1:

INTRODUCTION

TO

NON-PERFORMING

ASSET

IN

BANKING
NPAs reflect the performance of banks. A high level of NPAs suggests high probability of a
large number of credit defaults that affect the profitability and net-worth of banks and also erodes
the value of the asset. The NPA growth involves the necessity of provisions, which reduces the
overall profits and shareholders value. The issue of Non Performing Assets has been discussed
at length for financial system all over the world. The problem of NPAs is not only affecting the
banks but also the whole economy. In fact high level of NPAs in Indian banks is nothing but a
reflection of the state of health of the industry and trade.
1.1: DEFINITION OF NPA:An asset becomes non-performing when it cease to generate income to the bank. A
non-performing asset (NPA) is defined as a credit facility in respect of which the interest
and/or instalments of principal has remained overdue for a specified period of 90 days
(with effect from March, 2004) of time.
According to RBI:
An asset, including a leased asset, becomes non performing when it ceases to generate income
for the bank. A non performing asset (NPA) is 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, 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,

the installment of principal or interest thereon remains overdue for two

crop seasons for short duration crops,

the installment of principal or interest thereon remains overdue for one

crop season for long duration crops,

the amount of liquidity facility remains outstanding for more than 90 days,
in respect of a securitisation transaction undertaken in terms of guidelines
on securitisation dated February 1, 2006.

in respect of derivative transactions, the overdue receivables representing

positive mark-to-market value of a derivative contract, if these remain
unpaid for a period of 90 days from the specified due date for payment.

Banks should, classify an account as NPA only if the interest due and

charged during any quarter is not serviced fully within 90 days from the end of the
quarter.

1.2: MEANING:
An asset is classified as non-performing asset (N.P.As) if dues in the form of principal
and interest are not paid by the borrower for a period of 180 days. However with effect from
March 2004, default status would be given to a borrower if dues are not paid for 90 days. If any
advance or credit facility granted by bank to a borrower becomes non-performing, then the bank
will have to treat all the advances/credit facilities granted to that borrower as non-performing
without having any regard to the fact that there may still exist, certain advances / credit facilities
having performing status. Action for enforcement of security interest can be initiated only if the
secured asset is classified as Non Performing Asset. Non Performing Asset means an asset or
account of borrower, which has been classified by a bank or financial institution as sub-standard,
doubtful or loss asset, in accordance with the directions or guidelines relating to asset
classification issued by RBI.

Standard
Assets

Loss

CLASSIFICATION
OF

Assets

NPAs

Doubtful
Assets

Non-Standard
Assets

NPA statistics is executed through the following ways.

Failure to identify an NPA as per stipulated guidelines: There were instances of `sub-

standard' assets being classified as `standard';

Wrong classification of an NPA: classifying a `loss' asset as a `doubtful' or `sub-standard'

asset; classifying a `doubtful' asset as a `sub-standard' asset.

Classifying an account of a credit customer as `substandard' and other accounts of the
same credit customer as `standard', throwing prudential norms to the winds.

Essentially arising from the wrong classification of NPAs, there was a variation in the level
of loan loss provisioning actually held by the bank and the level required to be made. This
practice can be logically explained as a desperate attempt on the part of the bankers, whenever
adequate current earnings were not available to meet provisioning obligations. Driven to
desperation and impelled by the desire not to accept defeat, they have chosen to mislead and
claim compliance with the provisioning norms, without actually providing. This only shows that
the problem has swelled to graver dimensions.
The international rating agency Standard & Poor (S & P) conveys the gloomiest picture, while
estimating NPAs of the Indian banking sector between 35% to 70%, of its total outstanding
credit. Much of this, up to 35% of the total banking assets, as per the rating agency would be
accounted as NPA if rescheduling and restructuring of loans to make them good assets in the
book are not taken into account. However RBI has contested this dismal assessment. But the fact
remains that the infection if left unchecked will eventually lead to what has been forecast by the
rating agency. This invests an urgency to tackle this virus as a fire fighting exercise.

1.3 MEANING & DEFINITION OF BANKING:

Banks are institutions that accept various types of deposits and use those funds for granting
loans. The business of banking is that of an intermediary between the saving and investment

units of the economy. It collects the surplus funds of millions of individual savers who are
widely scattered and channelizes them to the investors.

Money Surplus
Units
(Savers)

Money
Intermediary

Money Deficit
Units
(Investors)

(Banks)

In simple terms, banks serve as a middle man from the money surplus units to the money deficit
units. They are intermediaries, who transfer funds from savers to investors through grants for
business, commerce, education, and other purposes.
According to Section 5(b) of the BANKING REGULATION ACT, 1949 defines banking as, the
accepting for the purpose of lending or investment, of deposits from the public, repayable or
otherwise & withdrawal by cheque, draft, order or otherwise.

