Substandard Assets or NPAs: Understanding Loan Classification – UPSC Economy Notes

In the realm of banking and finance, the term “Substandard Assets” or “Non-Performing Assets (NPAs)” carries significant weight, serving as key indicators of a financial institution’s health and risk management practices. These terms refer to loans or advances that are either overdue for payment or exhibit a higher likelihood of default, jeopardizing the lender’s ability to recover the principal and interest. Understanding the classification of loans into these categories is crucial for both financial institutions and regulatory bodies, as it enables effective risk assessment, allocation of resources, and implementation of remedial measures to mitigate potential losses. Delving into the nuances of Substandard Assets and NPAs unveils the intricate dynamics of loan quality assessment, provisioning norms, and the broader implications for the stability of the banking sector.

When a borrower fails to make both interest and principal payments for a specified duration, the loan is deemed non-performing. This non-performing status, or Non-Performing Asset (NPA), undergoes different phases as the repayment delays. Specifically, when a borrower defaults for 90 days, the loan is classified as NPA, initially termed as a ‘Special Mention Account’ (SMA). If the loan remains in the SMA category for less than or equal to 12 months, it is labeled as a Sub-Standard Asset.

Sub-Standard Asset Classification:

• A sub-standard asset necessitates a provision of 15% on the secured portion and 25% on the unsecured exposure.
• After 12 months as a sub-standard asset, it progresses to the Doubtful Asset 1 (DA1) stage, requiring a provision of 25% on the secured portion and 100% on the unsecured portion.

Bank Loans: Good and Bad:

All bank loans fall into two categories – standard or substandard loans.

• Standard Assets:
  • These are performing assets with regular servicing of principal and interest payments as per the agreed contract.
• Doubtful Asset Classification:
  • If an account crosses one year as DA1, it transforms into Doubtful Asset 2 (DA2 – 1 to 3 years), necessitating a provision of 40% on the secured portion and 100% on the unsecured portion.
  • After three years, it becomes Doubtful Asset 3 (DA3), requiring a 100% provision, irrespective of available security. In essence, it becomes a loss-making asset. Unsecured loans, like clean loans and educational loans, attract a 100% provision even at the DA1 stage.

Fraudulent Accounts:

• Accounts classified as fraud do not follow the usual progression through these stages. Instead, they demand a 100% provision as soon as they are categorized as NPA. These provisions impact profits, thereby eroding the bottom line.

Understanding these classifications is crucial for banks to manage risks effectively and ensure the health of their loan portfolios.

Stressed Assets: Understanding the Challenges and Measures

When an asset displays weakness and is on the verge of becoming a Non-Performing Asset (NPA), it is termed a stressed asset. The Reserve Bank of India (RBI) permits prevention of its progression to NPA status through restructuring, involving softer terms such as rescheduled repayment periods, lower interest rates, additional financial assistance, etc. Despite their weakness, stressed assets are classified as standard assets.

Additional Disclosures and Concerns:

RBI mandates banks to disclose information about restructured loans, including the number of proposals received and the amount involved. By 2018, approximately 11% of total loans given by banks turned into bad loans, with over 90% belonging to public sector banks. This figure rises when considering all troubled loans, encompassing restructured assets, written off loans, and bad loans yet to be recognized.

Causes of NPAs:

Various factors contribute to Non-Performing Assets:

• Bad lending practices.
• Economic slowdown.
• Challenges faced by power distribution companies (discoms) due to government policies.
• Losses incurred by steel companies from import competition.
• Hindrances faced by infrastructure companies in obtaining clearances due to environmental reasons, natural calamities, and business cycles.
• Wilful defaulters influenced by crony capitalism.

Impact of High NPAs:

The high levels of NPAs have several ramifications:

• Diminished profitability for banks.
• Capital locked up.
• Increased borrowing costs as lendable assets shrink.
• Decline in stock prices, causing losses for investors.
• Negative impact on the overall economy.
• Potential loss for employees and depositors if banks have to close down.
• Budgetary pressure due to necessary bailouts.

Measures Taken to Address NPAs:

Several measures and acts have been implemented to tackle NPAs:

• Provisioning.
• Adherence to Basel 3 norms for capital adequacy.
• SARFAESI Act.
• Asset Reconstruction Companies (ARCs).
• Foreclosure (closing loans before the due date and taking over mortgaged property if terms are not met).
• One-time settlement.
• Interest waiver.
• Write-offs/write-downs.
• Debt recovery tribunals.
• Insolvency and Bankruptcy Code (IBC).
• Banking Regulation Act 2017.
• Recapitalization bonds.

