UNIT II – CREDIT

MONITORING & RISK

MANAGEMENT
 Credit Analysis
• Credit analysis is a technique of analyzing the
credit worthiness of a borrower. It checks
whether the borrower is able to meet its financial
obligations or not.
• Every bank does the credit analysis before
granting the loan or providing credit to the
customers.
 Steps involved in Credit Analysis
• The credit analysis process is a lengthy one, lasting from
a few weeks to months. It starts from the information-
collection stage up to the decision-making stage when
the lender decides whether to approve the loan
application and, if approved, how much credit to extend
to the borrower.
– Information Collection
– Information Analysis
– Decision Making Stage – Approval (or Rejection) of the loan
application
 Steps involved in Credit Analysis

• Credit analysis involves various financial

techniques such as
– Ratio analysis
– Trend analysis
– Analysis of financial statements
– Analysis of cash flow statement
 5 C’s involved in the Credit Analysis

• Capital
• Capacity
• Collateral
• Character
• Conditions
 5 C’s involved in the Credit Analysis
• Capital – Banks should take into account the amount
invested by the customers in its business before granting
any loan as banks cannot grant huge amount to small
businesses
• Capacity – Ability of the customers to meet financial
obligations on time
• Collateral – Banks also look at the type of security offered
by the customers for the credit as it provides the base of
recovery in case of default
• Character – Integrity and the moral attitude of the
customers to repay the loan amount along with the interest
• Conditions – General economic and competitive conditions
that affect the customer’s ability to repay the credit amount
 Credit Delivery and Administration
• Who takes the decision to lend?
• It depends on
– Size of the bank
– Loan size
– Type of risk
– Final decision to lend may be taken by an authorized layer of the
bank

• Organizational hierarchy
– Credit officers – least discretionary limit
– Branch heads
– Senior & Top Management
– Board of Directors
• Underwriting Department
 Credit Delivery and Administration
• Key elements
– Nominated senior management individuals to
support, own the credit management process and
lead on credit management
– Credit management policies and benefits following –
clearly communicated to all staffs
– Existence and adoption of a framework for
management of credit that is transparent and
repeatable
– Existence of an organizational culture that supports
well thought – through risk taking and innovation
– Management of credit fully embedded in
management processes and consistently applied
• Management of credit closely linked to achievement of
objectives
• Risk associated with working with other organizations
explicitly assessed and managed
• Risks actively monitored and regularly reviewed on a
constructive non – blame basis

• Appropriate use of business continuity plans and

contingency plans is an important element of the
management of credit.
 Credit Appraisal Techniques and
Viability Studies
• Credit Appraisal is the process of evaluating the credit
worthiness of the loan applicant ie., financial condition &
ability to repay back the loan in future.
• Bank needs following information while assessing a customer:
– Incomes of the applicants & co – applicants
– Age of applicants
– Educational qualification
– Profession
– Experience
– Additional sources of income
– Past loan record
– Family history
– Employer / business
• Security of tenure
• Tax history
• Assets of applicants and their financing pattern
• Recurring Liabilities
• Other present and future liabilities and investments

• Out of these, the incomes of applicants are the most

important criteria to understand and calculate the credit
worthiness of the applicants
• Actual norms decided by banks differ greatly
• Each as certain norms within which the customer needs to
fit to be eligible
• Besides the above process, profile of the customer is studied
properly
• Their CIBIL (Credit information Bureau (India) Limited
score is checked
 Modes of Credit Delivery
Purpose Security Mode of Credit Delivery
Inventory Cash Credit, Working Capital
Demand Loan (WCDL),
Overdraft, Commercial Paper,
Working Capital Letter of Credit
Book Debts Cash credit, WCDL
Receivables Bills Discounted, Letter of
Credit
Capital Expenditure Capital Assets Term Loan, Loan Syndication
Assets purchased under Short term loans, mortgage
Consumer Loans
loan loans in case of housing
Parameters to determine the Eligibility
of a Customer

Parameter Documents

Technical Feasibility Field Investigation, Market value of asset

Economic Viability LTV (Loan to Value), HR

Past month bank statements, Asset and Liabilities of

Bankability
the applicant
 Parameter components and how bank
assess your creditworthiness through it
Technical Feasibility
Technical Feasibility What bank is looking for
Living Standard Decent living standard with some tangibles like TV., &
Fridge with provide assurance to bank regarding your
residential status
Locality Presence of some undesirable elements like local goons or
controversial areas adversely affects your loan appraisal
process
Telephonic Verification At least one response is need from person to establish the
identity of the person from contact point of view
Educational Not an essential barrier but essential to understand the
Qualification complex terms & conditions of bank loan
Political Influence An interesting reference point in the sense that they are not
one of major category of loan defaulters
References To establish the residential identity of person from human
contact point of view & cross check of their loans
 Economic Viability
Economic Viability Bank is looking for
Installment to income ratio IIR for salaried cases would be capped at 60%
of net income in general
Pension income cases IIR to be restricted to
40%
Fixed obligation to income FOIR kept at 55%
ratio
Loan to cost ratio LTV amount to 80%
 Bankability Parameters
Parameter Norms Checkpoints
To check the average
amount client is
6 months bank statements
Bank Statements maintaining in the account
need to be furnished
is sufficient to pay the
installment amount or not
Two year IT returns made To enquire primary source
Business continuity proof
compulsory of income
To check the general
attitude of customer along
For the big loan amount
Credit interview with efforts are put in to
credit interview is necessary
understand their needs
better
Salaried professionals get an
Secured source of income
Profile of customer edge over business income
give them a edge
people
Asset of value equal to or
more than loan amount To safeguard bank interest
Security
taken has to be put as against any future default
pledge or collateral
 Parameter Norms
To be on the name or blood
Ownership title
relative of applicant
To check the credit history
CIBIL Report
of the bank applicant
Checkpoints
To establish the ownership
claim of the loan applicant
Bank tool to check any
default incidence in loaning
history of applicant
 Economic Feasibility or Viability
• There are three methods used to arrive at
Eligibility:
– Installment to income ratio
– Fixed obligation to income ratio
– Loan to cost ratio
 Installment to income ratio

• Ratio denotes the portion of the customer’s

monthly installment on the home loan taken.
• This ratio is generally expressed as a percentage
• Usually, bank use 33.33 percent to 40 percent
ratio, because it is been observed that under
normal circumstances, a person can pay an
installment up to 33.33 to 40% of his salary
towards loan.
 Example