1.4 HISTORY OF BANKING:

Banking in its simplest form is as old as authenticated history. In India, reference about banking
habits and regulations exist in our scriptures and ancient texts. During the Vedic times (20001400 B.C), money lending and debt are repeatedly mentioned in the Vedic period and epic
literature. During the smirit period, which followed the Vedic period and epic age Manu, the
great law giver of that time spoke of vaishs earning money through interest.
Chanakyas Arthashastra (About 300 B.C) is full of facts to show that there were powerful guilds
of merchant bankers in existence who received deposits, advanced loans and carried on the other
banking functions. A system of banks had also been devised as early as 2000 B.C by the
Babylonians. In ancient Greece and Rome, the practice of granting credit was widely prevalent.
The Bank of Venice, which was established in 1157, is considered to be the most ancient bank. In

Florence, Monte was established in 1336, and a public bank was set up in 1401 in Barcelona.
For fulfilling the needs of merchants, the Bank of Amsterdam was set up in 1609.
Early history apart modern banking began with the goldsmiths of London in the 17 th century. At
that time money was held in the form of gold and silver coins. As the goldsmiths had excellent
strong rooms, people started keeping their money with them for safe keeping in return for a fee.
The goldsmiths used to issue receipts for the same which began to be transferred from one trader
to another for settlement of debts. In this manner, the trader avoided the problem of withdrawing
their coins from the goldsmith to make the payment to their creditors. The creditors, in turn, were
saved from the necessity of having to deposit the same with the goldsmith for safe keeping. To
make such transactions simpler, the goldsmith started issuing receipts in convenient
denominations and made them payable to bearer.
The goldsmiths soon observed that at a time only a small proportion of coin were needed for
making payment, so they started lending the surplus money and charging certain interest for
doing so.
The goldsmiths began entrusting reserves to the Exchequer under sanction and care of king.
Unfortunately, King Charles 2 shut up the exchequer one day and that caused the ruin of the
goldsmiths. However, this proved to be a turning point in the history of English banking with the
growth of private banking and the Bank of England in 1694. At this point, it is pertinent to
mention that apart from the goldsmiths, the money lenders and merchants also had a strong role
to play. Each of these was closely concerned in dealing of money which in those days was in the
form of coins made of precious metals. Merchants were trustworthy people to whom people gave
their money for safe keeping. They also issued receipts acknowledging their liabilities and
honored them when the receipts were presented. Money lenders in villages too lent money to
people on interest. This money was usually their own, but it also belonged to people with surplus
money who gave it to them. Money lenders, thus, became embryonic banks by serving as money
borrowers as well as moneylenders. As these money changers transacted their business sitting on
benches, they came to be known as BANKS.

1.5 FEATURES:

Borrowing, raising or taking up of money.

Lending / advancing of money either with or without security.

Drawing, making, accepting, discounting, buying, selling, collecting & dealing in bills of
exchange, hundis, promissory notes, coupons, drafts, bills of lading, railway receipts,
warrants, debentures, certificates & other instruments whether transferrable or negitable
or not.

Granting & issuing of Letter of Credit, travelers cheque & circular notes.

Buying & selling of foreign exchange including bank notes.

Buying & selling of bullion & specie.

Receiving all kinds of bonds & Valuables on deposit or for safe custody.

Acquiring, holding, issuing on commission, underwriting & dealing in stocks, funds,

shares, debentures, bonds, obligations, securities & investments of all kinds.

Purchasing & selling of bonds, scripts or other form of securities on behalf of

constituents or others, the negotiating of loans & advances.

1.6 STRUCTURE:
Scheduled banking structure in India

1.7 FUNCTIONS:

Functions of Banks are elucidated as follows:

A) ACCEPTANCE OF DEPOSIT:
1) Saving Deposit:
Encourages small savings.
Rate of Interest is comparatively lower than any other accounts.
Provided with Cheque facility for withdrawal of money.
Limited amount of withdrawal in a week.
2) Fixed Deposit:
It is also known as Term Deposit.
Money deposited for a specific period, i.e., for 1, 2 or 5 years.
Restricted to Withdraw money before maturity.
Rate of interest is higher than any other accounts.
Longer the period higher the rate of interest.
Entails a penalty if withdrawn before the maturity.
3) Current Deposits:

It is also known as Demand deposit.

Withdrawal of money is allowed at any time.
Generally opened & operated by businessmen.
The bank levies charges for the facilities provided to the depositors such as

incidental charges.
Bank pays money to the depositor or the authorized person whom the cheque
is given by the depositor.

4) Recurring Deposit:
Form of a saving account.
Opens account with a fixed amount & the same amount is deposited every

month.
A higher rate of interest is earned depending upon the maturity period.
Pre Maturity withdrawal is restricted.
Instead a loan upto 75% of the deposit can be given to the depositor at 2% rate
of interest charged on the same.

B) GRANTING ADVANCES:
1) Overdrafts:
Allowed to withdraw over and above the depositors credit balance in the

current account either against or without any security.

Temporary facility allowed to respectable & reliable Current account holders.
Limited amount can be withdrawn but only by cheques.
Permitted to repay any no. of times upto the sanctioned amount.
An interest is charged to the depositors for availing this facility.

2) Cash Credit:
Its one type of short period (more period than overdraft) finance or loan.
Cash Credit faclitiy is a provision to create loan or advance or credit by lender

(mainly bank or financial institute) to borrower (mainly business concern).

Its used to fulfill working capital requirements which are needed to run
trading operation in a business. Only business concern can enjoy this facility.

Working Capital = Current Assets Current Liabilities.

Business concern can enjoy Cash Credit facility against Pledge or

Hypothecation of Stock, book debt as a security or guarantee of the finance.

Advance is sanctioned & money transfer to Cash Credit account by Bank or
Financial Institute.

Borrower can withdraw money from Cash Credit account within permissible

amount fixed by Bank for specific period.

Borrower cant withdraw total loan amount at a time.
Interest charged amount actually withdrawn in daily basic, not full loan
amount. Bank can charge certain amount on portion of loan not used by

business concern because bank cant use cash credit sanctioned amount.
Bank is not funded total required working capital. Some portion of working
capital is invested by the business entities himself & balance amount is supply
by bank in way Cash Credit.

