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The genesis (origin) of an NPA

There are many reasons as to why a loan goes bad. For a business, it could be
because it fails to take off.

Such a situation may arise because of sudden health expenditure or job loss or
death. Often, as in the US today, it can be because of over-leveraging, when
consumers borrow against most of their assets and, maybe, have unsecured loans
too.

In such a case, any hit on income can jeopardize all repayments. They, however,
can file for bankruptcy under Chapters 7, 11 and 13 of the United States
Bankruptcy Code. Indians don’t have such an option.

In India, the situation has worsened due to banks aggressively pushing loans,
even unsecured ones, to individuals to prevent idle assets on their books.
President and founder of International Consumer Rights Protection Council, an
NGO, says most customers in India are not financially educated and banks are
luring them to take more and more loans, often without checking their financial
position
Definitions:_-An asset, including a leased asset, becomes non-performing when
it ceases to generate income for the bank.

A 'non-performing asset' (NPA) was defined as a credit facility in respect of


which the interest and/ or installment of principal has remained 'past due' for a
specified period of time.

With a view to moving towards international best practices and to ensure greater
transparency, it has been decided to adopt the '90 days' overdue' norm for
identification of NPAs, from the year ending March 31, 2004. Accordingly, with
effect from March 31, 2004, a non-performing asset (NPA) shall be a loan or an
advance where;

> Interest and/ or installment of principal remain overdue for a period of


more than 90 days in respect of a term loan,

> The account remains 'out of order' for a period of more than 90 days, in
respect of an Overdraft/Cash Credit (OD/CC),

> The bill remains overdue for a period of more than 90 days in the case of
bills purchased and discounted,
> Interest and/or 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 purposes, and
 Any amount to be received remains overdue for a period of more than 90
days in respect of other accounts.

Basis of non-performing assets

The basis of treating a credit facility as N.P.As is as detailed below: ASSET- In


respect of which interest has remained past due for six months.

1. TERM LOAN –

Inclusive of unpaid interest, when the installments is overdue for more than six
months/on which interest amount remained past due for six months.

2. Bills: - Which remains overdue for six months

3. OTHER CURRENT ASSETS –


The interest in respect of a debt/income on a receivable in the nature of short-
term loans/advances, which remains overdue for a period of six months.

4. SALE OF ASSETS/SERVICE RENDERED –

Any dues on account of these/reimbursement of expenses rendered, which


remained overdue for a period of six months.

5. LEASE RENTAL/HIRE PURCHASE INSTALMETS –

The installments, which has become overdue for a period of more than twelve
months.

6. OTHER CREDIT FACILITES –

The balance outstanding including interest accrued made available to the


borrower/beneficiary in the same capacity when any of the credit facilities
become N.P.A
Identification of assets as NPAs should be done on an ongoing
basis
The system should ensure that identification of NPAs is done on an on-going
basis and doubts in asset classification due to any reason are settled through
specified internal channels within one month from the date on which the account
would have been classified as NPA as per prescribed norms. Banks should also
make provisions for NPAs as at the end of each calendar quarter i.e. as at the
end of March/ June/ September/ December, so that the income and expenditure
account for the respective quarters as well as the P&L account and balance sheet
for the year end reflects the provision made for NPAs.
Treatment of Accounts as NPAs
Record of Recovery

The treatment of an asset as NPA should be based on the record of recovery.


Banks should not treat an advance as NPA merely due to existence of some
deficiencies which are of temporary in nature such as non-availability of
adequate drawing power, balance outstanding exceeding the limit, non-
submission of stock statements and the non-renewal of the limits on the due
date, etc. Where there is a threat of loss, or the recoverability of the advances is
in doubt, the asset should be treated as NPA.
Borrowers have been regularized by repayment of overdue amounts through
genuine sources (not by sanction of additional facilities or transfer of funds
between accounts), the accounts need not be treated as NPAs. In such cases, it
should, however, be ensured that the accounts remain in order subsequently and
a solitary credit entry made in an account on or before the balance sheet date
which extinguishes the overdue amount of interest or installment of principal is
not reckoned as the sole criteria for treatment the account as a standard asset.

Types of non-performing assets

Classified as 1) gross NPA 2) net NPA


1) Gross NPA
Gross NPAs are the sum total of all loan assets that are classified as NPAs as
per RBI guidelines as on Balance Sheet date. Gross NPA reflects the quality
of the loans made by banks. It consists of all the non standard assets like as
sub-standard, doubtful, and loss assets.

2) Net NPA

Net NPAs are those type of NPAs in which the bank has deducted the
provision regarding NPAs. Net NPA shows the actual burden of banks.
Since in India, bank balance sheets contain a huge amount of NPAs and the
process of recovery and write off of loans is very time consuming, the
provisions the banks have to make against the NPAs according to the
central bank guidelines, are quite significant. That is why the difference
between gross and net NPA is quite high.

