AU Small Finance is in repair mode, but net interest margin could be a challenge

AU Small Finance Bank Ltd investors have entered FY26 with mixed feelings. While the anticipates elevated credit cost in the first half of the year, the management expects an improvement in the second half.

Credit cost (on average total assets) stood at 1.3% in FY25 due to increased stress in unsecured portfolios, mainly microfinance (MFI) and credit cards. What offers comfort is that AU Small Finance Bank has seen an improvement in collection efficiency in the MFI portfolio and expects the trend to continue in FY26. Also, slippages eased to 3.62% in the March quarter (Q4FY25) from 4.06% in Q3FY25.

MFI credit cost is seen declining to 3.5% in FY26 versus 7.7% in FY25. What’s more, the bank is exercising caution and pursuing balanced growth in the unsecured segment. It looks to cap the MFI book at 10% of the total portfolio, while the entire unsecured segment exposure would be capped at 15%. All new disbursals are expected to be Credit Guarantee Fund for Micro Units (CGFMU)-insured. Roughly 36% of the current MFI portfolio is already covered under CGFMU.

To tackle stress in the credit card portfolio, the bank has tightened the underwriting and credit filters, thus limiting credit card issuance, which stands at around 10,000 versus 40,000-45,000 cards earlier.

Credit card credit cost is seen declining to 6-7% in FY26 from 11% in FY25. Overall, credit cost (on average total assets) could fall to around 85 basis points in FY26 and 75 bps in FY27.

However, tight control on costs and efforts on improving asset quality should translate into meaningful improvement in credit costs, paving way for the bank to reach its return on asset (RoA) target of 1.8% by FY27 from 1.5% in FY25. For now, the management didn't give RoA guidance for FY26. The management expects the credit card business to breakeven by FY27 and that should contribute to overall RoA from FY28 onwards.

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

NIM pressure

That said, net interest margin (NIM) would be a challenge in FY26. The management acknowledged the likely NIM pressure as a 50bps rate repo cut would put pressure on near-term NIM outlook given around 30% floating rate book. AU has already cut the savings account rate by 25bps in April, but it is not looking to cut savings account rates in near-term.

NIM fell 10bps sequentially in Q4FY25 to 5.8% as a higher proportion of low-yielding secured loans weighed on spreads. “While credit cost is unlikely to normalize soon, we expect it to decline enough to offset any pressure from a declining NIM—and probably more,” said Kotak Institutional Equities report on 23 April.

Even so, given the broader macro uncertainty, the brokerage prefers to wait and establish a recovery in the core secured businesses before turning more positive. But it acknowledges that the discomfort with valuations has declined.

Meanwhile, the bank expects to receive a universal bank licence in 2025. This would support growth, boost market positioning and enable better deposit mobilisation at a more favourable cost.

That said, according to Emkay Global Financial Services, the bank’s plan to transition toward secured loans and elevated operational cost in the run-up to its transition into a universal bank could limit RoA to 1.5-1.6% over FY26-28E. In the last one year, the stock is up around 12%, trajectory of margin and asset quality trends in mainly in unsecured portfolios would decide the stock’s trajectory ahead.

Also Read: MFI stress may weigh on small finance banks’ loan growth, asset quality in short term