGFMU).

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As for unsecured retail loans, which total around ₹4,000 crore, ₹1,000 crore comes from personal loans that align with industry standards. The remaining ₹3,000 crore in credit card loans, however, has seen higher delinquencies and credit costs.

To address this, AU implemented corrective measures in Q3 to improve the credit quality of its credit card portfolio. The bank has shifted to income-documented underwriting, reduced exposure on existing cards and new issuances, halted digital card issuance, and strengthened daily transaction monitoring to prevent fund misuse. Notably, while industry-wide overleveraging has contributed to stress, only 8% of AU’s borrowers are associated with more than five lenders.

AU also follows a stringent provisioning process, fully writing off microfinance and credit card loans overdue by more than six months, well beyond the RBI-mandated 25% provisioning requirement. This minimizes the risk of hidden stress on its books.

Furthermore, the bank has significantly expanded its collection team, from 600 employees in June 2024 to about 1,500 in December 2024, improving collection efficiency. While Q4FY25 may still see elevated stress, recoveries are expected to improve in FY26, leading to moderating credit costs and better margins.

Universal bank ambitions and macro tailwinds

AU’s application for a universal banking licence remains a key potential catalyst. If approved, it could enhance brand credibility, boost deposit mobilization, and lower funding costs. However, while the RBI has formed an external advisory committee to review applications, the timeline and outcome remain uncertain.

On the macroeconomic front, the RBI’s recent policy decisions have provided a welcome relief. Earlier this week, the central bank reversed the hike in risk weights on microfinance and NBFC lending, offering a lifeline to microfinance lenders. In response, AU’s stock gained about 6% on Thursday, even as the broader Nifty 50 index remained flat.

Additionally, the RBI initiated monetary easing earlier this month, delivering its first rate cut after two years of elevated rates. Given that nearly two-thirds of AU’s assets are fixed-rate, this policy shift is set to improve its margins over the next year.

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While AU faces near-term challenges, the combination of regulatory tailwinds, a diversified portfolio, and proactive risk management suggests that its long-term growth story remains intact.

Ananya Roy is the founder of Credibull Capital, a SEBI-registered investment adviser. X: @ananyaroycfa

Disclosure: The author does not directly hold any shares of the companies discussed. The views expressed are for informational purposes only and should not be considered investment advice. Readers are encouraged to conduct their own research and consult a financial professional before making any investment decisions.