Difference between gross NPA and net NPA


Gross NPA is the amount outstanding in the borrowal account, in books of the
bank other than the interest which has been recorded and not debited to the
borrowal account. Net NPAs is the amount of gross NPAs less (1) interest
debited to borrowal and not recovered and not recognized as income and kept in
interest suspense (2) amount of provisions held in respect of NPAs and (3)
amount of claim received and not appropriated.

The Reserve Bank of India defines Net NPA as


Net NPA = Gross NPA – (Balance in Interest Suspense account +
DICGC/ECGC claims
Received and held pending adjustment + Part payment received and kept in
suspense
Account + Total provisions held).
The Reserve Bank of India Banks has advised the banks to compute their Gross
Advances, Net Advances, Gross NPAs and Net NPAs as per the following
format w.e.f.
September 2009.
ASSET CLASSIFICATION

Banks should classify their assets into the following broad groups, viz.

1. Standard Assets
2. Sub-standard Assets 3.Doubtful Assets
4. Loss Assets
1. Standard Assets

Standard Asset is one which does not disclose any problems and which does
not carry more than normal risk attached to the business. Such an asset
should not be an NPA.

2. Sub-standard Assets

(I) with effect from March 31, 2005 an asset would be classified as Sub-
standard if it remained NPA for a period less than or equal to 12 months. In such
cases, the current net worth of the borrowers/ guarantors or the current market
value of the security charged is not enough to ensure recovery of the dues to the
banks in full. In other words, such assets will have well defined credit
weaknesses that jeopardize the liquidation of the debt and are characterized by
the distinct possibility that the banks will sustain some loss, if deficiencies are
not corrected.

(ii) An asset where the terms of the loan agreement regarding interest and
principal have been re-negotiated or rescheduled after commencement of
production, should be classified as substandard and should remain in such
category for at least 12 months of satisfactory performance under the re-
negotiated or rescheduled terms. In other words, the classification of an asset
should not be upgraded merely as a result of rescheduling, unless there is
satisfactory compliance of this condition.

3) Doubt full assets

With effect from March 31, 2005, an asset is required to be classifieds doubtful,
if it has remained NPA for more than 12 months. For Tier I banks, the 12-
month period of classification of a substandard asset in doubtful category is
effective from April 1, 2009. As in the case of sub-standard assets, rescheduling
does not entitle the bank to upgrade the quality of an advance automatically. A
loan classified as doubtful has all the weaknesses inherent as that classified as
sub-standard, with the added characteristic that the weaknesses Make collection
or liquidation in full, on the basis of currently known facts, conditions and
values, highly questionable and improbable.

Note: Consequent to change in asset classification norms w.e.f. March 31, 2005
banks are permitted to phase the consequent additional provisioning over a five
year period commencing from the year ended March 31, 2005, with a minimum
of 10 % of the required provision in each of the first two years and the balance
in equal installments over the subsequent three years.

4) Loss Assets A loss asset is one where loss has been identified by the bank or
internal or external auditors or by the Co-operation Department or by the
Reserve Bank of India inspection but the amount has not been written off,
wholly or partly. In other words, such an asset is considered un-collectible and
of such little value that its continuance as a bankable asset is not warranted
although there may be some salvage or recovery value.

Guidelines for Classification of Assets

Basic Considerations
(I) broadly speaking, classification of assets into above categories should be
done taking into account the degree of well defined credit weaknesses and extent
of dependence on collateral security for realization of dues.

(ii) In respect of accounts where there are potential threats to recovery on


account of erosion in the value of security and existence of other factors such as,
frauds committed by borrowers, it will not be prudent for the banks to classify
them first as sub-standard and then as doubtful after expiry of 12 months from
the date the account has become NPA. Such accounts should be straight away
classified as doubtful asset or loss asset, as appropriate, irrespective of the
period for which it has remained as NPA.

Internal System for Classification of Assets as NPA

I) Banks should establish appropriate internal systems to eliminate the tendency


to delay or postpone the identification of NPAs, especially in respect of high
value accounts. The banks may fix a minimum cut-off point to decide what
would constitute a high value account depending upon their respective business
levels. The cut-off point should be valid for the entire accounting year.

(ii) Responsibility and validation levels for ensuring proper asset classification
may be fixed by the bank.

(iii) The system should ensure that doubts in asset classification due to any
reason are settled through specified internal channels within one month from the
date on which the account would have been classified as NPA as per extant
guidelines.

