What are NPAs? Here’s how bad loans can affect a bank’s finances

What do you know about NPAs? Find out here

What are NPAs? Here’s how bad loans can affect a bank’s finances

A non-performing asset (NPA) is a banking industry term for a ‘bad loan’ – i.e. one that has not been repaid within the stipulated time, or where the scheduled payments are in arrears. A bank’s assets are the loans and advances it extends to customers. If these clients, including companies, do not repay either interest or part of principal or both, the loan turns into a bad loan.

Monetary watchdog Reserve Bank of India (RBI), while laying down in detail the various circumstances when a loan will be deemed an NPA, broadly defines non-performance thus: “An asset, including a leased asset, becomes non­-performing when it ceases to generate income for the bank.”

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Current NPA situation

Today, Indian banks are so saddled with bad debts that they figure among the worst in the world in this respect, and definitely the worst in the BRICS bloc. As per CARE Ratings, India’s second-largest credit rating agency, India falls in a group of countries beset with a ‘high level of NPAs’ – a collection of the world’s worst performers led by Greece. The only other BRICS nation in India’s group is Russia, which has a lower (better) NPA ratio than India’s. 

Two other BRICS nations, Brazil and South Africa, are in a group with a medium level of NPAs, while the remaining member, China, features alongside the best – with those that have a low level, such as the US, Norway, Sweden, and Germany, among others. 

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While there is no official ‘acceptable’ limit for NPA, it is considered manageable if the banking industry in any country has bad loans within 3%. Compared with most BRICS members, India fares quite poorly: China’s NPA stands at 1.75%, Brazil’s at 3.69% and South Africa at 2.83%, while India’s NPA is a steep 9.85%.

According to a PwC India report, the NPA crisis has been long in making – since 2008, when Lehman Brothers collapsed, and triggering a global financial crisis that hit the Indian shores as well, impacting domestic companies here.

With the meltdown threatening to upset the economy, the Indian government poured money into domestic banks so they could restructure their loans to borrower companies, and help them with more time and easier terms of repayment. The bulk of the restructuring was through PSU banks; thereafter, loan restructuring became commonplace, adding to the losses for the banks. 

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The sectors that have hurt Indian banks the most were the basic metals and cement industries – reflecting 45.8% and 34.6% stressed assets respectively, says the PwC India report. ‘The numbers are unlikely to improve as the metal industry continues to be hamstrung by slow demand and cheaper imports,’ it warns. 

An analysis by the Indian Express newspaper in March 2018 also identifies corporate borrowers, rather than retail borrowers, as creating the most mess; corporate loans accounted for over 73% of the total NPAs in 2016-17, while retail loans, which make up nearly 23% of the overall credit, contributed only 3.7%.

What all this means in hard numbers is that the gross NPAs for 36 banks – both state-owned and private – have risen to Rs 8.72 lakh crore over a year till September 2018-end, according to data collated by Moneycontrol. 

Accounting for NPAs

Goaded by the RBI and led by the State of Bank of India (SBI), banks have now taken initiatives to recoup the dues. In November, SBI put 11 NPAs on the auction block in a bid to recoup some of their losses – to the tune of a little over Rs 1000 crore. 

Three more PSU lenders announced they would join SBI in selling their NPAs to asset reconstruction companies and other financial institutions. The total value of the assets on sale between the four: nearly Rs 7500 crore. 

The move comes in the wake of an RBI directive to the banks towards the end of 2015 to pull up their socks after it realised they were underreporting their NPAs by postponing bad-loan classification and evergreening loan accounts.

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In fact, two years earlier, the then RBI Deputy Governor KC Chakraborty had accused banks of writing off bad loans without putting in any genuine effort to recover them. In fact, he identified several other shortcomings on the part of the banks, all of which added to the slippages – i.e. fresh accretion to NPAs; according to him, the banks themselves fuelled the NPA situation, rather than the 2008 global meltdown, which is cited often as the cause. 

“Contrary to the popular notion that the rising NPAs are a fallout of the global financial crisis… credit administration in the banks had started weakening and the asset quality had started deteriorating even before the onset of the crisis,” Chakraborty had said at a banking conference in November 2013.

Describing the practice of write-offs as “a pointer to weaknesses in credit management” of banks, he also said this “contributed significantly to the reduction in the quantum of gross NPAs”, sometimes by as much as 50% of reductions. “These practices clearly engender moral hazard issues as they reduce the banks’ drive to improve recovery efforts.”

In 2015, RBI decided to carry out an Asset Quality Review (AQR), or inspection of balance sheets, on select banks after it became quite apparent then some corporates were playing the system – squaring off the dues of some banks and holding back with others. RBI prepared a list of such companies and asked the banks, including those which were being repaid, to classify them as defaulters.

It was this AQR in 2015 that forced banks to start recognising restructured assets as NPAs, manifest in the November sales of assets by SBI and the others. 

Impact of NPAs

In its Nov-Dec 2016 issue, the IOSR Journal of Economics and Finance published the findings of researchers from Amity University, Rajasthan, who studied the impact of NPAs. Their take: if loan non-recovery balloons, the bank’s financials get hit – net interest margin (NIM), profitability, return on assets, dividend payout, etc. Moreover, credit inflow is also jeopardised as its very financial soundness comes under the scanner.

Let us look at the different areas they identified: 

  • Profitability: The researchers found that the practice of provisioning on account of incremental NPAs (25%-30%) often led to the bank’s profitability getting reduced
  • Credit contraction: Burgeoning NPAs reduces recycling of funds, and by extension, also that of the bank’s ability to lend more. This, in turn, results in interest income decline. On a macro level, it contracts money circulation that can lead to an economic slowdown
  • Liability management: High NPAs frequently goad banks to lower interest rates on deposits and raise that on advances to sustain NIM. This may prove a hurdle to growth
  • Capital adequacy: Expanding NPAs add to the risk-weighted assets; this means the bank has to buttress its capital base further as per Basel norms on risk-weighted assets. This can mean borrowing at a high-interest rate
  • Shareholders’ returns: When high incidence of NPAs affects profitability, also hurt are bank’s shareholders; they are not only deprived of expected returns, but also find the value of their investments eroded. (RBI guidelines stipulate that banks with net NPA level of 5% and above take prior permission from it to declare dividend or cap the dividend payout)
  • Credibility: The credibility of the banking system also gets hit, which can affect the economy as a whole

Last words

When a loan account is categorised as an NPA, any one of the following two recourses are open to the bank as the lender: 

  1. It can write off the loan, in which case the bank assumes that the loan is a loss it has to bear. This was the prevalent practice during 2006-2015 that RBI’s deputy governor Chakraborty spoke against. 
  2. The bank can sell the loss-making NPA to an Asset Reconstruction Company (ARC), which is what SBI and other banks have started doing since November. This way, the bank recovers a part of the loan amount instead of losing the entire sum.

In case of individual defaulters, banks can take the following measures:

  • Send a legal notice to the defaulter for repayment
  • Initiate an auction process
  • Seal the property

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