“NON PERFORMING ASSETS”

INDEX
1. Introduction

2. Indian Economy and NPAs

3. Global Developments and NPAs

4. Meaning of NPAs

5.Why such a huge level of NPAs exists in Indian banking

system (IBS)?

6. Why NPAs have become an issue for banks and financial

institutions in India?

7. RBI Guidelines on income recognition (interest income on

NPA)

8.What does Accounting Standard 9 (AS 9) on revenue

recognition of

9.Issued by ICAI say?

10. Are RBI guidelines on NPAs and ICAI Accounting

Standard 9 on revenue recognition, consistent with each other?

11. RBI guidelines on classification of bank advances

12.How to classify bank advances, if recovery is highly

unlikely?
13. RBI guidelines on provisioning requirement of bank
advances

14.Credit Risk and NPAs

15.Public Trust and NPAs

16.How important is credit rating in assessing the risk of

default for lenders?

17. Usage of financial statements in assessing the risk of default

for lenders

18.Can Universal Banking solve the problem of NPA for DFIs?

19. Capital Adequacy Ratio (CAR) of RBI and Basle

Committee on Banking Supervision (BCBS)

20.Excess Liquidity? No problem, but no lending please!!!

21. High cost of funds due to NPAs

22.Why Bankers say, finally, what a relief for our business?

23. Conclusion

24. What about banks in India?

25. Finally, what about India?

Introduction
It's a known fact that the banks and financial institutions in India
face the problem of swelling non-performing assets (NPAs) and
the issue is becoming more and more unmanageable. In order to
bring the situation under control, some steps have been taken
recently. The Securitisation and Reconstruction of Financial Assets
and Enforcement of Security Interest Act, 2002 was passed by
Parliament, which is an important step towards elimination or
reduction of NPAs.

Indian economy and NPAs

Undoubtedly the world economy has slowed down, recession is at
its peak, globally stock markets have tumbled and business itself is
getting hard to do. The Indian economy has been much affected
due to high fiscal deficit, poor infrastructure facilities, sticky legal
system, cutting of exposures to emerging markets by FIIs, etc.

Further, international rating agencies like, Standard & Poor have

lowered India's credit rating to sub-investment grade. Such
negative aspects have often outweighed positives such as
increasing forex reserves and a manageable inflation rate.

Under such a situation, it goes without saying that banks are no

exception and are bound to face the heat of a global downturn. One
would be surprised to know that the banks and financial
institutions in India hold non-performing assets worth Rs.1,10,000
crores. Bankers have realized that unless the level of NPAs is
reduced drastically, they will find it difficult to survive.

Global Developments and NPAs

The core banking business is of mobilizing the deposits and
utilizing it for lending to industry. Lending business is generally
encouraged because it has the effect of funds being transferred
from the system to productive purposes which results into
economic growth.

However lending also carries credit risk, which arises from the
failure of borrower to fulfill its contractual obligations either
during the course of a transaction or on a future obligation.

A question that arises is how much risk can a bank afford to take ?
Recent happenings in the business world - Enron, WorldCom,
Xerox, Global Crossing do not give much confidence to banks. In
case after case, these giant corporates became bankrupt and failed
to provide investors with clearer and more complete information
thereby introducing a degree of risk that many investors could
neither anticipate nor welcome. The history of financial institutions
also reveals the fact that the biggest banking failures were due to
credit risk.

Due to this, banks are restricting their lending operations to

secured avenues only with adequate collateral on which to fall
back upon in a situation of default.

Meaning of NPAs
An asset is classified as non-performing asset (NPAs) if dues in the
form of principal and interest are not paid by the borrower for a
period of 180 days. However with effect from March 2004, default
status would be given to a borrower if dues are not paid for 90
days. If any advance or credit facilities granted by bank to a
borrower becomes non-performing, then the bank will have to treat
all the advances/credit facilities granted to that borrower as non-
performing without having any regard to the fact that there may
still exist certain advances / credit facilities having performing
status.

Why such a huge level of NPAs exist in the Indian

banking system (IBS)?
The origin of the problem of burgeoning NPAs lies in the quality
of managing credit risk by the banks concerned. What is needed is
having adequate preventive measures in place namely, fixing pre-
sanctioning appraisal responsibility and having an effective post-
disbursement supervision. Banks concerned should continuously
monitor loans to identify accounts that have potential to become
non-performing.