3) Loans:
A specified sum of money is given against some collateral security.
Entire Loan amount is transferred to the borrowers account at once & he can

use it as per his requirements.

Bank can recall such loans at its option.

4) Discounting of Bills:
It is a type of loan against the security of the bill or the bill is purchased by the

banks in some cases.

A sum after deducting the discount is transferred to the customers account.
Bank receives her interest in advance at the time of discounting.
Bank collects the amount on maturity from the drawee of the bill.

C) AGENCY FUNCTIONS:
1) Transfer of Funds:
Helps in transferring funds from one place to another.
Instrument used for this transfer is known as Bank Draft.
A small commission is charged for providing the facility by the banks.
2) Collecting Customers Funds:
Bank collects funds of its customers from other banks & credits them to their
accounts.
3) Purchase & Sale of Shares & Securities for its Customers:
Banks buys & sells stocks & shares of private companies as well as
government securities on behalf of its customers.

4) Collecting Dividends on shares of the Customers:

Banks collects dividends as well as interest on the shares & debentures of its
customers & credits them to their accounts.
5) Acts as Trustee & the executor:
Banks preserves the wills of the customers & executes them after their death.
6) Income Tax Consultant:
Banks gives advices on Income Tax matters to its customers.
Banks also files Income Tax Returns for their customers on payment of its fee.
7) Acts as correspondent:
Banks acts as a correspondent, agent or representative for its customers.
Bank may obtain passports, travelers tickets & even secure air & sea passages
for its customers.
D) UTILITY FUNCTIONS:
1) Locker:
Bank provides this facility for the safe custody of valuable goods.
Valuables like gold, ornaments, important papers, shares & debentures.
An annual rent is charged for this service.
2) Underwriting:
Banks also do underwriting for private companies.
Banks charges a small underwriting commission from the companies.
3) Social welfare programmes:
Nationalized banks in India have framed schemes of credit to help small
agriculturists, village & cottage industries, retailers, artisans, etc through loans

at concessional rates of interest.

These scheme serves in reduction & eradication of inequalities of income &

wealth, poverty & unemployment in the country.

4) The other Functions are as follows:
Drafts
Project reports
Creation of Credit.
Giving Advices on Financial Matters.
Giving information about its customers.
Collection of statistics.
Financing Internal & Foreign Trade.
Purchase & Sale of Foreign Exchange.
Investments of Funds, etc.

2: RESEARCH METHODOLOGY

2.1 RESEARCH OBJECTIVE:

To understand what is Non Performing Assets and what are the underlying reasons for

the emergence of the NPAs.

To know why NPAs are the great challenge to the Public Sector Banks.
To understand the impacts of NPAs on the operations of the Public Sector Banks.
To know what steps are being taken by the Indian banking sector to reduce the NPAs

2.2 RESEARCH SCOPE:

This project is mainly highlighting the issues of NPAs faced by banks in India.
The scope of study is the banking sector in India which focus the issue of NPAs.
2.3 DATA COLLECTION:
The data for study has been collected from various secondary sources:

Books
Newspapers
Internet Sources
Financial Magazines

2.4: LIMITATIONS TO THE STUDY:

Due to time constraint, a detailed study could not be done.

The professional help was not easily available so the project is made on the

understanding of the theories included in the academics.

A better project could have been made if more time was allotted.

3. EMERGENCE/CONCEPT/TYPES OF NPAs

3.1THREAT TO NATIONALISED BANKS:

NPA is a brought forward legacy accumulated over the past three decades, when prudent
norms of banking were forsaken basking by the halo of security provided by government
ownership. It is not wrong to have pursued social goals, but this does not justify relegating
banking goals and fiscal discipline to the background. But despite this extravagance the malaise
remained invisible to the public eyes due to the practice of not following transparent accounting
standards, but keeping the balance sheets opaque.
This artificially conveyed picture of 'all is well' with PSBs suddenly came to an end when
the lid was open with the introduction of the prudential norms of banking in the year 1992-93,
bringing total transparency in disclosure norms and 'cleansing' the balance sheets of commercial
banks for the first time in the country.

3.2 EVOLUTION OF NPA:

In the early Nineties, PSBs were suffering from acute capital inadequacy and many of them
were depicting negative profitability. This is because the parameters set for their functioning
were deficient and they did not project the paramount need for these corporate goals.

Incorrect goal perception and identification led them to wrong destination.

Since the 70s, the SCBs of India functioned totally as captive capsule units cut off from
international banking and unable to participate in the structural transformations, the
sweeping changes, and the new type of lending products emerging in the global banking
Institutions.

The personnel lacked desired training and knowledge resources required to compete with
international players. Such and other chaotic conditions in parts of the Indian Banking
industry had resulted in the accumulation of assets, which were termed as nonproductive in an unprecedented level

"Audit and Inspections" remained as functions under the control of the executive
officers, which were not independent and were thus unable to correct the effect of
serious flaws in policies and directions of the higher ups.

The quantum of credit extended by the PSBs increased by about 160 times in the three
decades after nationalization (from around Rs. 3000 crore in 1970 to Rs. 475113 Crore in
2004). The Banks were not developed in terms of skills and expertise to regulate such
stupendous growth in the volume and manage the diverse risks that emerged in the
process.