(iv) RBI would continue to identify the divergences arising due to non-
compliance, for fixing accountability. Where there is willful non-compliance by
the official responsible for classification and is well documented, RBI would
initiate deterrent action including imposition of monetary penalties.
INCOME RECOGNITION

Income Recognition – Policy


1. The policy of income recognition has to be objective and based
on the record of recovery. Income from non-performing assets
(NPA) is not recognized on accrual basis but is booked as
income only when it is actually received. Therefore, banks
should not take to income account interest on non-performing
assets on accrual basis.
2. However, interest on advances against term deposits, NSCs, IVPs, KVPs and
Life policies may be taken to income account on the due date, provided adequate
margin is available in the accounts.
3. Fees and commissions earned by the banks as a result of renegotiations or
rescheduling of outstanding debts should be recognized on an accrual basis over
the period of time covered by the re-negotiated or rescheduled extension of
credit.
4. If Government guaranteed advances become 'overdue' and
thereby NPA, the interest on such advances should not be
taken to income account unless the interest has been realized.

Provisional norms and disclosure norms of NPA

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 (100%)
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 up to 1-year old, provision should be made of
20% of secured portion, in case of 1-3 year old NPAs up to 30% of the secured
portion and finally in case of more than 3 year old NPAs up to 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 outstanding


should be made.

Standard Assets – general provision of a minimum of 0.25%

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 substantial uncertainty to recovery, higher
provisioning should be made by the bank concerned.

ASSETS PROVISION NORMS


Standard assets General provision of
0.25%
Sub standard assets 10% on total
outstanding balance, 10
% on unsecured
exposures identified as
sub-standard & 100%
for unsecured
“doubtful” assets.
Doubtful debts 100% to the extent
advance not covered by
realizable value of
security. In case of
secured portion, provision
may be made in the range
of 20% to 100%
depending on the period
of asset remaining sub-
standard
Loss assets 100% of the out standing

Disclosure Norms:
Banks should disclose in balance sheets maturity pattern of advances, deposits,
investments and borrowings. Apart from this, banks are also required to give
details of their exposure to foreign currency assets and liabilities and movement
of bad loans. These disclosures were to be made for the year ending March 2000

In fact, the banks must be forced to make public the nature of N.P.As being
written off. This should be done to ensure that the taxpayer’s money given to the
banks, as capital is not used to write off private loans without adequate efforts
and punishment of defaulters. # A Close look: For the future, the banks will
have to tighten their credit evaluation process to prevent this scale of sub-
standard and loss assets. The present evaluation process in several banks is
burdened with a bureaucratic exercise, sometimes involving up to 18 different
officials, most of whom do not add any value (information or judgment) to the
evaluation. But whether this government and its successors will continue to play
with bank funds remains to be seen. Perhaps even the loan waivers and loan
"melas" which are often decried by bankers form only a small portion of the
total N.P.As. As mentioned above, much more stringent disclosure norms are
the only way to increase the accountability of bank management to the
taxpayers. A lot therefore depends upon the seriousness with which a new
regime of regulation is pursued by RBI and the newly formed Board for
Financial Supervision.

Treatment of NPAs – Borrower-wise and not Facility-wise

(i) In respect of a borrower having more than one facility with a bank, all the
facilities granted by the bank will have to be treated as NPA and not the
particular facility or part thereof which has become irregular.

(ii) However, in respect of consortium advances or financing under multiple


banking arrangements, each bank may classify the borrowal accounts according
to its own record of recovery and other aspects having a bearing on the
recoverability of the advances.

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 corporate
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.

Why such huge levels 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.

Health code system

A critical analysis of a comprehensive and uniform credit monitoring was


introduced in 1985-86 by RBI by way of the Health Code System in banks,
which inter alia, provided information regarding the health of individual
advances, the quality of credit portfolio and extent of advances causing in
relation to total advances. It was considered that such information would be of
immense use to bank management for control purposes. The RBI advised all
commercial banks to introduce the Health Code Classification indicating the
quality of individual advances in the following eight categories with a health
code assigned to each borrowal account:
1. Satisfactory: Conduct is satisfactory, all terms and conditions are compiled
with, all accounts are in order, and safety of the account is not in doubt.
2. Irregular: The safety of the advances is not suspected, though there may be
occasional irregularities, which may be considered to be as a short-term
phenomenon.
3. Sick-Viable: Advances to units, which are sick but viable under nursing and
unit in respect of which nursing/revival programs are taken up.
4. Sick-Nonviable/Sticky:

The irregularities continue to persist and there are no immediate prospects of


regularization, the accounts could throw some of the usual signs of incipient
sickness.
5. Advances Recalled: Accounts where the repayment is highly doubtful and
nursing is not considered worthwhile, includes where decisions have been taken
to recall the advances.
6. Suit Filed Accounts: Accounts where legal actions or recovery proceedings
have been initiated.

