NPA (Non-Performing Assets)

India’s NPA crisis has been all over the news for some time now. And with a pile up of all these bad loans, India seems to be winning the wrong race.

The Non-Performing Assets (NPA) accumulated by Indian financial institutions are higher than those of in most major economies, including the US, UK, China and Japan.

India with its NPAs at a ratio of 9.9% of total assets, is ranked 5th on the list of countries with the highest NPAs and is on top spot among the BRICS nations, a recent report by CARE Ratings revealed. The country is behind only Greece, Italy, Portugal and Ireland, in that order.

According to RBI, the gross Non-Performing Assets (NPAs) of all banks stands at 8.85 lakh crores as of December 2017. Out of this the NPAs of Public Sector Banks are 7.34 lakh crore. They collectively account for 87 % of the total NPAS of the county’s banking system.

What is NPA?

The assets of the bank which do not perform (that is – do not bring any return) are called Non-Performing Assets (NPAs) or bad loans.

Bank’s assets are the loans and advances given to customers. If customers don’t pay either interest or part of the principal or both, the loan turns into a bad loan.

According to RBI, term loans on which interest or installment of principal remain overdue for a period of more than 90 days from the end of a particular quarter is called a Non-Performing Asset.

Banks are required to classify NPAs into three categories:

• Substandard Assets: Assets which have remained an NPA for a period of less than or equal to 12 months.
• Doubtful Assets: Assets that have remained in the substandard category for a period of 12 months.
• Loss assets: As per RBI, “Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted, although there may be some salvage or recovery value.”

However, for Agriculture/Farm loans; the NPA is defined for Short Duration agriculture loans (such as for crops like paddy, jowar, Bajra etc.) if the loan (installment/interest) is not paid for 2 crop seasons. For Long Duration Crops, NPAs are defined for non-repayment after 1 crop season from due date.

Why DO assets become NPAs?

Macroeconomic factors

To understand the NPA scenario correctly we should understand the pro-cyclical nature of bank lending.

Banks generally give high volume of loans when the economy is in good shape or during an economic boom. When there is a boom, assets and income of burrowers is expected to be high. Value of property etc. being at peak level enables investors/business people to borrow heavily citing their wealth and prospects. Banks give loans depending upon the value of the mortgaged assets.

Later, when recession comes after the boom, (for every boom there will be a recession) the value of mortgaged assets falls. The income, profit and thus the repayment capacity of borrowers comes down resulting in non-payment or NPAs. The large volume of loans given during boom may not come back smoothly during recession.

Many-a-times, the RBI cautions banks to show restraint during the boom phase of the economy. But, the banks, with a view to expand business, do not give too much consideration to the RBI’s advice, and continue to give out loans during the period. When recession hits, the banks are compelled to take difficult decisions and even book loss.

As can be observed, Banks suffer from economic cycles (boom and recession). Wilful defaults, other types of defaults on loans, etc. just reflects the economic conditions like recession. Hence the banks are termed as “procyclical” and they suffer from “procyclicality”.

Inadequate Credit Assessment

A second reason for loans becoming NPAs is the lack of proper credit assessment process done by the banks. Conservativeness while lending is considered to be an optimal way to reduce the chances of a loan becoming bad and suffering from non-payment. There may be a lack of proper monitoring after the loan has been sanctioned. This leads to poor follow -up measures and complacency in the recovery process. Hence, the borrower, not compelled by any stringent measures to give the loaned amount back, wilfully defaults on it, or uses it for purposes not stated in the loan agreement.

Change in economic policies of the government

Because of a change in the central government, there is a change also, in the economic policies of the country. If a bank fails to adjust and realign itself with the new norms, it falls behind to cope up. Different sectoral norms affect the analysis of determining a good loan and side-lining a potential bad one. Banks that do not keep themselves updated and do not make considerations in their lending process to include these changes suffer.

Companies in the power, infrastructure, metals and real estate are the major contributors to the stressed assets situation. It is caused largely due to stalled projects, delayed policy decisions, economic slowdown, and several factors relating to supply and demand and mismanagement. Also, these sectors suffer from long gestation periods for the actualization of the project. Directed lending to these sectors results in defaults of the loan. Further, if there is a shutdown in the business to any of the reasons, recovery becomes extremely difficult.

Lax monitoring of credit and failure to recognize Early Warnings Signals

It has been stated that approval of loan proposal is generally thorough, and each proposal passes through many levels before approval is granted. However, the monitoring of sometimes complex credit files has not received the attention it needed which meant that early warning signals were not recognized, and standard assets slipped to NPA category without banks being able to take proactive measures to prevent this.

Over optimistic promoters

Promoters were often optimistic in setting up large projects and in some cases were not fully above board in their intentions. Screening procedures did not always highlight these issues. Often projects were set up with the expectation that part of the funding would be arranged from the capital markets which were booming at the time of the project appraisal. When the capital markets subsequently crash, the requisite funds could never be raised, promoter often lose interest and lenders are left stranded with incomplete/unviable projects.

Directed lending

Loans to some segment were dictated by Governments policies than commercial imperatives.

Highly Leveraged borrowers

Some borrowers were undercapitalized and over burdened with debt to absorb the changing economic situation in the country. Operating within a protected market resulted in low appreciation of commercial/market risk.

Funding mismatch

There are said to be many cases where loans granted for short terms were used to fund long term transactions.

Wilful Defaulters

There are a number of borrowers who have strategically defaulted on their debt service obligation realizing that the legal resource available to creditors is slow in achieving results.

What is the impact of NPAs?