While Corporate Debt Restructuring, Sustainable Structuring of Stressed Assets (S4A), and Strategic Debt Restructuring were practiced before the IBC came into effect in 2017, they were subsequently abolished by the RBI.

Securitization and Foreclosure:

• Securitization involves converting loan-related documents into securities and selling them in the market.
• Foreclosure is the lender closing the loan before the due date and taking over the mortgaged property if the borrower fails to comply with mortgage terms.

Asset Reconstruction Company (ARC): A Catalyst for NPA Resolution

Some Non-Performing Assets (NPAs) have the potential for revival, contributing not only to job creation but also to the national output. However, effective management and timely interventions are essential for making these assets productive and profitable. Asset Reconstruction Companies (ARCs) emerge as a solution in this context.

Key Aspects of ARCs:

1. Regulation and Licensing:
   • The Reserve Bank of India (RBI) issues licenses for ARCs and regulates their operations.
2. Narasimham Committee Recommendations:
   • The Narasimham Committee on the Banking Sector recommended the use of ARCs to take NPAs off the lender’s books at a discount.
3. Functions under SARFAESI Act:
   • ARCs, operating under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI Act), can purchase NPAs from banks and other financial institutions.
   • Benefits of ARCs under SARFAESI Act include monetizing NPAs, cleaning up bank balance sheets, allowing the financial system to focus on core activities, and facilitating the development of a market for distressed assets.
4. Functions According to RBI:
   • According to the RBI, ARCs perform several crucial functions:
     • Acquisition of financial assets.
     • Change or takeover of management.
     • Rescheduling of debts.
     • Settlement of dues payable by the borrower.
5. Legislative and Regulatory Changes:
   • The Government of India has made legislative and regulatory changes to create an enabling operational environment for ARCs. These changes include allowing 100% Foreign Direct Investment (FDI) in ARCs.
6. Opportunities for Fresh Investments:
   • The success of ARCs could initiate a positive cycle, fostering fresh investments, generating new jobs, and creating additional demand.
7. Role in Insolvency and Bankruptcy Code (IBC) 2016:
   • The Insolvency and Bankruptcy Code (IBC) 2016 provides opportunities for asset reconstruction companies to play a crucial role in the resolution of stressed assets.

ARCs, with their capacity to revitalize NPAs and contribute to economic rejuvenation, serve as important entities in the financial landscape. Their success has the potential to unlock new avenues for growth and development.

Asset Quality Review (AQR): Ensuring Genuine Asset Classification

Bank management’s focus on the quality of loans is crucial, as it directly impacts the bank’s earnings. However, there may be instances where banks are hesitant to classify a loan as bad, employing tactics such as evergreening or window dressing. In such practices, banks might extend further loans to defaulting borrowers to encourage repayment with borrowed money, presenting the loan as standard in the bank’s balance sheet.

Evergreening and Window Dressing:

• Evergreening: Continually renewing or rolling over loans to avoid classifying them as non-performing assets (NPAs).
• Window Dressing: Manipulating financial statements to present a more favorable picture than the actual financial health.

Challenges of Genuine Asset Classification:

• Reluctance to classify loans as NPAs to avoid setting aside additional capital as security.
• NPAs restrict the lending capacity of banks, impacting their financial health.

Asset Quality Review (AQR) – RBI’s Intervention:

• In response to concerns about the authenticity of asset classifications, the Reserve Bank of India (RBI) initiated special inspections known as Asset Quality Review (AQR) in 2015-16.

Objectives of AQR:

1. Ensure Genuine Asset Classification:
   • Verify that the asset classification made by banks accurately reflects the quality of their loans.
2. Prevent Evergreening and Window Dressing:
   • Identify and prevent practices like evergreening and window dressing that may compromise the true health of the bank’s loan portfolio.
3. Reveal Actual Extent of NPAs:
   • Uncover the actual extent of non-performing assets, providing a more transparent picture of the bank’s financial condition.

Subsequent AQRs:

• Following the initial AQR in 2015-16, RBI continued to conduct additional AQRs in subsequent years, shedding light on the real magnitude of NPAs in the banking sector.