• If we consider the installment to income ratio

equal to 33.33% and assume the gross income to
be Rs.30000 per month, then as per the ratio, the
applicant is eligible for a loan with the
maximum installment of Rs.10000 per month.
 Fixed obligation to income ratio
• This ratio signifies the importance of the regularity in the
repayment of previous loans.
• In this calculation, the bank considers the installments of
all other loans already availed of by the customer and
still due, including the home loan applied for.
• In other words, this ratio includes all the fixed
obligations that the borrower is supposed to pay
regularly on a monthly basis to any bank.
• Statutory deductions from salary like provident fund,
professional tax and deductions for investment like
insurance premium, recurring deposit etc are exmpt
from these fixed obligations
 Example
• Assume that monthly income of an applicant is Rs.30000 and the
applicant has a car loan installment of Rs.4000 per month, a TV
loan installment of Rs.1000 per month. In addition to this is
proposed housing loan installment is Rs.10000 per month.
Numerically, the ratio is equal to Rs.15000 or 50% (ie., 50% of the
monthly income).
• If the bank has decided on the standard of 40% of ratio as the
criteria, then the maximum total installments the person can pay,
as per the standard, would be Rs.12000 per month.
• As he is already paying Rs.5000 for the car and TV, he only has
Rs.7000 left out
• Hence the customer would be given only that loan for which the
EMI would be equal to Rs.70000, keeping in mind the repayment
capacity of the applicant
 Loan to cost ratio
• This ratio is used by banks to calculate the loan amount that
an applicant is eligible to pay on the basis of the total cost of
the property.
• This ratio sets the upper limit or the maximum loan amount
that a person is eligible for, irrespective of the loan
eligibility under any other criteria
• The maximum amount of loan the borrower is eligible to
pay is pegged as equal to the cost or value of the property
• Even if the bank’s calculations of eligibility, according to the
above mentioned two criterions, turns out to be higher, the
loan amount can’t exceed the cost or value of the property.
• This ratio is set equal to between 70 to 90% of the registered
value of the property.
• Hence, while deciding on the maximum amount of loan
a customer can be given, the banks use these three
parameters.
• These parameters help in computing loan eligibility,
which is crucial in calculating the creditworthiness of a
customer.
• It also acts as a guide to determine the loan amount.
 Credit Monitoring
• “Credit Management “ in a bank consists of two distinct
processes – before and after the credit sanction is made.
• After the credit sanction is made, and the loan is
disbursed to the borrower, it is important to ensure that
the principal and interest are fully recovered.
• Loan review is therefore, a vital post – sanction process.
• Whenever the bank grants loan to customers it is
necessary to monitor it.
• The bank may avoid losses if it finds weak signals of
borrower’s financial position at early stages by
continuously monitoring the credit
 Need for Credit Monitoring
• Monitoring of the credit portfolio and individual accounts is
essential in order to maintain the quality of the credit
portfolio of the bank in a sound condition.
• In line with the international practices, classification of assets
• On the basis of record of recovery of installment amount, the
banks classify the accounts as Standard, Sub-standard,
Doubtful and Bad Assets.
• More than 90 days – Sub standard assets
• Thereafter on the period of default, falls under Doubtful and
Bad Assets. Also called as NPA
• It is the challenging task for the bank to keep the borrowers’
in standard category and, for this purpose, continuous
monitoring of the accounts is called for.
• The credit monitoring department deals with only
standard assets and the sub-standard assets which are
not marked for recovery action.
• “Watch List” Accounts and need constant monitoring by
the Monitoring Officer of the bank.
 Need for Credit Monitoring
• Written credit policies
• Set objective standards and parameters to guide bank
officers who grant loans and manage the loan portfolio
• BOD’s, Regulators and internal and external auditors
with a basis for evaluating a bank’s credit management
performance
• When credit policies are carefully formulated,
administrated from the top, and clearly understood at all
organizational levels, they enable the bank management
to maintain proper credit standards, avoid excessive
risks an evaluate business opportunities properly
 Need for Credit Monitoring
• Maintain uniform and sound credit – granting standards
• Ensure operational consistency and efficiency
• Monitor and control credit risk
• Evaluate new business opportunities
• Identify and administer problem accounts appropriately in
a given time

• Credit monitoring is particularly important when bank has

to adopt to a complex and rapidly changing environment
• Helps in determining the level of acceptable risk and
expected return
 Categories of Sickness
• Sickness at birth – the project itself has become infeasible
either due to faulty assumptions or a change in
environment
• Induced Sickness – caused by management
incompetencies or willful default
• Genuine Sickness – Sickness are beyond the borrowers’
control and happened in spite of the borrowers’ sincere
efforts to avert the situation
 Reasons for Sickness
• Reasons for sickness and whether remedial measures
can revive the firm
• Basic logic reasons for categorizing the borrower as
“sick”
• Risks involved in rehabilitating the borrowing firm
• In case the bank decides to rehabilitate, the requirements
for such revival in the form of additional financing,
government support, management input or upgraded
technology
 Signals of Borrowers’ Financial
Sickness
• Early signs of liquidity problems such a delay in service
charges
• Inadequate information of financial statements
• Condition and control over collateral is questionable
• No corporation by the borrower or difficulty in keeping
contact with him
• Slow down of the business which has a negative impact on
the financial position
• Change in economic or competitive environment which
would have a negative impact on the borrower’s financial
position
• If the earnings are not stable and decreasing than the
industry on an average
• If the business is highly cyclical in nature and subject to
regulatory constraints or if the management is too slow
to change
• Negative financial records for over a period of time
• If the borrower is in ill health

• Example – If the business of the borrower slows down

and the borrower is not picking up the calls or is not
accessible then the banker should understand these as
the signal of the borrower’s weak financial position
• Tardiness is the identification of weak signal of
borrower’s financial position may place the bank in the
financial distress
 Signals of Borrowers’ Financial
Sickness
• Shortages of liquid assets to meet short term obligations
• Inventories in excessive quantities
• Non – submission of data to banks and financial institutions
• Irregularity in maintaining bank accounts
• Frequent breakdown
• Decline in the quality of product manufactured or service
rendered
• Delay or default in the payment of statutory dues such as
provident fund, sales tax, insurance etc
• Decline in technical deficiency
• Frequent of turnover of personnel in the industry
 Financial Distress Prediction Models
• It is a condition in which a company is not able to pay off its
financial obligations to its creditors
• When a company has high fixed cost, illiquid assets or revenues
which are sensitive to economic downturns, the chances of
financial distress increases
• Two of the most obvious reasons businesses suffer financial
distress are low sales and high costs. When sales decrease, you
must begin to drain your working cash and increase your credit
use. When you run out of cash and credit, you enter into a crisis
mode.
• Forecasting a debtor’s ability to repay its financial obligations is
a crucial endeavor for lenders and investors
• “How likely is the loan will be repaid on time” – is a central
question to the valuation and asset allocation of debt portfolios.
 Models for the Prediction of Financial
Distress
• Z- Score
• TLTA
• Distance to Default
• Zeta Score
 Z - Score
• Z – score model was developed by Professor Edward I.
Altman in 1968, commonly referred to as Altman Z –
Score.
• Modified original Z – Score model to create the Z’- Score
Model, the Z” – Score Model. The Z – score model is still
a common component of many credit rating systems and
is relevant as a benchmark for the Distance to Default
model.
• The Z-Score Test uses statistical techniques to predict the
likelihood of bankruptcy within the next two years.
• Dr. Altman's test was developed using 66 companies,
The test achieved an accuracy rate of 95%.
 Altman’s Z Score
• Altman’s Z Score is a measurement tool to assess a
company’s financial condition.
• The Z Score provides a quantitative measurement into a
company’s financial health
• It uses profitability, leverage, liquidity, solvency and
activity to predict whether a company has high
probability of being insolvent.
• The Z Score is an effective tool to demonstrate credit
worthiness to bankers and soundness of business model
to investors.
 Altman’s Z Score

• The Z score method examines liquidity, profitability,

reinvested earnings and leverage which are integrated
into a single composite score. It can be used with past,
current or projected data as it requires no external inputs
such as GDP or Market Price.
• The Z Score uses a series of data points from a
company’s balance sheet.
 Objectives of Z - Score
• It is employed by credit professionals to mitigate risk in
debt portfolios and by lenders to extend loans.
• It is widely utilized because it uses multiple variables to
measure the financial health and credit worthiness of a
borrower.
 Z – Score – Public Companies
• Five pillars are combined using Equation 1 to result in a
company’s Z – Score (Altman 2002)

• Z=1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5

where
• X1 – Working Capital / Total Assets
• X2 – Retained Earnings / Total Assets
• X3 – Earnings Before Interest and Taxes (EBIT) / Total Assets
• X4 – Market Value of Equity / Book value of total liabilities
• X5 – Sales / Total Assets
• Z – Overall Index or Score

• This formula appeals to the practitioner’s intuition because each pillar

describes a different credit relevant aspect of a company’s operations.
 Zones of Discrimination
• Z > 2.99 -“Safe” Zones
• 1.81 < Z < 2.99 -“Grey” Zones
• Z < 1.81 -“Distress” Zones
 Private Companies
Altman Z-Score =
• 0.717 x Working Capital / Total assets +
• 0.847 x Total retained earnings / total assets +
• 3107 x Profit before tax and interest / total assets +
• 0.420 x book value of assets / Book value of debt +
• 0.998 x Sales / Total assets.
The risk that a private company goes bankrupt is a very
large when the Altman Z-score is below 1.23.
The gray area for this specific formula exists with a result
between 1.23 and 2.9.
The risk that a private company goes bankrupt is almost
zero for an Altman Z-score above 2.9.
• Five ratios are addressed by Z – score respectively.