7. Decreed Debts: Where decrees have been obtained.


8. Bad and Doubtful Debts: Where the recoverability of the banks’ dues has
become doubtful on account of shortfall in value of security, difficulty in
enforcing and realizing the securities, or inability/unwillingness of the borrowers
to repay the banks’ dues partly or wholly.
FACTORS CONTRIBUTING TO NPAs
According to recent study conducted by the RBI, the underlying
reasons for NPAs in India can be classified into two heads, namely:

a) internal factors
b)external factors

INTERNAL FACTORS

The following internal factors contribute to NPAs in the order of performance:

1. Defective Lending process

There are three cardinal principles of bank lending that have been followed by
the commercial banks since long
Principles of safety
Principle of liquidity
Principles of profitability
Principles of safety:-
By safety it means that the borrower is in a position to repay
the loan both principal and interest. The repayment of loan
depends upon the borrowers:

a. Capacity to pay

b. Willingness to pay

Capacity to pay depends upon:


1. Tangible asset
2. success in business
Willingness to pay
Character
Honest
Reputation of borrower
The banker should, there fore take utmost care in ensuring that the enterprise or
business for which a loan is sought is a sound one and the borrower is capable of
carrying it out successfully .he should be a person of integrity and good character.
2. Inappropriate technology- Due to inappropriate technology and
management information system, market driven decisions on real time basis
can not be taken. Proper MIS and financial Accounting system is not
implemented in the banks, which leads to poor credit collection, thus NPA.
All the branches of the bank should be computerized

3. Improper SWOT analysis-The improper strength, weakness, opportunity


and threat analysis is another reason for rise in NPAs. While providing
unsecured advances the banks depend more on the honesty, integrity, and
financial soundness and credit worthiness of the borrower.
• Banks should consider the borrowers own capital investment.
it should collect credit information of the borrowers from_
A. From bankers.
B.Enquiry from market/segment of trade, industry, business.
C.From external credit rating agencies.

• Analyze the balance sheet:-True picture of business will be revealed on


analysis of profit/loss a/c and balance sheet.
• Purpose of the loan

When bankers give loan, he should analyze the purpose of the loan. To ensure
safety and liquidity, banks should grant loan for productive purpose only. Bank
should analyze the profitability, viability, long term acceptability of the project
while financing 4. Poor credit appraisal system--Poor credit appraisal is
another factor for the rise in NPAs. Due to poor credit appraisal the bank gives
advances to those who are not able to repay it back. They should use good credit
appraisal to decrease the NPAs

5. Managerial deficiencies
The banker should always select the borrower very carefully and
should take tangible assets as security to safe guard its interests. When
accepting securities banks should consider the_

1. Marketability
2. Acceptability
3. Safety
4. Transferability.
The banker should follow the principle of diversification of risk based on the
famous maxim "do not keep all the eggs in one basket"; it means that the banker
should not grant advances to a few big farms only or to concentrate them in few
industries or in a few cities. If a new big customer meets misfortune or certain
traders or industries affected adversely, the overall position of the bank will not
be affected.

Like OSCB suffered loss due to the OTM Cuttack, and Orissa hand loom
industries. The biggest defaulters of OSCB are the OTM (117.77lakhs), And the
handloom sector Orissa hand loom WCS ltd (2439.60lakhs).

6. Absence of regular industrial visit--The irregularities in spot visit also


increases the NPAs. Absence of regularly visit of bank officials to the customer
point decreases the collection of interest and principals on the loan. The NPAs
due to willful defaulters can be collected by regular visits.

7.Re loaning process--Non remittance of recoveries to higher financing


agencies and re loaning of the same have already affected the smooth
operation of the credit cycle.
Due to re loaning to the defaulters and CCBs and PACs, the NPAs of OSCB is
increasing day by day.

EXTERNAL FACTORS

The external factors that contribute to NPAs are the following:

1. Ineffective recovery tribunal--The Govt has set of numbers of recovery


tribunals, which works for recovery of loans and advances. Due to their
negligence and ineffectiveness in their work the bank suffers the consequence of
non-recover, their by reducing their profitability and liquidity.

2. Willful Defaults

There are borrowers who are able to payback loans but are intentionally
withdrawing it. These groups of people should be identified and proper measures
should be taken in order to get back the money extended to them as advances
and loans.

3. Natural calamities

This is the measure factor, which is creating alarming rise in NPAs of the PSBs.
every now and then India is hit by major natural calamities thus making the
borrowers unable to pay back there loans. Thus the bank has to make large
amount of provisions in order to compensate those loans, hence end up the fiscal
with a reduced profit.
Mainly ours farmers depends on rain fall for cropping. Due to irregularities of
rain fall the farmers are not to achieve the production level thus they are not
repaying the loans.

4. Industrial sickness

Improper project handling , ineffective management , lack of adequate resources


, lack of advance technology , day to day changing govt. Policies give birth to
industrial sickness. Hence the banks that finance those industries ultimately end
up with a low recovery of their loans reducing their profit and liquidity.