The need for organizing an effective mechanism to gather and disseminate credit
information amongst the commercial banks was never felt or implemented. The archaic
laws of secrecy of customers-information that was binding Bankers in India, disabled

banks to publish names of defaulters for common knowledge of the other Banks in the
system.

Lack of effective corporate management

Credit management on the part of the lenders to the borrowers to secure their genuine
and bonafide interests was not based on pragmatically calculated anticipated cash flows
of the borrower concern, while recovery of installments of Term Loans was not out of
profits and surplus generated but through recourse to the corpus of working capital of the
borrowing concerns. This eventually led to the failure of the project financed leaving idle
assets.

Functional inefficiency was also caused due to over-staffing, manual processing of over
expanded operations and failure to computerize Banks in India, when elsewhere
throughout the world the system was to switch over to computerization of operation.

3.3 CONCEPT OF NPA:

The concept of specified period is reduced in a phased manner. The shortening of the period is
from 4 quarters in 1993 when the concept of Income Recognition Asset Classification (IRAC)
norms was first introduced in India to present level of 90 days.
Action for enforcement of security interest can be initiated only if the secured asset is
classified as Non Performing Asset. Non Performing Asset means an asset or account of
borrower, which has been classified by a bank or financial institution as sub-standard, doubtful
or loss asset, in accordance with the directions or guidelines relating to asset classification issued
by RBI.
An amount due under any credit facility is treated as "past due" when it has not been paid
within 30 days from the due date. Due to the improvement in the payment and settlement
systems, recovery climate, upgradation of technology in the banking system, etc., it was decided
to dispense with 'past due' concept, with effect from March 31, 2001. Accordingly, as from that
date, a Non performing asset (NPA) shell be an advance where

interest and /or installment of principal remain overdue for a period of more than 180
days in respect of a Term Loan,

the account remains 'out of order' for a period of more than 180 days, in respect of an
overdraft/ cash Credit(OD/CC),

the bill remains overdue for a period of more than 180 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
purpose, and

any amount to be received remains overdue for a period of more than 180 days in respect
of other accounts.

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,
form the year ending March 31, 2004. Accordingly, with effect from March 31, 2004, a nonperforming asset (NPA) shell 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
purpose, and

any amount to be received remains overdue for a period of more than 90 days in respect
of other accounts.

3.4 ASSET CLASSIFICATION:

While new private banks are careful about their asset quality and consequently have low nonperforming assets (N.P.As), public sector banks have large N.P.As due to wrong lending policies
followed earlier and also due to government regulations that require them to lend to sectors
where potential of default is high. Allaying the fears that bulk of the Non-Performing Assets
(N.P.As) was from priority sector, NPA from priority sector constituted was lower at 46 per cent
than that of the corporate sector at 48 per cent.
Loans and advances account for around 40 per cent of the assets of SCBs. However,
delay/default in payment of interest and/or repayment of principal has rendered a significant
proportion of the loan assets non-performing. As per RBIs prudential norms, a Non-Performing
Asset (NPA) is a credit facility in respect of which interest/installment has remained unpaid for
more than two quarters after it has become past due. Past due denotes grace period of one
month after it has become due for payment by the borrower.

Asset Classification

Term

Provision requirements

Standard assets

90 days

0.25%

Substandard assets

12 months

20%(irrespective of value of security)

Doubtful assets

12 months

20% - 50% of the secured portion depending on the

age of NPA, and 100% of the unsecured portion.

Loss assets

12 months

100%

3.5 REGULATIONS FOR ASSET CLASSIFICATION

Assets should be classified into four classes - Standard, Sub-standard, Doubtful, and Loss
assets. N.P.As is loans on which the dues are not received for two quarters. N.P.As consist of
assets fewer than three categories: sub-standard, doubtful and loss. RBI for these classes of assets
should evolve clear, uniform, and consistent definitions. The health code system earlier in use
would have to be replaced. The banks should classify their assets based on weaknesses and
dependency on collateral securities into four categories:
Standard Assets:
It carries not more than the normal risk attached to the business and is not an NPA.
Sub-standard Asset:
An asset which remains as NPA for a period exceeding 24 months, where the current net worth
of the borrower, guarantor or the current market value of the security charged to the bank is not
enough to ensure recovery of the debt due to the bank in full.
Doubtful Assets:

An NPA, which continued to be so for a period exceeding two years (18 months, with effect from
March, 2001, as recommended by Narsimham Committee II, 1998).

Loss Assets:
An asset identified by the bank or internal/ external auditors or RBI inspection as loss asset, but
the amount has not yet been written off wholly or partly.The banking industry has significant
market inefficiencies caused by the large amounts of Non Performing Assets (N.P.As) in bank
portfolios, accumulated over several years. Discussions on non-performing assets have been
going on for several years now. One of the earliest writings on N.P.As defined them as "assets
which cannot be recycled or disposed off immediately, and which do not yield returns to the
bank, examples of which are:
Overdue and stagnant accounts, suit filed accounts, suspense accounts and miscellaneous assets,
cash and bank balances with other banks, and amounts locked up in frauds".
3.6 GUIDELINES FOR THE CLASSIFICATION OF ASSETS:
1) Classification of assets into above categories should be done taking into account the
degree of well defined credit weaknesses and the extent of dependencies on collateral
security for the realization of dues.

