Asset quality at small finance banks (SFBs) is expected to improve this fiscal, with gross non-performing assets (GNPAs) projected to decline by around 120bps (basis points) to 2.6%-2.8% by March 2027, from 3.8% as of March 2026 and 4.4% a year earlier, according to CRISIL Ratings.
The improvement is expected to be driven by a recovery in the credit performance of SFBs' microfinance portfolios, along with continued growth in their non-microfinance businesses, where asset quality has remained stable.
The ratings agency said SFBs appear to be moving beyond the recent credit stress cycle, supported by tighter underwriting standards, improved borrower selection and healthier performance from newer microfinance loan vintages.
Microfinance Stress Expected To Ease
According to CRISIL, microfinance portfolios have faced elevated credit stress over the past two fiscal years, primarily due to borrower overleveraging. Although microfinance accounted for only around 30% of SFB advances, the segment contributed disproportionately to overall delinquencies.
In response, SFBs recalibrated their growth strategies, strengthened underwriting and tightened risk management standards. They also aligned their practices with the microfinance industry's Guardrails 2.0 framework.
SFBs wrote off advances equivalent to around 7% of their outstanding portfolio as of March 2024, with most of the write-offs coming from microfinance loans. This helped bring down GNPAs last fiscal, CRISIL said.
Aparna Kirubakaran, director, CRISIL Ratings, said tighter underwriting by SFBs had improved borrower selection and materially strengthened the asset quality of microfinance portfolios.
"As newer vintages originated under the revised guardrails season and account for a larger share of the overall microfinance book, asset quality is expected to improve further," she said.
CRISIL expects GNPAs in the microfinance segment to decline to 3.8%-4.0% by March 2027, from peaks of 7.6% in fiscal 2026 and 8.4% in fiscal 2025.
The improvement is expected to be reflected through lower loan slippages and higher recoveries, supported by steady growth in the microfinance portfolio, the rating agency said.
Non-microfinance Portfolio Expands
CRISIL said the overall improvement in SFB asset quality will also be supported by the growth of the non-microfinance portfolio, which has maintained relatively stable credit performance.
The portfolio now accounts for around 70% of total SFB advances, up from about 50% in fiscal 2022. SFBs have expanded their non-microfinance businesses rapidly in recent years as they diversified into more secured lending segments.
However, CRISIL cautioned that some of these portfolios have limited seasoning. Their performance through a full credit cycle, particularly amid a changing macroeconomic environment, therefore, remains to be tested.
Vani Ojasvi, associate director, CRISIL Ratings, said GNPAs in the non-microfinance portfolio had remained stable at 2.2%-2.4% in fiscals 2025 and 2026 and were expected to remain within that range this fiscal.
"As these portfolios mature, asset quality across segments such as MSME lending, loans against property and vehicle finance will warrant close monitoring," Ms Ojasvi said.
These segments have varying degrees of sensitivity to macroeconomic factors, including fuel prices, rural income trends and monsoon outcomes. However, CRISIL said these factors were not expected to pose any material risk at present.
Early Stress Indicators Improve
According to the rating agency, the improvement in asset quality of SFBs is also visible in early delinquency indicators. The aggregate share of special mention accounts (SMA) I and II in SFBs' gross advances declined to 2.4% as of March 2026, from around 3.4% a year earlier.
According to CRISIL, the decline reflects improved collection efficiency and a lower build-up of delinquent accounts.
The trend in early stress indicators over the past year has reinforced the ratings agency's expectation of a continued recovery in credit quality.
Recovery Still Needs To Be Sustained
While near-term asset quality trends are expected to remain favourable, CRISIL said the sector's ability to sustain the recovery would require close monitoring as the composition of SFB loan books changes and newer portfolios mature.
The ratings agency said SFBs had strengthened underwriting and risk management in response to the recent microfinance stress. The resulting improvement in borrower selection, combined with the seasoning of newer microfinance vintages, is expected to support further improvement in asset quality.
At the same time, the growing contribution of non-microfinance loans means that the performance of newer portfolios, such as MSME (micro, small and medium enterprise) lending, loans against property and vehicle finance, will become increasingly important.
Overall, CRISIL expects SFBs' GNPAs to moderate to 2.6%-2.8% by March 2027, signalling a significant improvement from the 4.4% recorded in March 2025 and 3.8% in March 2026.
The trajectory, however, will depend on whether the improvement in microfinance credit quality is sustained and whether the rapidly expanding non-microfinance portfolio continues to maintain stable asset quality as it seasons, the rating agency concluded.