• Liquidity
• Cumulative Profitability
• Asset Productivity
• Market based financial leverage
• Capital turnover

• Z – score presumes that each ratio is linearly related to a

company’s profitability of bankruptcy.
 Z – Score – First Step
• The first step is to identify the seven items listed on the
balance sheet and income statement used in the
calculation:
 Step 2
• Seven figures are used to create five financial ratios, each
identified by Altman as having the greatest forecasting
power as to a company‘s financial strength:
 Formula
• Ratio A, Working Capital / Total Assets, is a liquidity
measure.
Working capital is comprised of cash and any other assets
that can be turned into cash on fairly short notice. The more
working capital a firm has, the more cushion it has to meet
any bills coming due.

• Ratio B, Retained Earnings / Total Assets, is a measure of

leverage.
It tells us whether the firm is paying for assets using profits
or using debt. A high ratio indicates that profits are being
used to fund growth, while a low ratio indicates that
growth is being financed through increasing debt levels.
 Formula
• Ratio C, EBIT / Total Assets, is a profitability measure also
known as return on assets (ROA).
It measures the amount of operating income generated by
each dollar of assets.

• Ratio D, Market Cap / Total Liabilities, is a measure of the

market‘s confidence in the company as reflected in its stock
price. If the ratio falls below 1.0, then the market is saying
that the firm is worth less than what it owes, or in other
words, insolvent.

• Ratio E, Sales / Total Assets, is a measure of efficiency in that

it describes the amount of sales generated by each dollar of
assets
• It should now be easier to see why the Z-score is such a
good measure of a firm's financial health. A healthy firm
(A) maintains enough liquid assets to pay whatever bills
are due,
(B) funds its growth with profits,
(C) invests in assets that generate profits for its owners,
(D) gets a vote of confidence from investors via its share
price, and
(E) converts its investments into revenues for the
company.
• Retained earnings total asset ratio = 135,000/600,000
• =22.5%
• In this case, the ratio ascertains that 22.5% of the total assets used
for operations are funded by the retained earnings, the rest of 77.5%
are financed by share capital and debts.
• It also shows that for every $1 of assets, a $0.225 accumulated profit
has occurred. Therefore, it also measures the profitability of the
assets.
• The higher the ratio the better because it shows that the entity was
successful enough to generate high profits and was able to retain
the profits to reinvest in the business.
• The retained earnings to total assets (RE/TA) ratio
measures the firm's ability to accumulate earnings using
its assets. A higher ratio is preferable because it indicates
that the company is able to retain more earnings.
 TLTA
• TLTA model is based on the ratio of Total Liabilities to
Total Assets.
• One would expect the probability of bankruptcy to
increase as this measure of capital structure leverage
increases.
• The debt to asset ratio is commonly used by analysts,
investors, and creditors to determine the overall risk of a
company. Companies with a higher ratio are more
leveraged and hence, riskier to invest in and provide loans
to. If the ratio steadily increases, it could indicate a default
at some point in the future.
• A ratio equal to one (=1) means that the company owns
the same amount of liabilities as its assets. It indicates
that the company is highly leveraged.
• A ratio greater than one (>1) means the company owns
more liabilities than it does assets. It indicates that the
company is extremely leveraged and highly risky to
invest in or lend to.
• A ratio less than one (<1) means the company owns
more assets than liabilities and can meet its obligations
by selling its assets if needed. The lower the debt to asset
ratio, the less risky the company.
 Distance to Default Model
• Underlying the structural model is the assumption that a
company’s equity can be considered an option with a
strike price equal to the book value of its liabilities and a
market price equal to the market value of its assets.
• This implies that a company is worth nothing, ie., it has
defaulted, when the market value of the assets drops
below the book value of the liabilities
• The Distance to Default is not an empirically created
model, but rather a mathematical conclusion based on the
assumption that a company will default on its financial
obligations when its assets are worth less than its liabilities.
It is also based on all of the assumptions of the Black
Scholes option pricing model, including for example, that
asset returns are log-normally distributed.
• Default happens when the value of company's asset falls
below "default point“ (value of the debt)
• Default happens when company has not paid debts.
• Default risk is the uncertainty surrounding arm's ability
to service debts and obligations
• A company defaults if it is not able to fulfill its liabilities
at the time they became due. If you use the model
suggested by Eric you will not take into account that the
company has not enough liquid assets to fulfill its due
liabilities. Therefore you would overestimate the distance
to default for companies with a high liquidity and vise
versa.
 ZETA Score
• ZETA score enables banks to appraise the risks involved
in firms outside the manufacturing sector.
• The score is reported to provide warning signals 3 – 5
years prior to bankruptcy (against 2 years for Z – score)
• It considers variables such as
– Return on Assets (ROA)
– Earnings stability
– Debt service
– Cumulative profitability
– Current ratio
– Capitalization
– Size of the business
• An increase in the score is a positive signal
 REHABILITATION
• The terms ‘revival’ or ‘rehabilitation’ means the selling
off of assets and starting a fresh industrial undertaking
in different places. It also indicates rearrangement or
reorganization of a company.
• The revival or rehabilitation of sick units is an important
step for industrial development
 Rehabilitation Process
• It is based on the development of a specific and viable
plan for the corrective action and subsequent monitoring
to ensure adherence to the plan.
• Rehabilitation process involves series of steps
– Corrective action overview
– Resolving credit and capital impairment problems
– Resolving liquidity problems
 Corrective Action Overview
• First step is to identify the problem and when problems
are detected, banks must determine their severity
promptly as well as the timing and form of corrective
action needed to overcome the problem
• Factors to consider include:
– Does the bank have any problem in the past?
– Has the severity of problems progressed?
– Is the ownership and management team is same as in the past?
– Does the management team have a history of identifying
problems within the bank or do they outsource?
– Has the bank been placed under an enforcement action before?
• After identifying the problem and severity of problem the
banks decides that which types of corrective action are
required?
 Corrective Action Overview
• The selection of specific corrective action is tailored and
designed to correct identified deficiencies improve the
all overall condition, and return the bank to a safe and
sound condition as quickly as possible.
 Resolving Credit and Capital
Impairment Problems
• Capital can dissipate rapidly in the face of significant credit losses,
underscoring the importance of early detection and timely resolution of
supervisory concerns.
• Various banking laws and regulations mandate minimum capital levels
for banks and detail actions
• A bank could take steps to improve its capital ratios by decreasing
either total assets or the aggregate risk weight of its assets.
• In some cases, actions may only temporarily address the capital
problems at the bank and in the long term, may increase the overall risk
to earnings and capital.
• Banks should review carefully any actual or planned balance sheet
changes to ensure that they address the capital issues effectively.
• Example:
• A bank could reduce assets and increase capital by
selling appreciated or low risk assets.
• A gain on the sale of assets increases net income that
adds capital, and combined with the decrease in assets,
improves the bank’s leverage ratio.
 Resolving Liquidity Problems
• To remain viable, a bank must have liquidity – the ability
to obtain cash for operations when needed a reasonable
cost.
• Managing a bank’s liquidity during a crisis, particularly
when difficulties arise and its financial deterioration is
known to the public, can mean the difference between an
orderly return to stability and an acute crisis, including
insolvency.
• Banks should be prepared to deal with wide – ranging
liquidity events caused by actual or perceived problems in
any area of the bank.
• Preventing liquidity insolvency may include a
combination of both discretionary and mandatory
supervisory actions
• Bank management manages assets, liabilities and off –
balance – sheet cash flows.
• Managing the release of information to the public is as
important as managing the bank’s financial positions
and cash flows.
• Public Perception of a bank’s condition, and thereby the
safety of customer deposits, can change quickly, because
of negative news about the soundness of a bank’s
condition.
• Customer reaction - needs for onhand liquidity and
access to contingency sources
• Effective processes in place to monitor and react to the
contraction of deposits and other funding.
 Sick Industries
• Rehabilitation of sick industries
• Sick Industries – The Sick Industrial Companies (Special
provision) Act, 1985, as amended in 1993 defines sick
industrial company (being a company registered for not
less than five years) which has at the end of any financial
year accumulated losses equal to or exceeding its entire
net worth.
• Nursing Programme - BIFR
 BIFR – Board of Industrial and
Financial Reconstruction
• The main function of Board of Industrial and Financial
Reconstruction (BIFR) is to revive the sick and loss
making enterprises.
Reporting to BIFR
 Enquiry by the BIFR
• When a case is referred to the BIFR, it is verified by the Registrar of the BIFR as
to whether the fact of the case falls within the provisions of the Sick Industrial
(special Provisions) Act, 1985.
• If so, the BIFR accepts the case and notifies a date for hearing of the case.
• For rehabilitating a sick unit, co-operation of various connected agencies is
necessary.
• This coordination is achieved by the BIFR. The BIFR invites the representatives
of the informant sick company, the representatives of the concerned financial
institutions and commercial banks, representatives of the Central or State
Governments, trade union representatives etc., to the hearing and inquiry is
made to take any decision.
• After the hearing, the BIFR itself may conduct a study or entrust the work to an
‘operating agency’ appointed by it to determine whether the company is in fact
sick.
• Normally, the lead financial institution (IDBI, ICICI, IFCI and SFC) or the lead
public sector bank that has financed the company is nominated as the
operating agency.
• Lead institution is one that has major financial stake in
the sick company.
• The enquiry is to be completed within sixty days. On
completion of the enquiry, the BIFR will declare whether
the company is sick or not.
• If BIFR is of the opinion that the sick industrial company
is not likely to make its net worth exceeds its
accumulated losses within a reasonable time and that it
is not likely to become viable in future, the BIFR asks the
company to wind up.
• Decision of BIFR is binding on all the concerned parties.
• The entire responsibility for diagnosing, identifying,
investigating, rehabilitating, reviving and ultimately
recommending the winding of such a sick unit lies with
the BIFR
 Revival Process
• Restructuring the capital base of the company
• Inducing more capital to improve its resource position
• Merger of the sick company with a healthy unit
• Providing soft loans (repayable in a longer period with
lower rate of interest) to the company
• Bringing about technological changes and
modernization in the company
• Bringing about a change in its management
• Writing off the interest burden of the company
• Rescheduling its loans
• Providing concessions like tax rebate or tax reliefs to it
 Debt Restructuring – Rehabilitation of
Sick Firms
• Debt restructuring is the process wherein a company or
an entity experiencing financial distress and
liquidity problems can refinance its existing obligations
in order to gain more flexibility in the short term.
• Debt restructuring refers to the reallocation of resources
or change in the terms of loan extension to enable the
debtor to pay back the loan to the creditor.
• It is an adjustment made by both the debtor and the
creditor to smooth out temporary difficulties in the way
of loan repayment.
• While filing for bankruptcy the best option for debt relief
for many businesses, some organizations may wish to
avoid bankruptcy if possible. For these companies, debt
restructuring techniques can be an effective way
addressing overwhelming debt without seeking
bankruptcy protection. For example, a business
could negotiate with creditors to change the terms of an
original agreement, including those concerning the
amount, interest and repayment period.
 Reason for Debt Restructuring