2) Banks should establish appropriate internal systems to eliminate the tendency to delay
or postpone the identification of NPAs especially in respect of high value of accounts.
3) Account with temporary Deficiencies:
The classification of an asset as NPA should be based on the record of recovery .Bank
should not classify an advance account as NPA merely due to the existence of some
deficiencies, which are temporary in nature as such as non availability of adequate
drawing power based on latest stock.

4) Asset classification to be borrower wise and not facility-wise:

It is difficult to envisage a situation when only one facility to a borrower becomes a
problem credit and not others. Therefore, all the facilities granted by a bank to a borrower
will have to be treated as NPA and not the particular facility or a part thereof, which has
become irregular.
5) Advances under consortium arrangements:
Asset classified of accounts under consortium should be based on the record of recovery
of the individual member banks and other aspects having bearing on the recoverability of
the advances.
6) Accounts where there is erosion in the value of security can be reckoned as significant
when the realizable value of the security is less than 50percent of the value assessed by
the bank or accepted by RBI at the time of last inspection, as the case may be. Such NPAs
may be straightway classified under doubtful category and provisioning should be made
as applicable to doubtful assets.
7) Agricultural Advances
(a) In respect of advances granted for agricultural purpose purpose where interest and / or
installment of principal remains unpaid after it has become past due for two harvest
seasons but for a period not exceeding two half years , such an advance should be treated
as NPA.

(b) Where the natural calamities impair the repaying capacity of agricultural borrowers,
banks may decide on their own as a relief measure-conversion of the short term
production loan into a term or re-schedulement of the repayment period.
(c) In such cases of conversation or re-schedulement, the term loan as well as fresh shortterm loan may be treated as current dues and need not be classified as NPA.
8) Restructuring /Rescheduling of loans:
A standard asset where the terms of the loan arrangement regarding interest and principal
have been renegotiated or rescheduled after the commencement of production should be
as sub-standard and should remain in such category for at least one year of satisfactory
performance under the renegotiated or restructured terms. In case of substandard and
doubtful assets also, rescheduling does not entitle a bank to upgrade the quality of
advances automatically unless there is satisfactory performance under the rescheduled
renegotiated terms.

'Out of order'
An account should be treated as 'out of order' if the outstanding balance remains
continuously in excess of the sanctioned limit/ drawing power. In case where the outstanding
balance in the principal operating account is less than the sanctioned limit/ drawing power, but
there are no credits continuously for six months as on the date of balance sheet or credits are not
enough to cover the interest debited during the same period, these account should be treated as
'out of order'.
Overdue
Any amount due to the bank under any credit facility is 'overdue' if it is not paid on the due
date fixed by the bank.

TYPES OF NPAs:
3.7 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 is advance which is considered
irrecoverable, for bank has made provisions, and which is still held in banks' books of
account Gross NPA reflects the quality of the loans made by Banks. It consists of all the
nonstandard assets like as sub-standard, doubtful, and loss assets. It can be calculated with
the help of following ratio:
Gross NPAs Ratio = Gross NPAs / Gross Advances

3.8 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. It can be calculated by following

Net NPAs = Gross NPAs Provisions / Gross Advances Provisions

3.9 NPA STATISTICS:

Table 1 shows the gross NPA ratio of nationalised banks for last five years with necessary
statistics like mean, growth rate of NPAS via CAGR. From the above table it is seen that gross
NPA of nationalised banks is in the upward trend generally in all the banks with varying growth.

The compound annual growth rate of banks under study is in the range of - 6.96 to 14.06 and
banks are having value of compound annual growth rate of gross NPAS during this range. As per
the mean which is representative of a group of data, banks are ranked in ascending order. The
reason for ranking them in ascending order is from the interpretation of NPA that better the
performance, lower the ratio and vice versa. From the above table it is found that Punjab and
Sind bank is ranked first as it was able to manage lowest means GNPA ratio of 0.94 percent,
followed by corporation bank at second position with mean GNPA ratio of 1.17 percent and third
rank achieve by Indian bank. United bank of Indian and Canara bank got lowest rank of 19 and
20 with a mean ratio of 2.94 and 2.97 percent respectively.

The above diagram portrays the GNPA ratio of all the banks for a five year period and break of
individual bar shows the annual gross NPA ratios for a five year period. It is seen from the
diagram that some banks are having high gross NPA ratio from year to year while others have
kept it under controlled conditions. From the figure it is depicted that Punjab and Sind bank,

Indian bank, corporation bank and Andhra bank have kept strict control on their NPAS and their
total NPA for the five year period is lowest relative to others. The bars of central bank, Indian
overseas bank, UCO bank, united bank are having highest level of bars which shows their higher
level of NPAs relative to other banks.

Amt in

Table 2 displays the net non performing assets ratio of nationalised banks. This is the actual
burden on the shoulders of bank and calculated by deducting necessary provisions from the gross
nonperforming assets of bank. From the analysis of above table it is inferred that net NPA of
nationalised banks is close vigilance and control in most of the banks by maintaining sufficient
level and of provisions to counter balance the decrease in the quality of assets. The CAGR is
varying in much range compared to GNPA of nationalised banks, the bank of Maharashtra is
having lowest CAGR of -0.7 and union bank having highest CAGR of 58.49 percent. The
ranking of banks is done on the basis of mean for last five years and ranking is done in ascending
order i,e lower the average better the rank, Andhra bank, bank of Maharashtra, corporation got
first second and third rank respectively with their lowest mean for five years and united bank of
India and UCO bank 19th and 20th rank respectively.