5. Lack of demand

Entrepreneurs in India could not foresee their product demand and starts
production which ultimately piles up their product thus making them unable to
pay back the money they borrow to operate these activities. The banks recover
the amount by selling of their assets, which covers a minimum label. Thus the
banks record the non recovered part as NPAs and has to make provision for it.
6. Change on Govt, policies

With every new govt, banking sector gets new policies for its operation. Thus it
has to cope with the changing principles and policies for the regulation of the
rising of NPAs.

The fallout of handloom sector is continuing as most of the weavers Co-


operative societies have become defunct largely due to withdrawal of state
patronage. The rehabilitation plan worked out by the Central government to
revive the handloom sector has not yet been implemented. So the over dues due
to the handloom sectors are becoming NPAs.

PROBLEMS DUE TO NPAs

1. Owners do not receive a market return on there capital .in the worst case, if
the banks fails, owners loose their assets. In modern times this may affect a
broad pool of shareholders.

2. Depositors do not receive a market return on saving. In the worst case if


the bank fails, depositors loose their assets or uninsured balance.
3. Banks redistribute losses to other borrowers by charging higher interest
rates, lower deposit rates and higher lending rates repress saving and financial
market, which hamper economic growth.

4. Non performing loans epitomize bad investment. They misallocate credit


from good projects, which do not receive funding, to failed projects. Bad
investment ends up in misallocation of capital, and by extension, labour and
natural resources.

IMPACT OF NPA

1. Profitability: -

NPA means booking of money in terms of bad asset, which occurred due to
wrong choice of client. Because of the money getting blocked the prodigality of
bank decreases not only by the amount of NPA but NPA lead to opportunity cost
also as that much of profit invested in some return earning project/asset. So NPA
doesn't affect current profit but also future stream of profit, which may lead to
loss of some long-term beneficial opportunity. Another impact of reduction in
profitability is low ROI (return on investment), which adversely affect current
earning of bank.

2. Liquidity:-

Money is getting blocked, decreased profit lead to lack of enough cash at hand
which lead to borrowing money for shot\rtes period of time which lead to
additional cost to the Company. Difficulty in operating the functions of bank is
another cause of NPA due to lack of money. Routine payments and dues.

3. Involvement of management:-
Time and efforts of management is another indirect cost which bank has to bear
due to NPA. Time and efforts of management in handling and managing NPA
would have diverted to some fruitful activities, which would have given good
returns. Now day's banks have special employees to deal and handle NPAs,
which is additional cost to the bank.
4. Credit loss:-
Bank is facing problem of NPA then it adversely affect the value of bank in
terms of market credit. It will lose its goodwill and brand image and credit
which have negative impact to the people who are putting their money in the
banks.
Preventive measures of NPAs

1. Early Recognition of the Problem:-

Invariably, by the time banks start their efforts to get involved in a revival
process, it's too late to retrieve the situation- both in terms of rehabilitation of
the project and recovery of bank's dues. Identification of weakness in the very
beginning that is: When the account starts showing first signs of weakness
regardless of the fact that it may not have become NPA, is imperative.
Assessment of the potential of revival may be done on the basis of a techno-
economic viability study. Restructuring should be attempted where, after an
objective assessment of the promoter's intention, banks are convinced of a
turnaround within a scheduled timeframe. In respect of totally unviable units as
decided by the bank, it is better to facilitate winding up/ selling of the unit
earlier, so as to recover whatever is possible through legal means before the
security position becomes worse.

2. Identifying Borrowers with Genuine Intent:-

Identifying borrowers with genuine intent from those who are non- serious with
no commitment or stake in revival is a challenge confronting bankers. Here the
role of frontline officials at the branch level is paramount as they are the ones
who have intelligent inputs with regard to promoters' sincerity, and capability to
achieve turnaround. Bases don this objective assessment, banks should decide as
quickly as possible whether it would be worthwhile to commit additional
finance.

In this regard banks may consider having "Special Investigation" of all


financial transaction or business transaction, books of account in order to
ascertain real factors that contributed to sickness of the borrower. Banks may
have penal of technical experts with proven expertise and track record of
preparing techno-economic study of the project of the borrowers.
Borrowers having genuine problems due to temporary mismatch in fund
flow or sudden requirement of additional fund may be entertained at branch
level, and for this purpose a special limit to such type of cases should be
decided. This will obviate the need to route the additional funding through the
controlling offices in deserving cases, and help avert many accounts slipping
into NPA category

3. Timeliness and adequacy of resources

Longer the delay in response, grater the injury to the account and the asset. Time
is a crucial element in any restructuring or rehabilitation activity. The response
decided on the basis of techno-economic study and promoter's commitment, has
to be adequate in terms of extend of additional funding and relaxations etc.
under the restructuring exercise. The package of assistance may be flexible and
bank may look at the exit option.