• A company that is considering debt restructuring is

likely experiencing financial difficulties that cannot be
easily resolved. Under such circumstances, the company
faces limited options such as restructuring its debts or
filing for bankruptcy. Restructuring existing debts is
more efficient and cost-effective in the long term than
filing for bankruptcy.
 Types of Debt Restructuring
• Debt for Equity Swap - This occurs when creditors agree
to cancel a portion or all of their outstanding debts in
exchange for equity in the company.
• Bondholder Haircuts - ”take a haircut” - where a portion
of the outstanding interest payments would be written
off, or a portion of the principal will not be repaid.
• Callable Bonds - A company will often issue callable
bonds to protect itself from a situation in which interest
payments cannot be made.
• Informal Debt Repayment Agreements
• Companies that are restructuring debt can ask for lenient
repayment terms and even ask to be allowed to write off
some portions of their debt. This can be done by
reaching out to the creditors directly and negotiating
new terms of repayment. This is a more affordable
method than involving a third party mediator and can
be achieved if both parties involved are keen to reach a
feasible agreement.
 Debt Restructuring vs. Bankruptcy
• Debt restructuring usually involves direct negotiations
between a company and its creditors. The restructuring
can be initiated by the company or, in some cases, be
enforced by the creditors.
• On the other hand, bankruptcy is essentially a process
through which a company that is facing financial difficulty
is able to defer payments to creditors through a legally
enforced pause. After declaring bankruptcy, the company
in question will work its creditors and the court to come
up with a repayment plan.
• In case the company is not able to honor the terms of the
repayment plan, it must liquidate itself in order to repay
its creditors. The repayment terms herein are decided by
the court.
 Impact of Sick Industries on the
Economy
• Under utilization of capital assets. Though under utilization of
capital assets affects the capital formation process of less
developed and developing countries.
• Entrepreneurship level declines because of increase in
industrial sickness.
• Investor confidence level declines because of increase in
industrial sickness.
• Industrial sickness results in large scale unemployment and
industrial unrest
• Profitability of banks and financial institutions gets affected
since they don’t get back their funds invested in projects that
have gone sick.
• Nor do they earn interest on their invested funds.
• Funds get blocked in sick units banks/financial
institutions could not recycle their funds with the result
that even a good project can not be funded by them.
• Prevention of sickness and rehabilitating sick projects
assume greater importance.
 Disadvantages of BIFR
• Members of a Parliamentary committee have questioned the move to wind up
the Company Law Board, Board for Industrial and Financial Reconstruction, and
Appellate Authority for Industrial and Financial Reconstruction and replace
them with two tribunals.
• Many cases were pending and noting that interests of 15 lakh workers were at
stake in 1,306 cases relating to sick companies pending at various stages in these
bodies, some members of the committee expressed the view that it was desirable
to give more teeth to these institutions instead of replacing them by two
tribunals.
• The Committee is not convinced with the government's explanation that BIFR
and AAIFR were not effective, the report headed by Pranab Mukherjee said,
adding the aim and objective of the Companies (Amendment) Bill 2001 is
different from that of Sick Industrial Companies (Special Provisions) Act 1985.
• The Companies (Amendment) Bill 2001 proposes to put in place the National Company Law
Tribunal (NCLT) and the National Company Law Appellate Tribunal (NCLAT) so as to take over
the functions that are hitherto performed by the CLB, BIFR, AAIFR and the high courts/district
courts in winding up of companies.
• Responding to the issue, the government stated that corporate restructuring, including insolvency
and winding up, and dispute resolution for the companies were being handled by many bodies
and hence the proposal to have one body (NCLT) that would replace both the BIFR and the CLB.
The government said, referring all matters to one single body would have the advantage of that
body being able to give focused attention to company matters.
• Provisions may be made in the present Bill to transfer cases to NCLT for winding up only from
BIFR and AAFIR, these members said.

Amongst its other recommendations, the report, tabled in Parliament, said the committee was
strongly in favour of devising a mechanism to detect sickness of industries at an early stage.
• The Insolvency and Bankruptcy code at present can only be
triggered if there is a minimum default of Rs 1 lakh. This
process can be triggered by way of filing an application
before the National Company Law Tribunal (NCLT).
Important aspect that has to be seen in respect of
Insolvency and Bankruptcy Code (IBC) is that at present
only companies (both private and public limited company)
and Limited Liability Partnerships (LLP) can be considered
as defaulting corporate debtors.
 Non – Performing Assets (NPAs)
• NPA means an asset or an account of borrower, which has been classified
by a bank or financial institution as substandard, doubtful or loss asset, in
accordance to the direction or guidelines on asset classification issued by
the RBI.
• “90 days overdue” norm for identification of NPAs, from the year ending
March 31, 2004.
• Accordingly, with effect from March 31, 2004, a loan or an advance shall
be a non – performing asset (NPA) where:
– Interest and / or installment of principal remains overdue for a period
of more than 90 days in respect of a term loan
– Account remains “out of order” for a period of more than 90 days, in
respect to an overdraft / Cash credit (OD/CC)
– Bill remains overdue for a period of more than 90 days in the case of
bills purchased and discounted
– Interest / installment of principal remains overdue for two harvest
seasons but for a period not exceeding two half years in the case of an
advance granted for agricultural purpose
– Any amount to be received remains overdue for a period of more than
90 days in respect of other accounts
 Non – Performing Assets (NPAs)