The above bar chart shows the annual ratios of net NPAs for five year term for each nationalised
bank and height of bars determine level of NNPAs and division of bars determine annual level of
annual NPPA ratio. Andhra bank, bank of Baroda corporation bank Indian bank and Punjab and
Sind bank are positive in terms of net npa ratio as there level is minimum and rest having higher
ratio with varying level of bars and UCO banks displayed bar length is maximum.

Table 3 shows the composite rank of each bank, this is arrived at by averaging the ranks of banks
as per GNPA and NNPA. This reason for this is that average performance in each will determine
the real performance in the management of nonperforming assets. So final ranks assigned to
banks is based on the average of earlier two ranks. It can be seen from the table that Andhra
bank and corporation bank has got first rank followed by Punjab and Sind at second rank and
Indian bank at third rank. In the management of nonperforming assets some banks have got the

same rank which is clearly shown in the table, two banks have got first rank, three banks have
got ninth rank and another three banks have got 15th rank. These banks are at the same
performance level in the management of nonperforming assets.

4: IMPACT OF NPA- AN ISSUE FOR BANKS AND FINANCIAL

INSTITUTIONS

4.1 INDIAN ECONOMY & NPAs:

Undoubtedly the world economy has slowed down, recession is at its peak, globally stock
markets have tumbled and business itself is getting hard to do. The Indian economy has been
much affected due to high fiscal deficit, poor infrastructure facilities, sticky legal system, cutting
of exposures to emerging markets by FIIs, etc.
Further, international rating agencies like, Standard & Poor have lowered India's credit
rating to sub-investment grade. Such negative aspects have often outweighed positives such as
increasing forex reserves and a manageable inflation rate.
Under such a situation, it goes without saying that banks are no exception and are bound
to face the heat of a global downturn. Bankers have realized that unless the level of N.P.As is
reduced drastically, they will find it difficult to survive.
4.2 GLOBAL DEVELOPMENT & 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 corporates 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.
4.3 IMPACT ON PROFITABILITY:
The enormous provisioning of NPA together with the holding cost of such non-productive
assets over the years has acted as a severe drain on the profitability of the PSBs. In turn PSBs are
seen as poor performers and unable to approach the market for raising additional capital. Equity
issues of nationalised banks that have already tapped the market are now quoted at a discount in
the secondary market. Other banks hesitate to approach the market to raise new issues. This has
alternatively forced PSBs to borrow heavily from the debt market to build Tier II Capital to meet
capital adequacy norms putting severe pressure on their profit margins, else they are to seek the
bounty of the Central Government for repeated Recapitalisation.
NPA is not merely non-remunerative. It is also cost absorbing and profit eroding.
In the context of severe competition in the banking industry, the weak banks are at
disadvantage for leveraging the rate of interest in the deregulated market and securing
remunerative business growth. The options for these banks are lost. "The spread is the bread for
the banks". This is the margin between the cost of resources employed and the return therefrom.
In other words it is gap between the return on funds deployed(Interest earned on credit and
investments) and cost of funds employed(Interest paid on deposits). When the interest rates were
directed by RBI, as heretofore, there was no option for banks. But today in the deregulated
market the banks decide their lending rates and borrowing rates. In the competitive money and
capital Markets, inability to offer competitive market rates adds to the disadvantage of marketing
and building new business.

In the face of the deregulated banking industry, an ideal competitive working is reached,
when the banks are able to earn adequate amount of non-interest income to cover their entire
operating expenses i.e. a positive burden. In that event the spread factor i.e. the difference
between the gross interest income and interest cost will constitute its operating profits.
Theoretically even if the bank keeps 0% spread, it will still break even in terms of operating
profit and not return an operating loss. The net profit is the amount of the operating profit minus
the amount of provisions to be made including for taxation.
4.4 DEVELOPMENT OF FINANCIAL INSTITUTIONS HEALTH:
The efficiency of any Development Financial Institutions is not always reflected only by the size
of its balance sheet but by the level of return on its assets. NPAs do not generate any income for
DFIs but at the same time DFIs are required to make provisions for such NPAs from their current
profits.
Following are the deleterious effect on the return on assets in several ways:

They erode current profits through provisioning requirements

They result in reduced interest income
They require high provisioning requirements affecting profits
They limit recycling of funds, set in asset- liability mismatches, etc.

NPA- an issue for Banks and Financial Institutions:

To start with, performance in terms of profitability is a benchmark for any business enterprise
including the banking industry. However, increasing N.P.As 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 N.P.As 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.

4.5 The following are the primary causes for turning the accounts into NPA:

Diversion of funds, mostly for the expansion/ diversification of business or for

promoting associate concern.

Factors internal to business like product/ marketing failure, inefficient management,

inappropriate technology, labour unrest

Changes in the Macro-environment like recession in the economy, infrastructural

bottlenecks etc.

Inadequate control/ supervision, leading to time/cost over-runs during project

Implementation.

Changes in Government policies e.g. Import duties.

Deficiencies like delay in the release of limits/ funds by banks/FIs

4.6 Secondary causes are as follows:

Selection of the project.

Implementation of the project- time over-run, cost over-run, under-financing technology

involved.
Intention of the borrower.

Industrial/ Economic trend.

Absence of the up gradation of the unit/ ploughing back of the profit.

