Fixed deposit (FD) rates have been steadily rising for a year now, and small finance banks have taken a lead in offering the highest interest rates across tenure. However, these banks are known to be riskier than scheduled commercial banks.

While all SFBs are governed by the Reserve Bank of India (RBI), the central bank does not offer any guarantee to the depositors. Therefore, it is better to do a thorough assessment of these banks before you deposit your money in one of them.

So how do you check if the small finance bank (SFB) where you plan to deposit your money is safe or not?

"Understanding the structure, reach and financial strength of such banks are important. Some of these banks have a huge base in terms of borrowers in certain regions or segments,” says Harshad Chetanwala, founder, My Wealth Growth. “There is always a reason why additional returns are being offered by banks. It is always better to diversify the deposits across various banks even though few banks are offering higher interest rates."

Here is how you can use easily available information to check whether a bank is safe or not.

1. USE MULTIPLE DICGC INSURANCE COVERS

The first and foremost way to ensure the safety of your deposit is to make sure that it is completely covered under the Deposit Insurance and Credit Guarantee Corporation (DICGC)’s insurance of Rs 5 lakh, which includes both principal and interest. If you are withdrawing regular interest income from FD, then your total principal (deposit) amount can be Rs 5 lakh. However, if it is a cumulative FD, make sure the maturity amount is not more than Rs 5 lakh.

Every FD opened in a different right and different capacity is eligible to enjoy the Rs 5 lakh insurance cover. For instance, you can open one FD in a single individual account, another as a joint first account holder or joint second account holder or joint third account holder, one as guardian of a minor, another as a director of a company and so on — each one of these will enjoy Rs 5 lakh deposit insurance cover. Check if it is feasible for you to have multiple insurance covers like this.

2. HOW STRONG IS THE BANK WHEN IT COMES TO ITS RISK CAPITAL?

If you invest your own money in a venture, the risk is fully with you. But if you borrow to invest, you pass on the risk to the lender. In case you suffer a big loss, the lender may not be able to get the money back on time. So higher is bank's own capital lesser the risk for depositors. Let us use this context to understand how a bank can be considered safe by using the most prominent financial ratios specific to a bank.

3. EVALUATING THE RISK IN ITS FUNDING

All data taken for the quarter ended 31 December 2022 unless expressed otherwise, & - 31 March 2021, 31 March 2022, $ 30 June 2022, * 30 September 2022

4. CAPITAL ADEQUACY RATIO

A well-capitalized bank — which has owner’s funds in a good proportion — is considered to be strong enough to withstand any adverse situation. A sufficient owner’s money in the bank ensures that in case of loss or distress, the owner’s money is sacrificed first to save the bank while keeping depositors’ money safe. High capital levels add to the strength of the bank.

The RBI’s operating guidelines for SFBs require them to maintain a minimum CRAR of 15%, with at least 7.5% as tier I capital. The bank’s total regulatory capital consists of tier I capital and tier II capital. Tier I includes paid-up equity share capital, statutory reserves and other eligible disclosed free reserves, according to RBI’s specifications. Tier II capital includes Upper Tier – II bonds, subordinate debt instruments (Lower Tier – II bonds), general provision, investment reserve account and investment fluctuation reserve. The higher the CRAR of the bank, the safer it is.

5. LIQUIDITY COVERAGE RATIO (LCR)

The LCR is a measure that aims to make banks more resilient to short-term liquidity shocks by ensuring that they have enough high-quality liquid assets (HQLAs). This helps them to cope with a severe stress scenario that lasts for 30 days. SFBs have to meet a minimum LCR of 100%, according to the RBI. Here also, a higher LCR brings greater stability to a bank and enhances its ability to withstand short-term funds outflow without disrupting other sources. A lower LCR indicates the vulnerability of the bank, and you should avoid putting your money in such a bank.

6. NET STABLE FUNDING RATIO (NSFR)

The NSFR is a measure introduced by the Basel Committee on Banking Supervision (BCBS) to make banks more resilient in the long term by requiring them to use more stable sources of funding for their activities. The NSFR is calculated by dividing the amount of stable funding that banks have by the amount of stable funding that they need. The NSFR considers a time horizon of one year and defines “stable funding” as the part of capital and liabilities that is expected to be reliable in that period. According to an RBI guideline that came into effect on October 1, 2021, SFBs must have an NSFR of at least 100%.

7. CURRENT ACCOUNT SAVING ACCOUNT (CASA) RATIO

This is a ratio that shows the share of current and savings account deposits in the total deposits of a bank. Current and savings account deposits are cheap sources of funds for banks, as the institutions do not pay much or any interest on them. A high CASA ratio means that the bank has a low cost of funds and a high profitability. A low CASA ratio means that the bank has a high cost of funds and low profitability. A CASA ratio of 40% or more is considered to be favorable for the bank.