4. Focus on Cash Flows


While financing, at the time of restructuring the banks may not be guided by the
conventional fund flow analysis only, which could yield a potentially
misleading picture.
Appraisal for fresh credit requirements may be done by analyzing funds flow in
conjunction with the Cash Flow rather than only on the basis of Funds Flow.

5. Management Effectiveness:-

The general perception among borrower is that it is lack of finance that leads to
sickness and NPAs. But this may not be the case all the time. Management
effectiveness in tackling adverse business conditions is a very important aspect
that affects a borrowing unit's fortunes. A bank may commit additional finance
to an align unit only after basic viability of the enterprise also in the context of
quality of management is examined and confirmed. Where the default is due to
deeper malady, viability study or investigative audit should be done - it will be
useful to have consultant appointed as early as possible to examine this aspect.
A proper techno- economic viability study must thus become the basis on which
any future action can be considered.
6. Multiple Financing

A.)During the exercise for assessment of viability and restructuring, a


Pragmatic
and unified approach by all the lending banks/ FIs as also sharing of all
relevant information on the borrower would go a long way toward overall
success
of rehabilitation exercise, given the probability of success/failure.

b). In some default cases, where the unit is still working, the bank should
make sure
that it captures the cash flows (there is a tendency on part of the borrowers
to
switch bankers once they default, for fear of getting their cash flows
forfeited),
and ensure that such cash flows are used for working capital purposes.
Toward
this end, there should be regular flow of information among consortium
members. A bank, which is not part of the consortium, may not be allowed
to
Offer credit facilities to such defaulting clients. Current account facilities
may also be denied at non-consortium banks to such clients and violation
may attract penal action. The Credit Information Bureau of India Ltd.
(CIBIL) may be very useful for meaningful information exchange on
defaulting borrowers once the setup becomes fully operational.

C) In a forum of lenders, the priority of each lender will be different. While one
set of
lenders may be willing to wait for a longer time to recover its dues, another
lender may have a much shorter timeframe in mind. So it is possible that the
letter categories of lenders may be willing to exit, even a t a cost - by a
discounted settlement of the exposure. Therefore, any plan for
restructuring/rehabilitation may take this aspect into account.

D) Corporate Debt Restructuring mechanism has been institutionalized in 2001


to
provide a timely and transparent system for restructuring of the corporate debt
of
Rs. 20 crore and above with the banks and FIs on a voluntary basis and outside
the legal framework. Under this system, banks may greatly benefit in terms of
restructuring of large standard accounts (potential NPAs) and viable sub
standard accounts with consortium/multiple banking arrangement

Different Approaches to Valuation of Non Performing Assets

N.P.As are by-product of most financial systems and the level of N.P.As is an
indicator of the health of the financial system of an economy. Valuation
techniques should present the situation, which maximize the overall interest of
all the concerned parties.

The broad objectives of the valuation framework are essentially:


1. To set a sound basis for the selling bank/institution to finalize the
Sale of assets,
2. To provide a basis for the fair market value of the assets,
3. To promote transparency of the valuation processes and,.
4. To comply with internationally accepted practices.

The valuation of an asset or the pool of assets is a precursor to any


restructuring exercise. Any valuation exercise shall attempt to address the
following issues:
• The fair market value of the asset should represent the price at which
market participants would undertake a restructuring.
• The transaction value should reflect the potential for income generation and
return of principal, balanced against the applicable risk profile and market
lending margins.
• The valuation framework should allow for valuation of specific assets as
well as a portfolio of assets (i.e. portfolio of loans to be acquired from a
bank.) In most cases, a single value will apply to each loan required. For
larger loans, however, an element of risk/return sharing with the selling
bank may be considered.

There are various methodologies used to value the companies or their debt.
Typically, cash flows, assets or replacement values, or a combination of these,
are considered when determining the value of the company or its debt. Some of
the widely used approaches towards valuation of an NPA by the valuation firms
are detailed as under:
1. Discounted Cash Flows
One of the commonly used methods for estimating the value of the company’s
debt is the anticipated cash flow. The cash flow stream will represent the interest
and principal payments expected to be received by the lender, primarily out of
the internal cash flow generation from underlying business activities. Where the
asset is a partly completed project, the cash flow stream will have to take onto
account whether the project will be completed and if so how it will be financed.
If certain lenders decide to fund through extended facility, this will be taken into
account I the asset’s cash flow stream. Essentially the decision on the project’s
financial viability will be determined by using an incremental cash flow
analysis. Normally, the value of a healthy asset is computed as the discounted
value of the expected future cash flows. However, a company is distress or an
NPA may have negative earnings and may be likely to incur operating losses for
the next few years. For such companies, the estimation of future cash flows is
not so easy, as there is a strong possibility of bankruptcy. Under such a scenario
the asset valuation is also based on subjective parameters. A company under
financial distress has some or all of the following characteristics: operating loss,
inability to meet the debt obligations and high debt equity ratio. When dealing
with such cases, the credit analysts need to evaluate the possibility and timing of
positive financial performance of the company of infusion of additional funds
and the overall macro economic environment. If the company is expected to
improve its financial position in the future, the following discounted cash flow
model may be used for the distress companies/ NPAs.