4.7 REASONS FOR AN ASSET TURNING NPA:

The various reasons, either singly or jointly, behind an asset turning NPA can be classified as
follows:
Internal reasons
External reasons
Reasons from the economy side
Reasons from the industry side
Reasons from the borrowers side
Reasons from the banking system side
Reasons from the loan structuring side
Reasons from the security side collateral v/s cash flow
Reasons from the regulatory side

From the above, it may be surprising to many that only the borrower is not always at fault. At
times, systemic faults can also adversely affect the profitability of financial intermediaries. The
following discussion will clarify our position.
Internal Reasons:
Diversion of Funds For expansion, modernization, setting up of new projects, helping
or promoting sister concerns.Time/Cost overruns while implementing the projects.
Business failure like product failing to capture market, inefficient management,
strike/strained labour relations, wrong technology, technical problems, product
obsolescence, etc.

External Reasons:
Failure, non-payment/overdue, recession in other countries, externalization problems,
adverse exchange rate, etc.
Government policies like excise, import duty changes, deregulation, pollution control
orders, etc. Willful default, siphoning of funds, fraud, misappropriation, and
promoter/management disputes, etc.
Deficiencies on the part of the bank, viz, in credit appraisal, monitoring and follow up,
delay in release of limits, delay in settlements payments/subsidies by government bodies,
etc.
External factors like raw material shortage, raw material/input price escalation, power
shortage, industrial recession, excess capacity, natural calamities like floods, accidents,
etc. Contribution to N.P.As

by factors like siphoning off funds through

fraud/misappropriation was less significant in comparison with other factors.

Incidence of N.P.As on account of deficiencies on the part of banks such as delay in

sanction and disbursement of funds whereby borrowing units are starved of funds when
in need, and delay in settlement of payments/subsidies by the government bodies was on
the low side in proportion to other factors. Lack of effective co-ordination between
banks and financial institution in respect of large value projects does contribute to the
emergence of N.P.As even at the implementation stage. RBI had, in February 2000
drawn up certain ground rules in this regard in consultation with the banks, FII and IBA
and circulated the same among banks and financial institution for implementation.
Susceptibility of the sanctioning authorities to external pressure, failings of CEOs and
the ineffectiveness of the board to check his ways also contributed in no small measures
to the unusual build up of N.P.As in some of the banks. One of the most prominent
causes for N.P.As, as often observed by RBI Inspectors, is the slackness on the part of
the credit management staff in their follow up to detect and prevent diversion of funds in
the post disbursement stage.

Reasons from the economy side

a) Political mindset regarding paradigm, proactive, fiscally responsible (national
b)
c)
d)
e)
f)

income accounts).
Economic growth, distribution, efficient allocation of resources.
Social acceptability, mobility, education
Technological advances in use of IT
Legal Enforceability of loan contracts
Environmental liberalization & globalization

If loan contracts are not easily enforceable, there will naturally be a tendency to default.
Opening up of the economy can render companies uncompetitive. Lack of adaptation of IT will
make data processing difficult and information dissemination will be impossible. Objective
analysis of risk would be difficult and appraisal would remain a subjective matter. Similarly,
directed programs of lending can be counterproductive.

Reasons from the industry side

a. Global competition
b. Cyclical downswing
c. Sunset industry
d. Frequent changes in regulatory norms

Reasons from the borrowers side

a. Misconceived project
b. Poor governance
c. Product failure
d. Inefficient management
e. Diversion of funds
f. Dormant capital market
g. Regulatory changes

Reasons from the banking system side

a) Parameters set for their functioning were deficient: incorrect goal

perception and

identification lazy banking.

b) Directed banking and lack of freedom to choose products and pricing.
c) Being unexposed to international marketing methods and products, people lacked training
d)
e)
f)
g)
h)
i)
j)
k)

and knowledge resources.

Ownership and management were not distinguished composition of Board of Directors.
Lack of systems and procedures audit and inspections
Banks lacked the ability to handle enormous growth in liabilities and assets
Lack of a mechanism of credit information dissemination
Lack of an effective judicial system for recovery from defaulters
Collateral based lending leading to idle assets
Fixing of price and quantum of loans
Lack of an effective IT system and MIS

Reasons from the loan structuring side

a)
b)
c)
d)
e)

High debt equity ratio

Timing of raising equity
Discrepancy between the rate of interest charged and the realistic rate of return.
Inconsistency between revenue generation and the loan repayment schedule
Lack of binding penal clauses and performance guarantees.

Reasons from the security side collateral vs cash flow

There is a tendency among banks and institutions to depend excessively on collateral for
advancing of loans. While this is important, it presumes from the very beginning that the
borrower would default and the security would need to be encashed for recovery of the loan.
Clearly, this logic is unacceptable. Emphasis should then be on cash generation and a charge on
this should be built into the loan contract through some escrow mechanism.

Reasons from the regulatory side

Frequent regulatory changes can turn assets non-performing. Accounting reason like reduction in
income recognition norms from 180 days to 90 days could be one such reason. Pollution related
issues could be the other reason. Distance between two sugar mills could be a third.Management
of non-performing assets of the financial sector was put on fast track recently with the Union
Cabinet approving the promulgation of an ordinance to facilitate securitisation and
reconstruction of financial assets.
4.8 DIFFICULTIES WITH THE NPAS:
1.) Owners do not receive a market return on their capital. In the worst case, if the bank fails,
owners lose their assets. In modern times, this may affect a broad pool of shareholders.
2.) Depositors do not receive a market return on savings. In the worst case if the bank fails,
depositors lose their assets or uninsured balance. Banks also redistribute losses to other
borrowers by charging higher interest rates .Lower deposit rates and higher lending rates repress
savings and financial markets, which hampers economic growth.
3.) Non performing loans represent bad investments. NPA 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. The economy performs below its
production potential.