• The assets of the banks which do not generate regular

income are called Non Performing Assets (NPA) or bad
loans.
• Bank’s assets are the loans and advances given to
customers.
• If customers don’t pay either interest or part of principal or
both, the loan turns into bad loans or NPAs
• “90 days overdue” norms
 Guidelines for considering NPAs
• Type # 1. Term Loans
• Type # 2. Cash Credit and Overdrafts: considered as
“Out of Order”
• Type # 3. Agricultural Advances
• Type # 4. Bill Discounting / Purchased
• Type # 5. Exempted Assets
• Type # 6. Advances under Rehabilitation Packages
• Type # 7. Take-out Finance
• Type # 8. Other Assets
• Non-performing Assets: Type # 1. Term Loans:
• A term loan facility will be treated as NPA for the year
ending 31st March, 1998 and onwards if interest or
installment of principal remains past due for a period of
more than 90 days.
 Some Important Terms
• “Out of order” – An account will be treated as “out of
order” if:
– The outstanding balance remains continuously in excess
of the sanctioned limit / drawing power
– Where the outstanding balance in the principal operating
account is less than the sanctioned limit / drawing power, but
there are no credits (to the account) continuously for six months
as on the date of balance sheet or credits (to this account) are not
enough to cover the interest debited during the same period
• Overdue:
– Any amount due to the bank under any credit facility is
“overdue” if:
• It is not paid on the due date fixed by the bank
 Agriculture Purpose
• Advances granted for agriculture purposes become NPA
if interest and / or installment of principal remains
overdue for two crop seasons in case of short duration
crops and one crop season for long duration crops will
be treated as NPA, if the installment of principal or
interest thereon remains overdue for one crop season.
• Crops having crop season of more than one year i.e. upto
the period of harvesting the crops raised will be termed
as ‘long duration’ crops and other crops will be treated
as ‘short duration’ crops. These NPA norms would also
be applicable to agricultural term loans.
 Exempted Assets
• Advances secured against term deposits, National
Savings Certificates, Vikas Patras, Kisan Vikas Patras
and surrender value of life insurance policies.
 Take out Finance
• A take-out loan is a loan that replaces another loan.
• Let's say Company XYZ is a real estate development company. It owns a piece
of land at a busy intersection and decides to build a huge apartment complex
on the site.
• Company XYZ first gets a $5 million construction loan from Bank A, which
Company XYZ uses to pay the general contractor and all the associated
expenses of constructing an apartment building. The loan must be repaid in 18
months, at the estimated completion of the construction. Because the collateral
-- the construction site -- isn't worth much until it becomes a fully rented and
operating apartment building, Bank A charges 9% on the loan.
• After the apartment building is finished, Company XYZ gets a $5
million mortgage from a take-out lender, Bank B. This loan has a 30-
months term, is collateralized by a fully functioning apartment building, and
has a 5% interest rate. Company XYZ uses Bank B's loan to pay off -- or take
out -- Bank A's loan.
 Asset Classification (Guidelines by RBI)
• Standard Assets – These are loan that do not have any
problem and are less risky
• Special Mention Account: If the borrower does not pay dues
for 90 days after end of a quarter; the loan becomes an NPA
and it is termed as “Special Mention Account”. If this loan
remains SMA for a period less than or equal to 12 months; it
is termed as Sub-standard Asset.
• Substandard Assets – An asset which is overdue for a period
of more than 90 days but less than 12 months
• Doubtful Assets – An asset which is overdue for a period of
more than 12 months.
• Loss Assets – These NPAs are those that are identified as
unreliable, non - recoverable by internal or external auditor,
internal inspector of bank or by the RBI. They may not get
recovered.
 Example of NPA
• We suppose that a party was disbursed a loan on January 1, 2010.
Its due date is June 1, 2010. But the party does not make a payment.
So
• It will be an Standard Asset from January 1, 2010 till June 1, 2010
(Due Date)
• It will be a Special Mention Account From June 2, 2010 till August
29, 2010 (90 days)
• It will be Sub-standard from August 30, 2010 till August 29, 2011
• It will be doubtful from August 30, 2011 till August 29, 2012
• It may remain doubtful Asset for a period of 3 years, beginning
from 12 months of being an NPA, but once the auditors identify it
as a loss, it will be assigned a loss asset; however, the period may be
anything above 3 years.
 Provisioning Coverage Ratio
• For every loan given out, the bank as to keep aside some
extra funds to cover up losses if something goes wrong
with those loans. This is called provisioning.
• Provisioning Coverage Ratio (PCR) refers to the funds to
be set aside by the banks as fraction to the loans.
 Provision for Loss
• A bank is required to make a provision for loss in respect of
different classes of its advances as follows:
(a)Standard Assets: Provision has to be made as follows:

• Housing loans at “teaser” rates attract a higher provision of 2%.

• Teaser rates on housing loans – competitive pricing practice among
banks, where the loan is granted at comparatively lower interest rates in
the first few years, after which rates are reset at higher rates, which
effectively is the appropriate lending rate.
• Restructured advances classified as standard assets will attract a
provision of 2%.
(b) Sub-standard Assets: Provision has to be on the
following lines:

(c) Doubtful Assets: Provision has to be on the following

lines:

(d) Loss Assets:

•The entire amount should be written off or full provision
should be made for the amount outstanding.
 Reasons for NPAs
• Over hang component (external) – is due to the
environment reasons or business cycles etc.
• Incremental component (internal) – may be due to
internal bank management, credit policy, terms of credit
etc.
 Internal Factors
• Defective Lending Process
• Inappropriate technology
• Improper SWOT Analysis
• Managerial Deficiencies
• Absence of regular industrial visit
• Diversion of funds
• Lenient Lending Norms
 External Factors
• Wilful defaults
• Natural Calamities
• Industrial Sickness
• Change on Government Policies
• Ineffective recovery tribunal
• Lack of demand
 Internal Factors
• No more proper risk management - Speculation is one
of the major reason behind default. Sometimes banks
provide loans to borrowers with bad credit history.
There is a high probability of default in these cases.
• Credit distribution Mis-management: Misuse of funds
by the borrowers also lead to NPA's. Some borrowers
bribe the bank officials and get the loan approved with a
sole intention of default.
• Diversion of funds - Many times borrowers divert the
borrowed funds to purposes other than mentioned in
loan documents. It is very hard to recover from this kind
of borrowers.
 Causes of NPA
• On a global scenario, there can be numerous reasons for rising
NPAs such as global slowdown, economic crisis, fall in
domestic demand etc.
• However, pertaining to the Indian banking sector, there are
certain other issues that cater to the rise of NPAs. These issues
are:
• Willful defaulters, fraud, mismanagement and
misappropriation of funds.
• Lack of proper pre-appraisal and follow up.
• Under financing
• Delay in completing the project.
• Business failures
• Deficiencies on the part of bank viz., in credit appraisal,
monitoring and follow ups.
 Causes of NPA
• Default - One of the main reason behind NPA is default
by borrowers.
• Economic conditions - The Economic condition of a
region affected by natural calamities or any other reason
may cause NPA.
• No more proper risk management - Speculation is one of
the major reason behind default. Sometimes banks
provide loans to borrowers with bad credit history. There
is a high probability of default in these cases.
• Mis-management - Often ill-minded borrowers bribe
bank officials to get loans with an intention of default.
• Willful Defaults: A willful defaulter is a person who has defaulted in
meeting its payments/repayment obligation to the lender even when
it can honor the said obligations. One of the best examples for willful
defaults is Kingfisher Airlines Ltd.
• Industrial Crisis: It is one of the external factor affecting NPAs in the
country. Industries depend on banks to fulfill their requirements on
funding their projects. In case of a crisis in the industry, it will
change the banking sector, and NPA will rise.
• Lenient Lending Norms: Lenient norms by the lender is also one of
the prime reasons for rising NPAs. Over analysis of financial status
and credit rating by banks for industry-barons are one of the reasons.
 Impact of NPAs on banking sector and
Indian economy
• Firstly, NPAs leads to asset contraction for banks. Due to
the presence of NPAs, the banks follow low interest policy
on deposits and high interest policy on advances provided.
Thus, this act puts a pressure on recycling of funds and
further creates a problem in getting new buyers.
• Secondly, as per the Basel norms all banks are required to
maintain capital on risk weighted assets. A rise in NPAs
pressurizes the banks to increase their capital base further.
• Lastly, rise in NPAs reduces the customer’s confidence on
the banks. Rise in the NPAs affects the profitability of the
bank which further hinders the returns to be received by
the customers.
• Decrease in profits leads to a lower dividend pay-out by
the banks and affects the ROI expectations of the
customers. Thus, a rise in NPAs not only affects the
performance of the banks but also affects the economy as
a whole.
 Remedies/Measures for managing
NPAs
• Banks today have a herculean task of both effectively managing
the NPA’s as well as keeping their profitability intact. In order
to achieve this, the banks need a well-established credit
monitoring system.
• Since, lending forms a major segment of bank’s transactions
thus they need to properly evaluate the credit proposals they
receive.
• Full information related to the client/company, industry,
management etc. should be collected.
• A centralized model for sanctioning and recovery of loans
should be setup.
• Staff with specialized skills in credit risk management must be
hired.
• Timely watch on the performance of the borrowers must
be kept so that recovery of instalments becomes easy.
• In conclusion, proper monitoring system and effective
business models need to be developed in order to
resolve the gigantic problem of NPAs.
 Resolution Mechanisms of NPA

