Rating Rationale

Strengths:
* Diversified product profile with increasing focus on secured lending
Equitas SFB benefits from its presence across diversified product segments - microfinance (23.98% of the overall Advances [including IBPC]), vehicle finance (24.54%), Small business loans (40.57%), corporate loans (5.20%), MSE (3.85%) and other products (1.85%) as of December 31, 2019. The bank has been able to diversity its loan book - reaping the benefits of its legacy book across retail asset segments. After transforming into a bank, the bank has expanded focus from core segments like microfinance and vehicle finance, to small business loans, MSE, corporate lending, housing finance and others. Owing to this diversity in asset mix, the bank was able to curtail the impact on collections post demonetisation and political issues faced by microfinance players in some geographies. Further, the volatility in asset quality due to socio political issues will reduce as the bank continues outgrow its secured loan book - replacing a larger portion of the existing unsecured portfolio. Apart from diversity, the secured portfolio has also been contributing to the overall growth of the Advances [Including IBPC]. Contributing to a 33.2% (CRISIL annualised) growth during nine months through December 31, 2019 small business loans - which is the largest segment in the loan portfolio of Equitas SFB - grew at 39.4% (CRISIL annualised), followed by vehicle finance which clocked a 28.7% (CRISIL annualised) growth and lastly, microfinance which grew at 18.9% (CRISIL annualised). Relatively smaller segments like MSE (281.9% CRISIL annualised growth) and corporate loans (CRISIL annualised 88.9% growth) also registered good growth over the nine month period.

* Adequate capitalisation
The bank's capital position, in relation to its scale and nature of operations, remains adequate - evidenced by a reported networth of Rs 2,705 crore on December 31, 2019. The bank, ever since transformation in September 2016, has maintained a capital adequacy ratio of over 20%. As on December 31, 2019 - the tier I and overall CAR stood at 22.6% and 23.7%, respectively. The bank enjoys significant flexibility to raise additional equity capital and has, in the past, raised equity well ahead of growth in asset base. Equitas Holdings Limited, the holding company, had raised Rs. 720 crore during its IPO in 2016 - of which Rs. 616 crore was invested in the bank. More recently in Q3 2020, the Bank has raised Rs. 250 crore. In the medium term, CRISIL believes that the bank's capitalisation would remain adequate. Gearing remained moderate at 5.8 times on December 31, 2019 and CRISIL expects it to range around 5 times in the medium term. As part of the listing process which is underway, the bank is expecting another round of equity raising in the near term as fresh proceeds from this public offer. The timing and quantum of these proceeds, would remain a key sensitivity factor.

* Gradually growing deposit franchise corresponding to an increasing share of retail deposits, traction herein remains a monitorable
Being the first among all SFBs to transform into a bank, Equitas SFB had the first mover advantage in context of deposit mobilization. The bank, after conversion in September 2016, started to mobilize deposits from Q1 2018. Over the three years of its banking history, the bank has garnered a deposit base of Rs 10,493 crore which formed 69% of its borrowing base on December 31, 2019. Over the 12 months through December 2019, the 32.6% growth in overall deposit base has been corresponded with an increased degree of granularity. CASA and retail term deposits (<Rs 2 crore) have grown at a healthy 62.9% over 12 months through December 2019, leading to an increase it its share from 40.9% to 50.3% over this timeline. This growth was largely driven by retail term deposits of ticket size less than Rs 2 crore - which increased to 29.3% as a proportion of total deposits as on December 31, 2019 from merely 15.4%, a year ago.

CRISL expects the bank to be able to restore its growth pace in deposits however its ability to extract a higher proportion of retail deposits and, at a faster pace, remains a key monitorable.

* Extensive experience, strong process orientation, and conservative risk policies of board of directors and senior management
Equitas SFB benefits substantially from the presence of experienced professionals from the financial services sector. The board members have rich domain expertise and extensive experience in the fields of microfinance and self-help groups, law and arbitration, audit and accounts, taxation, banking, technology, and strategy. The senior management team, which is highly experienced, has largely been stable over the past few years. There is a strong second line of management as well.
The management is highly process-driven. Robust systems and processes, with strong technology support were established since inception of the microfinance business. More recently, with the objective to monitor credit quality more vigilantly, the management adopted the practice of daily recognition of NPAs during fiscal 2019. Similarly the management has smoothly handled the transition to small finance bank over the past three year. The banking operations have also largely stabilized.

Weaknesses:
* Inherent weakness in the credit risk profile of the borrower segment
Despite diversification in portfolio across asset segments and increased focus on secured lending, the bank's customer base has not changed materially. The borrower base comprises people, living across urban and semi-urban areas, carrying out small business operations or doing petty jobs which may be associated with irregular cash flows.