2. Liquidation Value Approach


If the loan is in default with no or low expectations of its being services, the
cash flow from liquidation of the asset and collateral will be the primary
approach rather than net present value of the cash flow. In this case, the take out
of the lender is primarily by way of exercise of their rights on the assets and
attached collateral. The liquidation value of the company is the aggregate of the
value of the assets of the company if solid at the market rates, net of transactions
and legal costs. The estimation of the assets becomes quite complicated when
the assets of the company cannot be easily separated like in a steel, textile or
petrochemical plant. If such assets are sold individually, majority of the asset
may not fetch a price closer to their books value. Further, when such sale is to
take place at a quick place, the value of the assets further fall down, as it is more
or less equal to forced sale of the assets. As a result of this forced sale, the seller
has to accept a discount on the fair market value of such assets. In most cases,
such a realization is not able to cover even the secured debt fully and hence the
valuation of the debt would be limited by this realized value. This approach has
been widely used in countries like Thailand where a significant number of loans
were secured by real estate and other marketable securities of various kinds.

3. Earning Model

In performing companies, the P/E ration of the industry or other similar


companies may be used as a tool for determining the market value of the assets
of company. If the debt of the company is more than its assets, then a
proportionate discount may be applied to the debt. The above approach,
however, cannot be used for most of the N.P.As, as they would have negative
EPS. In such cases, the cash earning per share of the company and cash P/E ratio
of the similar companies may be used to arrive at a market value of the NPA
debt.

4. Case Specific Valuation Model -


Depending on case to case, various models have been evolved and used for
specific requirements. I shall discuss here one of such models to provide an
insight as to how provide varied models can be from the conventional
approaches.

Segmentation into buckets:


For a huge portfolio of small loans, different kind of approach may be used for
arriving at the realistic valuation. One of them is categorizing the loans in
various buckets and then analyzing a sample picked from various buckets. Post
currency crisis of late 1990’s in Thailand, the price of real estate had declined to
abysmally low levels and majority of the property-linked loans had become
N.P.As in the books of the local banks. One of the leading financial companies
in the world was contemplating to purchase these loans totaling over 20,000
small loans. For arriving at the appropriate valuation, they had followed the
following methodology:

■ Segmentation of the assets in various buckets.

■ Selection of a sample out of each bucket.


■ Detailed analysis of each sample.
■ Statistical extrapolation of the sample to the entire bucket.
■ Arriving at the final range of the valuation of the portfolio.
1. LokAdalat:

Lok Adalat institutions help banks to settle disputes involving account in


"doubtful" and "loss" category, with outstanding balance of Rs.5 lakh for
compromise settlement under Lok Adalat. Debt recovery tribunals have been
empowered to organize Lok Adalat to decide on cases of NPAs of Rs. 10 lakh
and above. This mechanism has proved to be quite effective for speedy justice
and recovery of small loans. The progress through this channel is expected to
pick up in the coming years.

Referring the cases to lakadalats constituted under the legal services


authorities act, 1987 which help in resolving disputes between the parties by
conciliation, mediation, compromise, or amicable settlement. Every award of
the lokadalt shall be deemed to be a decree of a civil court.

2. CDR: -Corporate Debt Restructuring mechanism has been institutionalized


in 2001 to provide a timely and transparent system for restructuring of the
corporate debt of Rs. 20 crore and above with the banks and FIs on a voluntary
basis and outside the legal framework. Under this system, banks may greatly
benefit in terms of restructuring of large standard accounts (potential NPAs) and
viable substandard accounts with consortium/multiple banking arrangements.

The objective of CDR is to ensure a timely and transparent mechanism for


restructuring of the debts of viable corporate entities affected by internal and
external factors, outside the purview of BIFR, DRT or other legal proceedings.

The legal basis for the mechanism is provided by the Inter-Creditor Agreement
(ICA). All participants in the CDR mechanism must enter the ICA with
necessary enforcement and penal clauses.

The scheme applies to accounts having multiple banking/ syndication/


consortium accounts with outstanding exposure of Rs.10 crore and above. The
CDR system is applicable to standard and sub-standard accounts with potential
cases of NPAs getting a priority. Packages given to borrowers are modified time
& again Drawback of CDR – Reaching of consensus amongst the creditors
delays the process

3.DRT ACT: -
The banks and FIs can enforce their securities by initiating recovery proceeding
under the Recovery if Debts due to Banks and FI act, 1993 (DRT Act) by filing
an application for recovery of dues before the Debt Recovery Tribunal
constituted under the Act. On adjudication, a recovery certificate is issued and
the sale is carried out by an auctioneer or a receiver.

