Financial Inclusion, Rural Lending And Its Impact On Profitability In Indian Small Finance Banks

Purpose - The research designates whether financial inclusion requirements, including Priority Sector Lending (PSL) compliance, microfinance lending intensity, and the rural branch density, have systematic effects on profitability of Indian Small Finance Banks (SFB) and to what conditions this relation is valid. Design/Methodology/Approach - A longitudinal panel dataset consisting of 6 large SFBs (AU, Equitas, Ujjivan, Utkarsh, Jana, and Suryoday), on FY2018-FY2025 generated 48 bank-year observations used to analyze with Fixed and Random Effects panel regression. Hausman test helps to select the estimators. Mediation is hypothesized using the Baron and Kenny (1986) model using Sobel testing and multicollinearity using Variance Inflation Factors. Findings - ROA belonging to moderate levels of PSL compliance (60-75% of ANBC) displays a non-linear optimum, which is optimally linear with these extremes. Microfinance concentration higher than 70% greatly reduces ROA and ROE with a complete mediation of the Gross NPA ratio (Sobel z = -4.21, p = -0.001). Branch density in rural branches lowers short term ROA but has positive impact on Net Interest Margin, in terms of increasing yields on portfolios. The inclusion-profitability relationship is also largely moderated by the size of the bank with a larger SFB being able to absorb the cost of high inclusion intensity. Fixed Effects model accounts of 68.4 percent of the variation in ROA between the panel. Limitations/Implication of the Research - The sample of six prevalent SFBs is restricted, and it can bring about survivorship bias. Disaggregation and disgustre of PS language and inclusion results that started at the ground level are beyond the scope of this study. The COVID-19 shock (FY2021-22) might have intensified the microfinance-NPA-profitability channel by magnifying it by even more than the non-crisis magnitudes. Respondent findings suggest tiered PSL compliance architecture, explicit microfinance concentration cap and differentiated supervisory norms that are adjusted to the institutional maturity. Originality /Value - The study is one of the first to model three financial inclusion variables concurrently with various dimension of profitability on eight-year panel data between pre-, during-, and post-COVID periods on a similar SFB sample. The find of nonlinear PSL optimality level and full GNPA-mediated transmission presents new empirical data contribution to the literature of mission-driven banking and suggests empirical evidence-based regulatory measures and SFB practitioners.