The problem of NPAs in the Indian Banking System is one of the foremost and the most formidable problems that had impacted the entire banking system. Higher NPA ratio affects the confidence of investors, depositors, lenders etc. It also causes poor recycling of funds, which in turn will have deleterious effect on the deployment of credit. The non-recovery of loans affects not only further availability of credit but also financial soundness of the banks.

Profitability: NPAs put detrimental impact on the profitability as banks stop earning income on one hand and attract higher provisioning compared to standard assets on the other hand. Provisioning is the process of setting aside of money from Profits to compensate a probable loss caused on lending a loan. On an average, banks are providing around 25% to 30% additional provision on NPAs which has direct bearing on the profitability of the banks.

Asset (Credit) contraction: The increased NPAs put pressure on recycling and healthy circulation of the funds of the bank and reduces the ability of banks to lend more. Thus, resulting in lesser interest income. It contracts the money stock with the bank which may lead to economic slowdown.

Liability Management: In the light of high NPAs, Banks tend to lower the interest rates on deposits and levy higher interest rates on advances to sustain Net Interest Margin (NIM). This may become a hurdle in smooth financial intermediation process and hampers banks’ business as well as economic growth.

Capital Adequacy: As per Basel norms, banks are required to maintain an optimum Capital Adequacy Ratio (CAR) on risk-weighted assets on an ongoing basis. It is the ratio of Capital to Risk(weighted)Assets. This is an indicator of the volume of the bank’s capital. Every point increase in NPA level adds to risk weighted assets. In order to maintain a positive and optimum CAR, the banks need to shore up their capital base further. Capital being a scarce resource, an increase of NPAs within the bank puts undue pressure on it..

Shareholders’ confidence: Normally, shareholders are interested to enhance value of their investments through higher dividends and market capitalization which is possible only when the bank posts significant profits through improved business. The increased NPA level is likely to have adverse impact on the bank business as well as profitability thereby the shareholders do not receive a market return on their investment and sometimes it may erode the value of their investments.
As per extant guidelines, banks whose Net NPA level is 5% & above are required to take prior permission from RBI to declare dividend and also stipulate cap on dividend pay-out.

Public confidence: Credibility of banking system is also affected greatly due to higher level NPAs because it shakes the confidence of the public about the reliability of the banking system. The increased NPAs may pose liquidity issues which is likely to affect bank depositors. Thus, the increased incidence of NPAs not only affects the performance of the banks but also affects the depositors and further, the entire economy.

In a nutshell, the high incidence of NPA has cascading impact on all important financial ratios of the banks viz., Net Interest Margin, Return on Assets, Profitability, Dividend Pay-out, Provision coverage ratio, Credit contraction etc., which may erode the value of all stakeholders including Shareholders, Depositors, Borrowers, Employees and public at large.

NPAs of Indian banks

The gross Non-Performing Assets of all the banks in the country amount to ₹. 8,85,074 Crore in December 2017, led by industry loans followed by services and agriculture sectors.

The highest amount of gross NPAs was for the country’s largest lender, SBI, at ₹. 1,99,155 Crore. Bank of India had gross NPAs 64,249 Crore; Punjab national Bank was at ₹ 57,519 crore; IDBI Bank at ₹. 50,622 crores; Bank of Baroda- ₹ 48,480 core;

A list of the stressed assets of banks is given below.

Gross Non-performing Assets (NPAs) of Public and Private Sector Banks, as on 31.12.2017

Amounts in crores of Rupees

Source: Reply in Parliament

Solution Framework

The apex bank in a dramatic move, on February 12, 2018, had discontinued programmes for banks to restructure their defaulted loans, such as Corporate Debt Restructuring (CDR), Sustainable Structuring of Stressed Assets (S4A), Strategic Debt Restructuring (SDR), among others and made the Insolvency and Bankruptcy Code as the main tool, to deal with defaulters. Lenders will now have to work out a resolution plan for defaults within 180 days, failing which the account would be referred to the bankruptcy courts

The upshot of the strong statement of intent by the RBI, will be structural streamlining, standardising and harmonising of the resolution process, leading to greater transparency, credibility and efficiency. The central bank has also asked lenders to report credit information, including classification of an account as special mention account (SMA) to the Central Repository of Information on Large Credits (CRILC), on all borrowers having an aggregate exposure of ₹ five crores and above.

RBI also said under a new framework, the resolution plan, which may involve restructuring, change in ownership in respect of ‘large’ accounts, will require independent credit evaluation of the residual debt by credit rating agencies (CRAs) authorised by it. Independent credit evaluation of the residual debt in resolution plans and minimum investment grade rating for any upgrade of NPAs, will improve investor and other stakeholder confidence over the long term.

The central bank has also asked all lenders to put in place board-approved policies, with timeliness, for resolution of stressed assets under the new framework. “By mandating weekly information on large delinquent accounts, by directing that a resolution plan be scripted immediately after default and by setting stringent timelines for referring an account to the Insolvency and Bankruptcy Code process, the RBI is establishing an ecosystem where NPAs would get recognised on time and their resolutions are structurally quicker than before,” the report said

The systemic resolution would imply: (i) comprehensive identification of the stressed asset, (ii) resolution of the stressed asset (liquidation where required) and (iii) recapitalization of banks for residual losses. A well thought -out synchronized effort is called between regulator, government and banks’ management.

In the absence of these, well intentioned moves may have unintended consequences. For instance, policy reversal with respect to NPA recognition will add transparency but if the move is not backed by concurrent addition of resources for provisioning capital infusion, it may create more confusion among stakeholders.

Hopefully, as these measures are implemented, the country can see an improvement in the NPA crises in the future.