4.) Non performing loans may spill over the banking system and contract the money stock,
which may lead to economic contraction.
This spillover effect can channelize through illiquidity or bank insolvency;
(a) When many borrowers fail to pay interest, banks may experience liquidity shortages. These
shortages can jam payments across the country.
(b) Undercapitalized banks exceeds the banks capital base.
4.9 CORRECTIVE STEPS & MEASURES TO RECOVER N.P.AS:
Over the last few years Indian banking in its attempt to integrate itself with the global
banking has been facing lots of hurdles in its way due to its inherent weaknesses, despite its high
sounding claims and lofty achievements. One of the major hurdles, the Indian banking is facing
today, is its ever-growing size of non-performing assets over which the top management of
almost each bank is baffled. On account of the intricacies involved in handling the N.P.As the
ticklish task of assets management of the bank has become a tight rope walk affair for the
controlling heads, because a little wavering this or that side may land the concern bank in
trouble. The growing N.P.As is a potent source of worry for the finance minister as well, because
in a developing country like ours, banking is seen as an important instrument of development,
while with the backbreaking N.P.As banks have become helpless burden on the economy.
N.P.As with outstanding up to 5 crore:
In case of doubtful and loss assets, through the modified schemes, the banks have been
directed to follow up a settlement formula under which the minimum amount to be recovered,
amounts to be entire outstanding running ledger balances as on the date the account was
identified as NPA i.e. the date from which the interest was not charged to the running ledger, an
analysis of the given formula shows that RBI has been very much generous in granting huge
relaxation to the borrowers who were not coming forward for setting their overdue loans due to
one or other reason. The scheme is of high practical value as it protects the borrowers who were
having genuine problems in clearing their dues because the interest component constituted a

multiplied amount of principal outstanding. On the other hand, the concerned banks were also
finding in difficult to sacrifice the entire interest component, but outstanding in the dummy
ledger. Now as per the provision to the scheme, they will be ready to grant such relaxation in
favour of the borrowers. These guidelines have come as a windfall for borrowers who after a lot
of negotiations were almost ready to repay back their principal as well as part of the interest
component to settle their accounts, as under the modified scheme, they would be able to save the
interest component. To that extent the concerned bank stands to lose.
In the case of sub standard assets, the settlement formula as given in the modified scheme states
that the minimum sum to be recovered must contain the entire running ledge outstanding balance
as on the date of the account was identified as NPA i.e. the date from the which interest was not
charged to the running ledger + interest at the existing prime lending rate of the bank. As per the
modified sac scheme, the terms suggested for the payment of settlement amount NPA are simple
and pragmatic. As per the terms of the scheme, the settlement amount should be paid in lump
sum by the borrower. However in case of the borrower is unable to repay back in a lump sum,
the scheme allows sufficient breathing period to enable him to arrange the funds and clear at
least 25 percent of the settlement amount to be paid upfront and the remaining amount to be
recovered in installments spread over a period of one year along with interest at the existing PLR
from the date of settlement up to the date of final payment.
N.P.As with outstanding over Rs. 5 crores:
For recovery of N.P.As over Rs. 5 crore, RBI has left the matter to the concerned banks
and advised that the concerned banks may formulate policy guidelines regarding their settlement
and recovery. The freedom, in such cases, is given to the banks, because the attending
circumstances in each case may vary from the other. Therefore it was in the right direction that
adopting a generalized approach was not thought appropriate. In cases, where the amount
involved is above Rs. 5 crore, RBI expects CMD of each bank to supervise the NPA personally.
The CMDs of the concerned banks are advised to review all such cases within a given timeframe
and decide the course of action in terms of rehabilitation/restructuring. RBI also desires the
submission of a quarterly report of all N.P.As above Rs. 5 crore from PSU banks. Thus by

putting up the cut-off dates for the implementing of the scheme, RBI desires the banks to realize
the seriousness of the issue and gear up to sweep away the N.P.As in one go.
For commercial banks, it is a golden opportunity to clear the mess, consolidate and come
out on a track leading t the path of global banking. The time given for weeding out the disastrous
N.P.As is neither too long nor too short and the banks, with proper planning and follow up can
drastically reduce their N.P.As, if they firmly resolve to do so. RBI expects the commercial
banks to follow the guidelines in letter and spirit without any discrimination or discretion as a
slight dilution may jeopardize their interest. A proper monitoring system is also desired to be
evolved for monitoring the progress of the scheme. As this is a rare opportunity given to the
defaulting borrowers so that they can avail the chance given for the settlement of their loans.
Without adequate publicity of the scheme the response from the defaulting borrowers may not be
there to the expected level.

4.10 DIFFERENT APPROACHES TO VALUATION OF NPAS:

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:

To set a sound basis for the selling bank/institution to finalize the sale of assets,

To provide a basis for the fair market value of the assets,

To promote transparency of the valuation processes and,

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. The matrix shows the risk profile of the NPA based on its cash
flows and collateral. As shown, stronger the cash flows and collateral, lower the risk profile of
the asset. Some of the widely used approaches towards valuation of an NPA by the valuation
firms are detailed as under:

Discounted Cash Flows

One of the commonly used methods for estimating the value of the companys 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 assets cash flow stream. Essentially the decision on the projects 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/ N.P.As.

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.
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.
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 1990s 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. 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.