Now, as a bank, Equitas SFB has been lowering its exposure to the microfinance segment in order to limit the volatility in asset quality. Historically, microfinance portfolio has been susceptible to regional, social and political issues and given the high degree of vulnerability for microfinance segment, the bank's exposure to this segment has been reducing gradually. Post demonetization, the quality of the bank's microfinance portfolio witnessed high deterioration - particularly in the states of Maharashtra, Madhya Pradesh and Karnataka.

Similarly in the vehicle finance segment, the bank offers majority of finance for purchase of pre-owned CVs to small road transport operators; such borrowers are typically new to formal lending system. CRISIL believes that the credit risk profile of these borrowers is weaker than that of borrowers in the new vehicles segment. Even though the bank is increasing the share of new CVs in its book, used CV still forms about 70% of its vehicle loan portfolio. Furthermore, in the Small business loans including LAP and housing finance segments, the bank provides finance mainly to self-employed borrowers, whose cash flows are highly sensitive to even minor business disruptions or unforeseen developments. Pressure on borrowers' cash flows will affect their repayment capacity, leading to mounting delinquencies. In addition, the high-tenor LAP and housing finance segments have grown significantly over the last 3 fiscals. Overall GNPA stood at 2.86% on December 31, 2019 and was largely driven by CV, HF and unsecured business loans.

For better risk management, the bank plans to reduce its presence in unsecured assets and is running down its unsecured loan book,

* Average but improving profitability
Having remained subdued in the aftermath of demonetisation, Equitas SFB's profitability has revived in fiscal 2019 and has sustained at average levels since then. For fiscal 2019, the bank reported a profit of Rs 211 crore corresponding to a return on assets of 1.5% as compared to a modest profit of Rs 32 crore and an RoA of 0.3%, for the previous fiscal. For the first nine months of fiscal 2020, the bank has sustained its earnings reflected in an RoA of 1.6% and a profit of Rs 201 crore for the period - which was driven by a healthier profitability in the third quarter, as compared to the first two. The variation in profitability is reflected in an RoA of 1.5% and 1.1% for quarters ended June and September, 2019 respectively, as against an RoA of 2.1% for the third quarter of fiscal 2020.

The bank has been able to sustain its net interest margins (NIMs) at healthy 8-9% levels throughout its banking history alongside sustenance in operating expenses and other income - which have resulted in a stable pre-provisioning profitability over the last few quarters. Credit costs, after spiking to 3% levels in fiscal 2018, have also restored to 1% levels - resulting in a better earnings performance at an overall level. With the increasing proportion of secured loans in the asset mix, the yields may decline marginally with some impact of it being offset by a corresponding decline in cost of funds. However, overall net interest margins may compress. In such a scenario, the bank's ability to diversify its streams of income and optimize the operating expenses - which are still on a relatively higher side, remains a key monitorable.

* Geographical concentration in microfinance, SBL and housing finance operations
The microfinance, small business loans (SBL) and housing finance businesses remain exposed to geographical concentration risks; as Tamil Nadu (TN) accounts for the highest proportion of the loans outstanding of the respective segments, as on December 31, 2019. Of the Advances [Including IBPC] as of December 31, 2019 - 55% was housed in Tamil Nadu, followed by 13.0% in Maharashtra and another 10% in Karnataka. Across segments, the concentration of portfolio within these three states is high with majority across Tamil Nadu. As on December 31, 2019, majority of the small business loans, housing finance and microfinance portfolio was parked in Tamil Nadu. Similarly, for all other segments, except vehicle, >30% of the portfolio was in Tamil Nadu. While the bank is undertaking measures to diversify its geographical presence, its ability to manage asset quality consistently, despite geographic concentration, will be closely monitored.

* Cost of funds and CASA - relatively weaker than that for the banking system
Despite good traction in deposits over a year through December 2019 with increasing share of retail deposits, the proportion of CASA in the total deposit and borrowing base remains low. In absolute terms, while CASA has increased from Rs 2,021 crore on December 31, 2018 to Rs 2,196 crore - a year later, as a proportion of total deposits - it has declined from 25.5% to 20.9% due to CASA being outgrown by retail term deposits. As a proportion of total borrowings (Rs 15,156 crore), CASA is even lower at 14.5% as compared to an average of 30% for the banking industry.

Similarly, Equitas SFB's cost of funds at 7.96% (for Q3 2020) remains higher than for other mid-sized banks, which avail funds at 5-6%. While this metric has been improving gradually ever since Equitas SFB has transitioned into a bank and is expected to improve further, over the medium term - it would remain higher than other mid-sized banks within the system.