Significance of AQR:

• AQR serves as a critical tool for regulatory authorities to assess and address issues related to the classification and health of assets within the banking system.

Long-Term Impact:

• While addressing immediate concerns, AQRs contribute to the long-term stability of the banking sector by promoting transparency and genuine asset classification.

Prompt Corrective Action (PCA): Safeguarding Financial Stability

In its role as the guardian of financial stability and banking health, the Reserve Bank of India (RBI) has implemented a Prompt Corrective Action (PCA) framework. This framework comes into play when certain predetermined risk thresholds are breached, addressing concerns related to asset quality, profitability, capital, and non-performing assets (NPAs).

Key Components of PCA:

1. Risk Thresholds:
   • PCA is activated when specific risk thresholds are exceeded, indicating potential financial stress for the bank.
2. Remedial Measures:
   • Once PCA is triggered, RBI instructs the banks to adopt remedial measures to address the identified risks.
3. Restrictions and Actions:
   • PCA norms empower the regulator to impose various restrictions on banks, including:
     • Halting branch expansion.
     • Suspending dividend payments.
     • Capping lending limits to a specific entity or sector.
4. Additional Corrective Actions:
   • Beyond restrictions, PCA allows for additional corrective actions such as:
     • Special audits.
     • Restructuring operations.
     • Activation of recovery plans.
5. Management Policies and Board Supersession:
   • Banks under PCA may be required to implement new management policies. In extreme cases, RBI reserves the right to supersede the bank’s board under the PCA framework.
6. Applicability and Exclusions:
   • PCA is applicable solely to commercial banks and does not extend to cooperative banks and non-banking financial companies (NBFCs).

Objectives of PCA:

1. Prevent Crises:
   • PCA is designed to prevent financial crises by proactively addressing risks within the banking system.
2. Ensure Timely Corrective Actions:
   • By setting predefined risk thresholds, PCA ensures that corrective actions are initiated promptly when the financial health of a bank is at risk.
3. Protect Stakeholders:
   • PCA safeguards the interests of various stakeholders, including depositors, by maintaining the stability and integrity of the banking sector.

The PCA framework serves as a vital regulatory tool, allowing RBI to intervene when necessary and take corrective measures to maintain the overall health and stability of the banking industry.

FAQs

Q: What are Substandard Assets or NPAs?

A: Substandard Assets, also known as Non-Performing Assets (NPAs), refer to loans or advances that have stopped generating income for the lender. These loans typically exhibit signs of credit weakness, such as late payments or failure to meet interest or principal repayments for a specified period. In essence, they pose a higher risk of default, impacting the lender’s financial health.

Q: How are NPAs Classified?

A: NPAs are classified based on the duration of overdue payments. In most banking systems, loans are classified into categories such as Substandard, Doubtful, and Loss assets. Substandard assets are those where the possibility of full recovery is low but not impossible. The classification criteria vary across jurisdictions, but common indicators include overdue payments, deterioration in the borrower’s financial condition, and the probability of repayment.

Q: What Causes Substandard Assets to Accumulate?

A: Various factors contribute to the accumulation of substandard assets. Economic downturns, industry-specific issues, poor credit appraisal processes, inadequate risk management practices, and borrower-related factors such as business failure or insolvency can all lead to loans becoming non-performing. Additionally, external factors like changes in government policies or global economic trends can impact borrowers’ ability to repay loans, further exacerbating the NPA problem.

Q: What are the Impacts of NPAs on Financial Institutions?

A: NPAs have significant implications for financial institutions. They weaken the institution’s balance sheet, erode profitability, and reduce the availability of funds for productive lending activities. Moreover, high NPA levels can tarnish the institution’s reputation, leading to loss of investor confidence and increased regulatory scrutiny. To mitigate these risks, banks often set aside provisions to cover potential losses associated with NPAs, which can affect their overall financial performance.

Q: How Do Financial Institutions Address NPAs?

A: Financial institutions employ various strategies to address NPAs and minimize their adverse effects. These strategies may include restructuring loans, offering concessions to borrowers, initiating recovery proceedings through legal channels, or selling off NPAs to asset reconstruction companies. Additionally, banks focus on strengthening credit appraisal processes, implementing effective risk management frameworks, and promoting early detection and resolution of potential NPA accounts to prevent their escalation. Ultimately, proactive management of NPAs is crucial for maintaining the stability and sustainability of financial institutions.

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