8. HOW STRONG IS THE BANK WHEN IT COMES TO LENDING?

If you have borrowed money from person A and then lent it to person B after a thorough assessment, then the quality of your assessment will determine whether person A will get back the money on time. This is what a bank does. Where SFBs differ is that they lend to a limited set of borrowers. So if you are putting your money in an SFB, check how that bank fares in its lending activities. Here is how you can check the quality of lending of an SFB with the four most critical financial ratios:

9. UNDERSTANDING THE RISK IN ITS LENDING

All data taken for the quarter ended 31 December 2022 unless expressed otherwise, & - 31 March 2021, ^ 31 March 2022, $ 31 June 2022, * 30 September 2022

10. GROSS NON-PERFORMING ASSET (GNPA)

A bank is primarily in the business of lending. Each loan or credit line is an asset the bank creates, and it earns from it. When an asset stops earning income for the bank, it becomes non-performing. Gross NPA is the term used by commercial banks to refer to the amount of debt that is unpaid and classified as non-performing loans. GNPA of a bank in India is the total value of loans that have gone bad or doubtful — meaning that the borrowers have defaulted on the interest or principal for a certain period, usually 90 days or more. The GNPA ratio is the percentage of GNPAs to the total loans given by the bank. A high GNPA ratio shows that the bank is having trouble collecting its loans and may face losses.

11. NET NON-PERFORMING ASSET (NNPA)

Whenever the GNPA of a bank rises, it has to make provisions for future losses. A provision is the amount of money that banks keep aside to cover the possible losses from NPAs. The net NPA of a bank in India is the value of non-performing assets (NPAs) after deducting the provisions made for them. The NNPA ratio is the percentage of NNPAs to the net loans given by the bank. A low NNPA ratio shows that the bank has made sufficient provisions for its bad loans and has a sound loan portfolio. A higher NNPA ratio is a red signal about possible risks and, hence, you should avoid putting your money in such a bank.

12. LEVERAGE RATIO

Going beyond your means always runs the risk of being left with no means. Leverage, in simple terms, shows how many times your total lent amount is in comparison to your actual asset size. The leverage ratio is designed to complement the risk-based capital requirements. It is calculated by dividing the capital measure (tier-1 capital of the risk-based capital framework) by the exposure measure; it is expressed as a percentage. The minimum leverage ratio the RBI stipulates is 4.5%. A higher leverage ratio is considered good which shows a lower level of leveraging and hence lesser risk. A good number of SFBs have leverage ratios in double digits.

13. PROVISION COVERAGE RATIO (PCR)

PCR shows the proportion of provisions made by a bank for its NPAs. Provisions are the money banks keep aside to cover potential losses from NPAs. To recap: NPAs are loans or advances that have gone bad or are doubtful, meaning that the borrowers have defaulted on the interest or principal for a certain period of time, usually 90 days or more. A high PCR means that the bank has made sufficient provisions for its NPAs and has a robust balance sheet. A low PCR means that the bank has made inadequate provisions for its NPAs and has a fragile balance sheet. The RBI has mandated a minimum PCR of 70% for all banks.

14. OTHER QUALITATIVE FACTORS TO CHECK

Besides the quality of capital and lending a depositor should also check other qualitative factors which help in understanding the stability of a bank.

15. DIVERSIFICATION OF FUNDING AND LENDING

Often banks fail when they lend a larger amount to a big corporation, industry or to a particular sector than the others, in the hope that the borrower will grow fast and will return their money with interest. However, if their estimate goes wrong, it puts the bank under stress. "SFBs should avoid excessive exposure to a single borrower or a group of related borrowers as a proportion of total loans advanced," says Sanjeev Govila, and CEO, Hum Fauji Initiatives, a financial planning firm.

On the other hand, the more diversified lending base a bank has, the less risky it is considered to be. "The loan portfolio should be well-diversified across different sectors and industries to reduce the concentration risk and limit the bank's exposure to sector-specific risks. This will also help the SFB to mitigate credit risk and improve its financial stability. The bank should have a diversified geographical presence, both in terms of lending and deposit-taking activities, to better manage local risks, such as economic, political and regulatory risks," says Govila, a SEBI-registered investment advisor. You can check their annual and quarterly reports to find how diversified their lending is.

16. TIMELY SHARING OF FINANCIAL DATA IS THE MOST CRITICAL FACTOR

If a bank is strong and stable, it will typically be more transparent and forthcoming in sharing its critical data. If a bank is delaying the process of sharing its financial and other reports, or appears to be hesitant to share all the relevant information quickly, it should set off the first alarm bells that everything is probably not good with the bank. Many SFBs do not share their quarterly financial reports on their websites, which should make you suspicious.

All the above information is easily available on the banks’ websites. Access these and evaluate the information before investing in an FD of an SFB. "All small finance banks are regulated by the RBI and so they all follow a set process. More information is available for listed banks when compared with unlisted ones. This can help in assessing the banks in a better manner. It can also help in finding well-managed and well-diversified banks," adds Chetanwala.

Besides, you can also refer to the annual financial statements, historical trends and reports of credit rating agencies to do a deeper investigation and satisfy yourself of the safety of your investment. "There are several other factors that must also be taken into account,” adds Govila. “The prominent ones are the management quality and their experience in managing the complexities of banking operations; the bank's long-, medium- and short-term liquidity positions; asset and liability management at various points of time; and, very importantly, overall profitability.”