Why NPAs have become an issue for banks and

financial institutions in India?
To start with, performance in terms of profitability is a benchmark
for any business enterprise including the banking industry.
However, increasing NPAs have a direct impact on banks
profitability as legally banks are not allowed to book income on
such accounts and at the same time banks are forced to make
provision on such assets as per the Reserve Bank of India (RBI)
guidelines.

Also, with increasing deposits made by the public in the banking

system, the banking industry cannot afford defaults by borrower s
since NPAs affects the repayment capacity of banks.

Further, Reserve Bank of India (RBI) successfully creates excess

liquidity in the system through various rate cuts and banks fail to
utilize this benefit to its advantage due to the fear of burgeoning
non-performing assets.

RBI guidelines on income recognition (interest

income on NPAs)
Banks recognize income including interest income on advances on
accrual basis. That is, income is accounted for as and when it is
earned.

The prima-facie condition for accrual of income is that it should

not be unreasonable to expect its ultimate collection. However,
NPAs involves significant uncertainty with respect to its ultimate
collection.

Considering this fact, in accordance with the guidelines for income

recognition issued by the Reserve Bank of India (RBI), banks
should not recognize interest income on such NPAs until it is
actually realized.

What does Accounting Standard 9 (AS 9) on

revenue recognition issued by ICAI say?
The Accounting Standard 9 (AS 9) on `Revenue Recognition'
issued by the Institute Of Chartered Accountants of India (ICAI)
requires that the revenue that arises from the use by others of
enterprise resources yielding interest should be recognized only
when there is no significant uncertainty as to its measurability or
collectability.

Also, interest income should be recognized on a time proportion

basis after taking into consideration rate applicable and the total
amount outstanding.

Are RBI guidelines on NPAs and ICAI

Accounting Standard 9 on revenue recognition
consistent with each other?
In view of the guidelines issued by the Reserve Bank of India
(RBI), interest income on NPAs should be recognised only when it
is actually realised.

As such, a doubt may arise as to whether the aforesaid guidelines

with respect to recognition of interest income on NPAs on
realization basis is consistent with Accounting Standard 9,
`Revenue Recognition'. For this purpose, the guidelines issued by
the RBI for treating certain assets as NPAs seem to be based on an
assumption that the collection of interest on such assets is
uncertain.

Therefore complying with AS 9, interest income is not recognized

based on uncertainty involved but is recognized at a subsequent
stage when actually realized thereby complying with RBI
guidelines as well.

In order to ensure proper appreciation of financial statements,

banks should disclose the accounting policies adopted in respect of
determination of NPAs and basis on which income is recognized
with other significant accounting policies.

RBI guidelines on classification of bank advances

Reserve Bank of India (RBI) has issued guidelines on provisioning
requirement with respect to bank advances. In terms of these
guidelines, bank advances are mainly classified into:

Standard Assets: Such an asset is not a non-performing asset. In

other words, it carries not more than normal risk attached to the
business.

Sub-standard Assets: It is classified as non-performing asset for a

period not exceeding 18 months

Doubtful Assets: Asset that has remained NPA for a period

exceeding 18 months is a doubtful asset.

Loss Assets: Here loss is identified by the banks concerned or by

internal auditors or by external auditors or by Reserve Bank India
(RBI) inspection.

In terms of RBI guidelines, as and when an asset becomes a NPA,

such advances would be first classified as a sub-standard one for a
period that should not exceed 18 months and subsequently as
doubtful assets.

It should be noted that the above classification is only for the

purpose of computing the amount of provision that should be made
with respect to bank advances and certainly not for the purpose of
presentation of advances in the banks balance sheet.

The Third Schedule to the Banking Regulation Act, 1949, solely

governs presentation of advances in the balance sheet.

Banks have started issuing notices under te Securitisation Act,

2002 directing the defaulter to either pay back the dues to the bank
or else give the possession of the secured assets mentioned in
thenotice. However, there is a potential threat to recovery if there
is substantial erosion in the value of security given by the borrower
or if borrower has committed fraud. Under such a situation it will
be prudent to directly classify the advance as a doubtful or loss
asset, as appropriate.

RBI guidelines on provisioning requirement of

bank advances
As and when an asset is classified as an NPA, the bank has to
further sub-classify it into sub-standard, loss and doubtful assets.
Based on this classification, bank makes the necessary provision
against these assets.

Reserve Bank of India (RBI) has issued guidelines on provisioning

requirements of bank advances where the recovery is doubtful.
Banks are also required to comply with such guidelines in making
adequate provision to the satisfaction of its auditors before
declaring any dividends on its shares.