Resolution Mechanisms of NPA

DRT & DRAT

LOK ADALAT

Assets Reconstruction
Companies (ARCs)

SARFAESI Act 2002

PCA

IBC
 Lok Adalat
• Lok Adalat, is ‘People’s Court,’ is one of India’s alternative dispute
resolution mechanisms.
• It is a forum where disputes or cases pending in the court of law or law
at the pre-litigation stage are resolved.
• As per section 18(1) of the Act, a Lok Adalat shall have jurisdiction to
determine and to arrive at a compromise or settlement between the
parties to a dispute in respect of -
(1) Any case pending before; or
(2) Any matter which is falling within the jurisdiction of, and is not brought before,
any court for which the Lok Adalat is organised. Amt – 50000 – 20L
• Recovery of small amount of dues from borrowers
• The first lok adalat was held in Gujarat in 1982.
• First time held in Chennai in 1986.
• There is no court fee and if a matter pending in the court of law is
referred to the Lok Adalat and is settled subsequently, the court fee
originally paid in the court on the complaints/petition is also refunded
back to the parties.
 DRT – Debt Recovery Tribunal
• During 1980s-90s, the banks in India did not have access to
any specialised mechanism to recover the dues from the
borrowers.
• Banks and FI was facing problems
• There was a need to have an effective system to recover
the money from borrowers.
• In order for recovery of money from borrowers, the banks
and financial institutions had to file a suit in the civil court.
• It took many years to recover the dues from borrowers
• A committee was formed in 1981 to suggest reforms under
the Chairmanship of Mr. T. Tiwari.
• Over burden of Courts
• In 1991, Narasimham Committee supported the
perspectives of the Tiwari Committee and suggested
setting up Special Tribunals.
• The recommendations of Narasimham Committee lead to
the enactment of Recovery of Debts Due to Banks and
Financial Institutions Act (RDDBFI), 1993.
• It established two forms of agencies namely Debt Recovery
Tribunals (DRTs) and Debt Recovery Appellate Tribunals
(DRATs)
• The primary objective and role of DRT is the recovery of
money from borrowers which is due to financial
institutions and banks.
• The Tribunal has all the powers vested with the District
Court.
• Currently there are 39 DRTs and 5 DRATs operational in
the country.
• It consists of one person only who is referred as Presiding
officer. The Presiding officer:
– Should be qualified to work as district judge
– Can have term of 5 years
– Can hold the office till he attains the age of 62 years
• The Tribunal also has a Recovery officer who helps in
executing the recovery Certificates as passed by the
Presiding Officers.
• The main features of DRT act are as follows:
– The Act extends to whole of India except State of Jammu &
Kashmir.
– The provisions of the Act applies in cases where amount due from
debtor is not less than Rs. 10,00,000.
– For debt less than 10,00,000, suite in civil courts may be initiated.
– Only Banks and Financial Institutions (which later includes Public
Financial Institutions & Securitization company / Reconstruction
company ) can file original application for recovery of Debts.
• Court fee , will be decided based on amount claimed in
original application and shall be limited to Rs. 1.50 lakhs.
• The fee payable as per Rule 7 of the Debts Recovery
Tribunal (Procedure) Rules, 1993 is Rs.12,000/- where
an amount of debt due is Rs.10.00 lakhs, Rs.12,000 plus
Rs.1000 for every one lakh of debt due or part thereof in
excess of Rs.10.00 lakhs subject to a maximum of
Rs.1,50,000/-
• Summary procedure is followed by the debt recovery
tribunals. Cross examination is generally not permitted
except in few deserving cases.
• The defendants have the rights to file counter claim.
• The final order is passed by the debt recovery tribunal
directing the borrowers to pay the required amount. If
borrower fails to pay the ordered amount, recovery
certificate shall be issued against the borrower which will
then be executed by Recovery Officer of DRT.
• In case a certificate of recovery is issued against a
company which is registered under the Companies Act,
1956 ,the Tribunal may order the sale proceeds of such
company.
 DRAT
Debt Recovery Appellate Tribunal (DRAT)?
• A person/entity aggrieved by orders of the DRT can appeal against its
orders to Debt Recovery Appellate Tribunal (DRAT). The appeal must be
made within 45 days of receiving the orders from DRT. The DRAT shall
not entertain the appeal until such person deposits the 75% of amount of
debt so due determined by the DRT. Both DRT and DRAT works on the
principle of natural justice and have same powers as vested in any civil
court.
Composition of DRAT
• It consists of one person only who is referred as Chairperson of
Appellate Tribunal. The Chairperson:
• Should be qualified to be judge of high court
• Should be member of legal service
• Held office of Presiding officer for at least 3 years
• Can have term of 5 years
• Can hold the office till he attains the age of 65 years
 Difference between NCLT & DRT

• NCLT is regulated by the Companies Act, whereas DRT

is regulated by the SARFAESI Act and Recovery of
Debts due to Banks and Financial Institutions.
Companies approach NCLT for winding up, strike off
cases in case of default whereas Banks and Financial
Institutions approach DRT for recovery procedure. The
liquidation that is Insolvency cases are dealt by NCLT.
 Securitization and Reconstruction of
Financial Assets and Enforcement of
Security Interest (SARFAESI) Act, 2002

• Banks utilize this act as an effective tool for bad loans

(NPA) recovery.
• SARFAESI is effective only for secured loans where bank
can enforce the underlying security eg hypothecation,
pledge and mortgages. In such cases, court intervention
is not necessary
• Upon loan default, banks can seize the securities (except
agricultural land) without intervention of the court.
 Contents of SARFAESI ACT, 2002
• How it works?
• Background of the act
• Rights of Borrowers
• Pre-conditions
• Methods of Recovery
How it works?
 Background of the Act
• The previous legislation enacted for recovery of the default
loans was Recovery of Debts due to Banks and Financial
institutions Act,1993.
• This act was passed after the recommendations of the
Narsimham Committee – I were submitted to the
government.
• This act had created the forums such as Debt Recovery
Tribunals and Debt Recovery Appellate Tribunals
• However, there were several loopholes in the act and these loopholes
were mis-used by the borrowers as well as the lawyers.
• The govt recommended a new committee to enact a new legislation for
the establishment of securitisation and reconstruction companies and to
empower the banks and financial institutions to take possession of the
Non performing assets.
• Sarfaesi act, for the first time, the secured creditors were
empowered to recover their dues without the
intervention of the court.
Right of Borrowers
Conditions
Methods of Recovery
The Act provides three methods for recovery of NPAs, viz:
•(i) Securitization;
•(ii) Asset Reconstruction; and
•(iii) Enforcement of Security without the intervention of the
Court.