DRT has powers to grant injunctions against the disposal, transfer or creation of
third party interest by debtors in the properties charged to creditor and to pass
attachment orders in respect of charged properties. In case of non-realization of
the decreed amount by way of sale of the charged properties, the personal
properties if the guarantors can also be attached and sold. However, realization
is usually time-consuming. Steps have been taken to create additional benches.

3. PROCEEDING UNDER CODE OF CIVIL PROCEDURE: -

For claims below Rs.10 lacks, the banks and FIs can initiate proceedings under
the Code of Civil Procedure of 1908, as amended, in a civil court.

The courts are empowered to pass injunction orders restraining the debtor
through itself or through its directors, representatives, etc from disposing of,
parting with or dealing in any manner with the subject property.
Courts are also empowered to pass attachment and sales orders for subject
property before judgment, in case necessary.

The sale of subject property is normally carried out by way of open public
auction subject to confirmation of the court. The foreclosure proceedings, where
the DRT Act is not applicable, can be initiated under the Transfer of Property
Act of 1882 by filing a mortgage suit where the procedure is same as laid down
under the CPC.

4. BIFR AND AIFR:-

BIFR has been given the power to consider revival and rehabilitation of
companies under the Sick Industrial Companies (Special Provisions) Act of
1985 (SICA), which has been repealed by passing of the Sick Industrial
Companies (Special Provisions) Repeal Bill of 2001.

The board of Directors shall make a reference to BIFR within sixty days from
the date of finalization of the duly audited accounts for the financial year at the
end of which the company becomes sick. The company making reference to
BIFR to prepare a scheme for its revival and rehabilitation and submit the same
to BIFR the procedure is same as laid down under the CPC.The shelter of BIFR
misused by defaulting and dishonest borrowers It is a time consuming process.

7. NATIONAL COMPANY LAW TRIBUNAL:-

In December 2002, the Indian Parliament passed the Companies Act of 2002
(Second Amendment) to restructure the Companies Act, 1956 leading to a new
regime of tackling corporate rescue and insolvency and setting up of NCLT.

NCLT will abolish SICA; have the jurisdiction and power relating to winding up
of companies presently vested in the High Court and jurisdiction and power
exercised by Company Law Board

The second amendments seeks to improve upon the standards to be adopted to


measure the competence, performance and services of a bankruptcy court by
providing specialized qualification for the appointment of members to the
NCLT.

However, the quality and skills of judges, newly appointed or existing, will need
to be reinforced and no provision has been made for appropriate procedures to
evaluate the performance of judges based on the standards
Writing off of NPAs

1. In terms of Section 43(D) of the Income Tax Act 1961, income by way of
interest in relation to such categories of bad and doubtful debts as may be
prescribed having regard to the guidelines issued by the RBI in relation to
such debts, shall be chargeable to tax in the previous year in which it is
credited to the bank’s profit and loss account or received, whichever is
earlier.
2. This stipulation is not applicable to provisioning required to be made as
indicated above. In other words, amounts set aside for making provision for
NPAs as above are not eligible for tax deductions.
3. Therefore, the banks should either make full provision as per the
guidelines or write-off such advances and claim such tax benefits as are
applicable, by evolving appropriate methodology in consultation with their
auditors/tax consultants. Recoveries made in such accounts should be
offered for tax purposes as per the rules.

4 Write-off at Head Office Level


Banks may write-off advances at Head Office level, even though the
relative advances are still outstanding in the branch books. However, it is
necessary that provision is made as per the classification accorded to the
respective accounts. In other words, if an advance is a loss asset, 100
percent provision will have to be made therefore.
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 hand managing 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 is 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 at least be 8% of their
risk-weighted assets. This in fact 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 corporate.
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 corporate 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 Securitization 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 is 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 Securitization Act, 2002 would be
defeated and the hope of seeing a must have growing banking sector can easily
vanish.
Reporting of NPAs to RBI
1) Banks are required to furnish a Report on NPAs as on 31st March each year
after completion of audit. The NPAs would relate to the banks’ global portfolio,
including the advances at the foreign branches. The Report should be furnished
as per the prescribed format given in the Annex I.

2) While reporting NPA figures to RBI, the amount held in interest suspense
account, should be shown as a deduction from gross NPAs as well as gross
advances while arriving at the net NPAs and net advances. Banks which do not
maintain Interest Suspense Account for parking interest due on non-performing
advance accounts, may furnish the amount of interest receivable on NPAs as a
foot note to the Report.

3) Whenever NPAs are reported to RBI, the amount of technical write off, if
any, should be reduced from the outstanding gross advances and gross NPAs to
eliminate any distortion in the quantum of NPAs being reported.

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