A short note on NPAs and their impact on Economies

NPAs is the short form of Non-Performing Assets. As per the standard definition of NPAs, Non-Performing Assets are the loans and advances issued by banks or financial institutions, on which, the default is done by the borrower, and they do not bring any money in the form of interest or principal, back to the lender within a time span as stipulated in Master Circular – Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances. (October 1, 2021). “An asset becomes non-performing when it ceases to generate income for the bank.” Said RBI in a circular dated 2007.

The banks are in the business of making money by lending out the surplus funds from the deposits of retail investors. The money that they use for lending is an asset for them, as that money generates income for the bank. The banks charge interest on the money lent out. Once the borrower, be it any individual or corporate, fails to return the principal amount lent and the interest thereof and a stipulated period passes from the principal and interest due date, the asset is known to be a non- performing asset.

The regulations relating to Non-Performing Assets are provided in RBI’s Master Circular – Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances. (October 1, 2021).

As per the master circular, non-performing asset is a loan or advance where:

a)???? Interest or installment of principal remain overdue for a period of more than 90 days

b)???? The account remains ‘out of order’, in respect of an Overdraft / Cash Credit (OD/CC). As per the regulation 2.2 of the Master Circular, an account should be treated as ‘out-of-order’ if the outstanding balance remains continuously in excess of sanctioned limit/drawing power for 90 days.

c)???? The bill remains overdue for a period of more than 90 days in the case of bill purchased and discounted.

d)???? The instalment of principal or interest thereon remains overdue for two crop seasons for short duration crops.

e)???? The instalment of principal or interest thereon remains overdue for one crop season for long duration crops.

f)????? The amount of liquidity facility remains outstanding for more than 90 days, in respect of a securitization transaction undertaken in terms of Reserve Bank of India (Securitization of Standard Assets) Directions, 2021.

g)???? In respect of derivative transactions, the overdue receivables representing positive mark-to-market value of a derivative contract, if these remain unpaid for 90 days from the specified due date of payment.

h)???? An account can also be classified as NPA in terms of paragraph 2.4.2 –‘Accounts with temporary deficiencies’ of the Master Circular, which should be based on record of recovery.

To curb the issue of NPAs and to improve the recovery rate of lenders in India, the key laws/regulations that have been promulgated by Government of India in consultation with RBI are:

1)???? Recovery of Debts Due to Banks and Financial Institutions Act, 1993: RDDBFI Act was aimed at removing the deficiency of over burdening of the courts, due to defaults made by the borrowers, and establishing the Debt Recovery Tribunals for speedy recovery of debts.

2)???? The Securitization and the Reconstruction of Financial Assets and Enforcement of Securities Interests Act, 2002 (“SARFAESI Act”): SARFAESI was again enacted as a revolutionary approach to recovering money without the intervention of the courts as per the recommendations of Narsimhan Committee. In this Act, the Banks were empowered to take control of the assets of the defaulter with the help of local magistrate through the prescribed procedure. ARCs (Asset Reconstruction Companies) were established aiming at bringing about a system of unlocking the stressed assets of the banks and financial institutions.

3)???? Insolvency and Bankruptcy Code, 2016: IBC was drafted by a specially constituted ‘Bankruptcy Laws Reform Committee’, BLRC under ministry of finance. The Code offers uniform legislation encompassing all companies, partnerships, and individuals (other than FIs).

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“An alternative approach is to try to put the stressed project back on track rather than simply applying band aids. This may require deep surgery. … But to do deep surgery such as restructuring or writing down loans, the bank has to recognize it has a problem – classify the asset as a Non-Performing Asset (NPA). Think therefore of the NPA classification as an anesthetic that allows the bank to perform extensive necessary surgery to set the project back on its feet.”

-??????? Professor Raghuram Rajan

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The non-performing assets are detrimental to the economy of any country. They put a burden on the economy and stress out the already existing assets, at times resulting in the collapse of banking and financial institution systems of a country. Loans and advances are the assets of any bank and financial institution. They help them generate money to keep their activities ongoing and keeping the FIs afloat. When these assets do not perform as expected, or in other words they do not bring in the desired profits to the bank, they are termed as Non-Performing Assets. Non-Performing assets, as classified in the Master Circular of RBI, if fail to bring the principal or interest back to the lending institution in a stipulated time, are categorized as Non-Performing Assets. Indian public sector banks collectively owed approximately 5.42 trillion Indian rupees in non-performing assets in fiscal year 2022. However, the Gross and Net NPA ratios have fallen from a high of 11.5 per cent and 6.1 per cent in March 2018 to 3.9 per cent and 1.0 per cent in March 2023. This is because of the Banking Sector Reforms and enactment of legislations that bring about the stability of recovery mechanisms in the banking sector.

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They There are several reasons for rising NPAs in India, which are listed below:

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1)???? Poor project evaluation: While financing a project or lending out loans for projects, the bank must critically evaluate the project. They must perform the required financial and operational due diligence and ensure checks and balances on the project. They must ensure that the project meets the requisite guidelines of profit generation and completion timelines. An examination of cashflows over a period of time must also be done, along with the risk evaluation at various stages of the project. However, banks fail to do a foolproof evaluation of the project and borrowers, resulting in high default rates.

2)???? Extensive project delays: When a project is conceptualized, it takes into account certain funding requirements. The mismanagement of the project or some unforeseen circumstances pose unprecedented delays on the project. There could be many reasons for the delays. They could be attributed to loss of interest of management and lenders, over optimism at the time of taking up the project, delay in obtaining government permissions and foot dragging. These delays escalate the cost of stalled projects, which leads to defaults.

3)???? Poor monitoring and cost overruns: Another major reason for generation of NPAs is that the monitoring of the projects is not up to the mark, resulting in cost overruns and time slippages. The higher the time taken to complete the project, the higher the cost is. This is the basic project governance principle, which goes missing in many of the projects. The lax attitude of the stakeholders and the authorities and rampant corruption and greed leads to the over burning of funds, capacity and time.

4)???? The effects of global overcapacity on prices and imports: Global financial crisis, over reliance on export and price escalations is another factor that results in stalling or increasing the costs of the projects.

Due to all these factors, the projects stall and investments turn into NPAs. “Deep Surgery” of NPAs in the above statement means that the bad loans are to be written down. If loans are written down, the promoter brings in more equity, and other stakeholders like the tariff authorities or the local government chip in, the project may have a strong chance of revival, and the promoter will be incentivized to try his utmost to put it back on track. In order to perform deep surgery, the banks must recognize that they have a problem of bad loans and NPAs. They must highlight and admit the problems and should not shy away from disclosing the NPAs for right stakeholders to act. It can classify the assets correctly and prudently set off the losses against the provisions of the buffer funding that the banks maintain. The bank’s balance sheet must maintain a true and fair picture of bank’s health rather than presenting the distorted picture of bank’s health. RBI Started the Asset Quality Review initiative in 2015 to ensure that the banks were taking proper measures and proactive steps to clean up their balance sheets.