•Securitization
•Securitization is the process of pooling and repackaging of
financial assets (like loans given) into marketable securities
that can be sold to investors.
•In the context of bad asset management, securitization is the
process of conversion of existing less liquid assets (loans)
into marketable securities. The securitization company takes
custody of the underlying mortgaged assets of the loan taker.
 Asset Reconstruction
• Asset reconstruction is the activity of converting a bad or
non-performing asset into performing asset.
• The process of asset reconstruction involves several
steps including purchasing of bad asset by a dedicated
asset reconstruction company (ARC) including the
underlying hypothecated asset, financing of the bad
asset conversion into good asset using bonds,
debentures, securities and cash, realization of returns
from the hypothecated assets etc
 Enforcement of Security Interests
• The Act empowers the lender (banker), when the borrower
defaults, to issue notice to the defaulting borrower and
guarantor, calling to repay the debt within 60 days from the
date of the notice. If the borrower fails to comply with the
notice, the bank or the financial institution may enforce
security interests (means interest of the bank/creditor) by
following the provisions of the Act:
• a) Take possession of the security;
• b) Sale or lease or assign the right over the security;
• c) Appoint Manager to manage the security;
• d) Ask any debtors of the borrower to pay any sum due to
the borrower.
 Asset Reconstruction Companies
• Asset reconstruction companies are in the business of buying
bad loans from banks. For instance, if a bank lends money to a
person or company, they expect to receive periodic payments of
principal and interest. However, when they do not receive
those periodic payments for an extended period of time, (let’s
say 90 days) these loans are classified as nonperforming assets.
If these NPA’s are allowed to stay on the bank’s balance sheet,
they erode investor confidence in the bank.
• Hence, banks sell these bad loans to specialists called asset
reconstruction companies. The business of these companies is
to buy bad loans from banks at a steep discount. These
companies then take special measures to recover the money
owed. If they are able to recover the money, they make a profit,
if not they lose the money.
• An Asset Reconstruction Company is a specialized
financial institution that buys the NPAs or bad assets
from banks and financial institutions so that the latter
can clean up their balance sheets.
• ARCs clean up the balance sheets of banks when the
latter sells these to the ARCs. This helps banks to
concentrate in normal banking activities. Banks rather
than going after the defaulters by wasting their time and
effort, can sell the bad assets to the ARCs at a mutually
agreed value.
• To create, operate and regulate Asset Reconstruction
Companies an act known as Securitization and
Reconstruction of Financial Assets and Enforcement of
Security Interest came into force since June, 2002.
 SARFAESI Act 2002– origin of ARCs
• The Securitization and Reconstruction of Financial
Assets and Enforcement of Security Interest (SARFAESI)
Act, 2002; enacted in December 2002 provides the legal
basis for the setting up ARCs in India. Section 2 (1) of the
Act explains the meaning of Asset Securitization.
Similarly, ARCs are also elaborated under Section 3 of
the Act.
• The SARFAESI Act helps reconstruction of bad assets
without the intervention of courts. Since then, large
number of ARCs were formed and were registered with
the RBI which has got the power to regulate the ARCs.
• Asset Reconstruction Company (Securitization Company
/ Reconstruction Company) is formed as a company
registered under Section 3 of the Securitization and
Reconstruction of Financial Assets and Enforcement of
Security Interest (SRFAESI) Act, 2002. It is regulated by
Reserve Bank of India as a Non-Banking Financial
Company (u/s 45I (f) (iii) of RBI Act, 1934).
 Capital needs for ARCs
• As per amendment made on the SARFAESI Act in 2016,
an ARC should have a minimum net owned fund of Rs 2
crore. The RBI plans to raise this amount to Rs 100 crore
by end March 2019. Similarly, the ARCs have to
maintain a capital adequacy ratio of 15% of its risk
weighted assets.
• The first asset reconstruction company (ARC) of India,
ARCIL, was set up under this act.
• 28 ARC
• JM Financial Asset Reconstruction Company Limited
• Reliance Asset Reconstruction Company Limited
 Objectives to establish ARC in India
• Rapid growth of bad debts/ non-performing assets was
the chronic hurdle for healthy growth of Indian economy.
Asset Reconstruction Companies were established as
specialized entities to facilitate securitization and asset
reconstruction of non-performing asset thereby earliest
resolution and bringing the liquidity in the system.
• The main objective of such companies is to help banks in
making their books clean by reducing the number of
Non-Performing Assets. Such companies make profit by
buying Non Performing Assets at a lower price.
• These entity will recover those sum through attachment
or liquidation.
ARCs - Funding to buy bad assets from
Banks
• Regarding funds, an ARC may issue bonds and
debentures for meeting its funding requirements. But the
chief and perhaps the unique source of funds for the
ARCs is the issue of Security Receipts.
• As per the SARFAESI Act, Security Receipts is a receipt
or other security, issued by a reconstruction company (or
a securitization company in that case) to any Qualified
Institutional Buyers (QIBs) for a particular scheme. The
Security Receipt gives the holder (QIB) a right, title or
interest in the financial asset that is bought by the ARC.
These SRs issued by ARCs are backed by impaired
assets.
• Security Receipt means a receipt or other security, issued by
an ARC to any Qualified Buyers (QBs) pursuant to a
scheme, evidencing the purchase or acquisition by the
holder
• “Qualified institutional buyer" means a financial institution,
insurance company, bank, state financial corporation, state
industrial development corporation, trustee or
securitization company or reconstruction company which
has been granted a certificate of registration under sub-
section (4) of section 3 or any asset management company
making investment on behalf of mutual fund or pension
fund or a foreign institutional investor registered under the
Securities and Exchange Board of India Act, 1992 (15 of
1992) or regulations made thereunder, or any other body
corporate as may be specified by the Board;
 Rules for the acquisition of assets and
its valuation by ARCs
• NPAs shall be acquired at a ‘fair price’ in an arm’s length
principle by the ARCs.
• SARFAESI Act permits ARCs to acquire financial assets
through an agreement banks. Banks and FIs may receive
bonds/ debentures in exchange for NPAs transferred to
the ARCs. A part of the value can be paid in the form of
Security Receipts (SRs). Latest regulations instruct that
ARCs should give 15% of the value of assets in cash.
• Bond or debentures can have a maximum maturity of six
years and should have a rate of interest at least 1.5%
above the RBI’s ‘bank rate’. While dealing with bad
assets, ARCs should follow CAR regulations.
 Resolution Strategies that can be followed
by ARCs while restructuring the assets
• The guidelines on recovery of money from the resolution
process by the ARCs say that regaining the value through
restructuring should be done within five years from the date
of acquisition of the assets. SARFAESI Act stipulates various
measures that can be undertaken by ARCs for asset
reconstruction. These include:
• a) taking over or changing the management of the business of the
borrower,
• b) the sale or lease of the business of the borrower
• c) entering into settlements and
• d) restructuring or rescheduling of debt.
• e) enforcement of security interest
• The last step of ‘enforcement of security interest’ means ARCs can take
possession/sell/lease the supported asset like land, building etc.
 ARC carry out the process of asset
reconstruction
• Change or takeover of the management of the business
of the borrower
• Sale or lease of such business
• Rescheduling the payment of debts – offering alternative
schemes, arrangements for the payment of the same.
• Enforcing the security interest offered in accordance
with the law
• Taking possession of the assets offered as security
• Converting a portion of the debt into shares
 Performance of ARCs
• At present, there are 28 ARCs in India. But collectively,
their capital base is also insufficient to tackle the
country’s nearly Rs 12 lakh crores NPAs.
• The main problems in the sector are: low capital base of
ARCs, low funds with the ARCS, valuation mismatch of
bad assets between banks and ARCs etc.
 Type of debts - ARC take over