In case of loss assets, guidelines specifically require that full

provision for the amount outstanding should be made by the
concerned bank. This is justified on the grounds that such an asset
is considered uncollectible and cannot be classified as bankable
asset.

Also in case of doubtful assets, guidelines requires the bank

concerned to provide entirely the unsecured portion and in case of
secured portion an additional provision of 20%-50% of the secured
portion should be made depending upon the period for which the
advance has been considered as doubtful.

For instance, for NPAs which are upto 1-year old, provision should
be made of 20% of secured portion, in case of 1-3 year old NPAs
upto 30% of the secured portion and finally in case of more than 3
year old NPAs upto 50% of secured portion should be made by the
concerned bank.

In case of a sub-standard asset, a general provision of 10% of total

outstandings should be made.

Reserve Bank Of India (RBI) has merely laid down the minimum
provisioning requirement that should be complied with by the
concerned bank on a mandatory basis. However, where there is a
subtantail uncertainty to recovery, higher provisioning should be
made by the bank concerned.

Credit Risk and NPAs

Quite often credit risk management (CRM) is confused with
managing non-performing assets (NPAs). However there is an
appreciable difference between the two. NPAs are a result of past
action whose effects are realized in the present i.e they represent
credit risk that has already materialized and default has already
taken place.
On the other handmanaging credit risk is a much more forward-
looking approach and is mainly concerned with managing the
quality of credit portfolio before default takes place. In other
words, an attempt is made to avoid possible default by properly
managing credit risk.

Considering the current global recession and unreliable

information in financial statements, there is high credit risk in the
banking and lending business.

To create a defense against such uncertainty, bankers are expected

to develop an effective internal credit risk models for the purpose
of credit risk management.

How important is credit rating in assessing the

risk of default for lenders?
Fundamentally Credit Rating implies evaluating the
creditworthiness of a borrower by an independent rating agency.
Here objective is to evaluate the probability of default. As such,
credit rating does not predict loss but it predicts the likelihood of
payment problems.

Credit rating has been explained by Moody's a credit rating agency

as forming an opinion of the future ability, legal obligation and
willingness of a bond issuer or obligor to make full and timely
payments on principal and interest due to the investors.

Banks do rely on credit rating agencies to measure

credit risk and assign a probability of default.
Credit rating agencies generally slot companies into risk buckets
that indicate company's credit risk and is also reviewed
periodically. Associated with each risk bucket is the probability of
default that is derived from historical observations of default
behavior in each risk bucket.

However, credit rating is not fool-proof. In fact, Enron was rated

investment grade till as late as a month prior to it's filing for
Chapter 11 bankruptcy when it was assigned an in-default status by
the rating agencies. It depends on the information available to the
credit rating agency. Besides, there may be conflict of interest
which a credit rating agency may not be able to resolve in the
interest of investors and lenders.

Stock prices are an important ( but not the sole ) indicator of the
credit risk involved. Stock prices are much more forward looking
in assessing the creditworthiness of a business enterprise.
Historical data proves that stock prices of companies such as Enron
and WorldCom had started showing a falling trend many months
prior to it being downgraded by credit rating agencies.

Usage of financial statements in assessing the risk

of default for lenders
For banks and financial institutions, both the balance sheet and
income statement have a key role to play by providing valuable
information on a borrower’s viability. However, the approach of
scrutinizing financial statements is a backward looking approach.
This is because, the focus of accounting is on past performance and
current positions.

The key accounting ratios generally used for the purpose of

ascertaining the creditworthiness of a business entity are that of
debt-equity ratio and interest coverage ratio. Highly rated
companies generally have low leverage. This is because; high
leverage is followed by high fixed interest charges, non-payment
of which results into a default.

Capital Adequacy Ratio (CAR) of RBI and Basle

committee on banking supervision (BCBS)
Reserve Bank of India (RBI) has issued capital adequacy norms for
the Indian banks. The minimum CAR which the Indian Banks are
required to meet at all times is set at 9%. It should be taken into
consideration that the bank's capital refers to the ability of bank to
withstand losses due to risk exposures.

To be more precise, capital charge is a sort of regulatory cost of

keeping loans (perceived as risky) on the balance sheet of banks.
The quality of assets of the bank and its capital are often closely
related. Quality of assets is reflected in the quantum of NPAs. By
this, it implies that if the asset quality was poor, then higher would
be the quantum of non-performing assets and vice-versa.

Market risk is the risk arising due to the fluctuations in value of a

portfolio due to the volatility of market prices.