• The ARC can take over only secured debts which have
been classified as a non-performing asset (NPA).
 ARC Process
• Asset reconstruction(ARC) company process:
1) ARC will take over the NPA's from banks for fixed cost
which is less than the NPA amount.
2) NPA is transferred to ARC along with any security which
is pledged while taking loan.
3) Now ARC will issue security receipts for fixed interest rate
and will raise money from QIB.(These raised money can be
invested in financial institutions)
“Security receipt" means a receipt or other security, issued by
a securitization company or reconstruction company to
any qualified institutional buyer pursuant to a scheme,
evidencing the purchase or acquisition by the holder
thereof, of an undivided right, title or interest in the
financial asset involved in securitization;
• 4) Now ARC will start legal procedure to sell the
pledged security in the market. Which will take many
years depending on the complications involved. Mean
while Money raised by issuing security receipts are used
for meeting expenses of the company, ARC has to pay
timely interest on security receipts to the buyers
(qualified institutional buyers)
• 5) After selling the asset by clearing all litigations, ARC
company will redeem (take back) the security receipts
which are issued earlier for agreed price.
• Profit of ARC = sale Price of security + interest on
investment - purchase cost of NPA - interest on security
receipts - Expenses.
 Prompt Corrective Action
• Prompt Corrective Action or PCA is a framework under
which banks with weak financial metrics are put under
watch by the RBI. The PCA framework deems banks as
risky if they slip below certain norms on three
parameters — capital ratios, asset quality and
profitability.
• The PCA is an early intervention package or resolution
guideline by the RBI when a bank turns weak in terms of
the identified indicators.
 Prompt Corrective Action
• The Reserve Bank of India initiated the Scheme of
Prompt Corrective Action (PCA) in 2002 to discipline
banks when they report poor and risky financial
performance.
• PCA is a policy action guideline (first in May 2014 and
revised effective from April 1, 2017) if a commercial
bank’s financial condition worsens below a mark.
 PCA
• In early 2018, there were 12 banks under PCA
framework, implying that their financial conditions were
weak. Out of these, 11 were PSBs. Later, the government
injected capital into the PSBs besides making several
steps to improve their performance. As a result, as on
March 9, 2019, there were only six banks (all PSBs) under
the PCA framework.
• Allahabad Bank, United Bank of India, Corporation
Bank, IDBI Bank, Uco Bank, Bank of India, Central Bank
of India, Indian Overseas Bank, Oriental Bank of
Commerce, Dena Bank, Bank of Maharashtra and
Dhanalakshmi Bank.
 Objective of Prompt Corrective Action
(PCA) Framework
• The main objective of PCA Framework is to facilitate the
banks to take corrective measures including those
prescribed by the RBI in a timely manner, in order to
restore their financial health.
• RBI has put in place some trigger points to assess,
monitor, control and take corrective actions on banks
which are weak and troubled.
 PCA – Applicable Banks
• The PCA framework is applicable only to commercial
banks and not extended to cooperative banks and non-
banking financial companies (NBFCs).
 Criteria for identifying bank as PCA
category bank
• The PCA framework specifies the trigger points or the
level in which the RBI will intervene with corrective action.
This trigger points are expressed in terms of parameters for
the banks.
• The trigger points are: capital to risk weighted assets ratio
(CRAR), net non-performing assets (NNPA), and return on
assets (RoA). This means that when a particular bank is
reporting the low level of CRAR, high level of NNPA or
Return on Assets (profit), the RBI will ask it to adopt
certain restrictive measures.
• The scheme was revised in April 2017. Under the Revised
PCA framework, apart from the capital, asset quality and
profitability, leverage is to be monitored additionally.
 Prompt Corrective Action Framework
Trigger Points

• Reserve Bank of India (RBI) has set four trigger points

– CRAR, NPA (Non Performing Assets), ROA(Return on
Assets), Leverage Ratio, on the basis of which it is decided
whether bank need to put under the ambit of Prompt
Corrective Action (PCA).
• Three Risk Thresholds viz. Risk Threshold 1, Risk Threshold
2, Risk Threshold 3 on the basis of above trigger points.
Further, these Risk Thresholds are linked with specific
corrective actions need to be taken to secure bank’s financial
health.
• Corrective Action depends on the level of risk threshold.
Higher the risk , more will be corrective actions imposed on
the bank.
 Capital to Risk Weighted Ratio (CRAR)
• It is a first parameter under Prompt Corrective Action
(PCA) used to measure financial health of a bank. This
ratio is used to determine adequacy of bank capital in
terms of risk assets.
• If CRAR is above 9 percent then the bank is able to
absorb reasonable amount of losses and considered to be
financially sound. If it is below 9 percent then its
financial health is weak and alarm is triggered for
Prompt Corrective Action.
 Asset Quality
• Non Performing Assets is a classification of loan or
advance on which the principal or interest payment has
remained past due for a specified period of time. If NPA
ratio breach following specified limit as below then the
alarm is triggered for prompt corrective action.
 Profitability
• Third parameter evaluated for prompt corrective action
is Profitability. Return on Assets is considered as
indicator for evaluating profitability by RBI.
 Leverage Ratio
• Leverage ratio is fourth parameter which is used to
measure a bank’s debt level. Leverage Ratio is
proportion of debts that a bank has compared to its
capital.
• If Tier 1 leverage ratio is in between 3.5 and 4.0 percent
then the bank is subject to PCA.
• Prompt Corrective Action will be trigger on following
Thresholds.
Restrictions
 Restrictions
• Bank is not allowed to renew or access costly deposit or
take measure to increase their fee based income. Bank is
restricted to carry out lending to companies that fall
below investment grade. Bank is not allowed to open or
expand its branch network. RBI imposes restriction on
bank on borrowing from interbank market.
• Banks are asked to launch special drive to reduce NPAs
and contain generation of fresh NPAs.
• However, these restrictions are categorised under
Mandatory and Discretionary Actions depending on the
level of RISK THRESHOLD.
• Once any of banks fall under PCA, it means such banks
are not allowed to renew or accept costly deposits or take
steps to increase their fee-based income.
• Banks needs to check the existing Non Performing Assets
(NPA) and speedy drive to further addition of any fresh
NPAs. Banks are not allowed to enter in any new ventures
or new lines of business. RBI will also impose restrictions
on the bank on borrowings from inter-bank market.
• Currently eight banks are imposed with PCA like Bank of
India, Central Bank of India, UCO Bank, United Bank of
India, IDBI Bank, Indian Overseas Bank, Corporation
Bank etc.
• When a bank is brought into the PCA framework, it
should face restrictions on distributing dividends,
remitting profits and even on accepting certain kinds of
deposits. Besides, there are restrictions on the expansion
of branch network, and the lenders need to maintain
higher provisions, along with caps on management
compensation and directors’ fees. The entire thrust of the
PCA framework is to prevent further capital erosion and
to bring back the bank to normal healthy conditions.
• a) Threshold 1: Banks falling in this category have to
submit capital restoration plan; restrictions on assets
expansion, entering into new lines of business. Besides
they cannot access costly deposits, restrict borrowing
from inter-bank market, and reduce exposure to
sensitive sectors like capital market, real estate or
investment in non-SLR securities.
b) Threshold 2: in addition to actions in hitting the first
trigger point, RBI could take steps to bring in new
management, appoint consultants for business
restructuring, take steps to change or also take steps to
merge the bank if it fails to submit a recapitalization
plan.
• c) Threshold 3: In addition to actions in hitting the first
and second trigger points, more close monitoring; steps
to merge/amalgamate/liquidate the bank or impose
moratorium on the bank if its CRAR does not improve
beyond 3% within one year or within such extended
period as agreed to.
• a) CRAR-Capital to risk weighted assets ratio- less than
9%, but equal or more than 6%: Banks falling in this
category have to submit capital restoration plan;
restrictions on assets expansion, entering into new lines
of business. Besides they cannot access costly deposits,
restrict borrowing from inter-bank market, and reduce
exposure to sensitive sectors like capital market, real
estate or investment in non-SLR securities.
• b) CRAR less than 6%, but equal or more than 3%:
in addition to actions in hitting the first trigger point, RBI
could take steps to bring in new management, appoint
consultants for business restructuring, take steps to
change or also take steps to merge the bank if it fails to
submit a recapitalisation plan.
• c) CRAR less than 3%: In addition to actions in hitting
the first and second trigger points, more close
monitoring; steps to merge/amalgamate/liquidate the
bank or impose moratorium on the bank if its CRAR
does not improve beyond 3% within one year or within
such extended period as agreed to.
 PCA Framework banks as on March
2019
• As on March 9, 2019, there are only six banks which are
under the PCA Framework. All these banks are PSBs:
Dena Bank, United Bank of India, IDBI Bank, UCO Bank,
Central Bank of India, Indian Overseas Bank.
• As per the recent RBI notifications, six banks- Bank of
Maharashtra, Bank of India, Oriental Bank of Commerce,
Dhanlaxmi Bank, Allahabad Bank and Corporation
Bank, are out of the PCA framework this year.
• Earlier, there were 11 PSBs under the PCA Framework.
Government has infused capital into several of these
PSBs and they were redeemed from the PCA list.