Operational risk refers to losses arising due to complex system and

processes.
It is important for a bank to have a good capital base to withstand
unforeseen losses. It indicates the capability of a bank to sustain
losses arising out of risky assets.

The Basel Committee On Banking Supervision (BCBS) has also

laid down certain minimum risk based capital standards that apply
to all internationally active commercial banks. That is, bank's
capital should atleast be 8% of their risk-weighted assets. This
infact helps bank to provide protection to the depositors and the
creditors.

The main objective here is to build a sort of support system to take

care of unexpected financial losses thereby ensuring healthy
financial markets and protecting depositors.

Excess liquidity? No problem, but no lending

please !!!
One should also not forget that the banks are faced with the
problem of increasing liquidity in the system. Further, Reserve
Bank of India (RBI) is increasing the liquidity in the system
through various rate cuts. Banks can get rid of its excess liquidity
by increasing its lending but, often shy away from such an option
due to the high risk of default.

In order to promote certain prudential norms for healthy banking

practices, most of the developed economies require all banks to
maintain minimum liquid and cash reserves broadly classified into
Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio
(SLR).

Cash Reserve Ratio (CRR) is the reserve which the banks have to
maintain with itself in the form of cash reserves or by way of
current account with the Reserve Bank of India (RBI), computed
as a certain percentage of its demand and time liabilities. The
objective is to ensure the safety and liquidity of the deposits with
the banks.

On the other hand, Statutory Liquidity Ratio (SLR) is the one

which every banking company shall maintain in India in the form
of cash, gold or unencumbered approved securities, an amount
which shall not, at the close of business on any day be less than
such percentage of the total of its demand and time liabilities in
India as on the last Friday of the second preceding fortnight, as the
Reserve Bank of India (RBI) may specify from time to time.

A rate cut (for instance, decrease in CRR) results into lesser funds
to be locked up in RBI's vaults and further infuses greater funds
into a system. However, almost all the banks are facing the
problem of bad loans, burgeoning non-performing assets, thinning
margins, etc. as a result of which, banks are little reluctant in
granting loans to corporates.

As such, though in its monetary policy RBI announces rate cut but,
such news are no longer warmly greeted by the bankers.
High cost of funds due to NPAs
Quite often genuine borrowers face the difficulties in raising funds
from banks due to mounting NPAs. Either the bank is reluctant in
providing the requisite funds to the genuine borrowers or if the
funds are provided, they come at a very high cost to compensate
the lender’s losses caused due to high level of NPAs.

Therefore, quite often corporates prefer to raise funds through

commercial papers (CPs) where the interest rate on working capital
charged by banks is higher.

With the enactment of the Securitisation and Reconstruction of

Financial Assets and Enforcement of Security Interest Act, 2002,
banks can issue notices to the defaulters to pay up the dues and the
borrowers will have to clear their dues within 60 days. Once the
borrower receives a notice from the concerned bank and the
financial institution, the secured assets mentioned in the notice
cannot be sold or transferred without the consent of the lenders.

The main purpose of this notice is to inform the borrower that

either the sum due to the bank or financial institution be paid by
the borrower or else the former will take action by way of taking
over the possession of assets. Besides assets, banks can also
takeover the management of the company. Thus the bankers under
the aforementioned Act will have the much needed authority to
either sell the assets of the defaulting companies or change their
management.

But the protection under the said Act only provides a partial
solution. What banks should ensure is that they should move with
speed and charged with momentum in disposing off the assets.
This is because as uncertainty increases with the passage of time,
there is all possibility that the recoverable value of asset also
reduces and it cannot fetch good price. If faced with such a
situation than the very purpose of getting protection under the
Securitisation Act, 2002 would be defeated and the hope of seeing
a must have growing banking sector can easily vanish.

Conclusion
To conclude with, till recent past, corporate borrowers even after
defaulting continuously never had any real fear of bank taking any
action to recover their dues despite the fact that their entire assets
were hypothecated to the banks. This is because there was no legal
Act framed to safeguard the real interest of banks.

However with the introduction of Securitisation Act, 2002 banks

can now issue notices to their defaulters to repay their dues or else
make defaulters face hard and tough actions under the
aforementioned Act. This enables banks to get rid of sticky loans
thereby improving their bottomlines. Also a hallmark of a good
business is approaching it with a fresh, new perspective and
requires management that is fully awake, fully alive and of course
fully focused on making things better.

Also, the passing of the Securitisation Act, 2002 came as a

bonanza for investors in banking sector stocks that in turn resulted
into an improvement in their share prices.