Non-Performing Assets (NPAs) and Effective Provisioning Strategies for Banks
Non-Performing Assets (NPAs) and Effective Provisioning Strategies for Banks to Boost Financial Stability and Compliance
Author-Tanvi Thapliyal
A bank is defined by the Reserve Bank of India (RBI) as a formal organisation that conducts financial operations, including taking deposits and making loans. When a bank lends money to one of its clients, it views the loan as an asset that it may benefit from by charging interest. The money for these loans comes from deposits made by bank customers, making this service only one of the various ways banks serve their customers.
Indian banks did not have a system of rules for classifying assets, recognising income, or making provisions for assets prior to 1991. These ideas were initially presented between 2010 and 2011 by the Narsimham Committee, also called the Committee on the Financial System. Subsequent to this, the Reserve Bank of India established extensive instructions on revenue recognition, asset categorization, provisioning, and related concerns in its master circular UBD.PCB.MC.No.3/09.14.000/2010-11, dated July 2010. This circular explained the classification of non-performing assets (NPAs) and the required provisioning for them, addressing the issue of NPAs in particular.
This article aims to make you aware of the intricacies of NPA its provisioning.
What are Non-Performing Assets (NPAs)
Following the implementation of the Narsimham Committee's recommendations on March 31, 1996, the term "Non-Performing Assets" (NPAs) was formalised in the Indian banking industry. At this turning point in banking history, a systematic way of dividing assets into standard, sub-standard, and doubtful categories was created. Based on this, the Reserve Bank of India (RBI) further clarified the definition of non-performing assets (NPAs) in its 2005 Master Circular as loans or advances when the principle or interest installment is still outstanding after 90 days from the balance sheet date. Nonperforming loans (NPAs) are loans that no longer generate income for the bank since the borrower did not repay the loan by the agreed upon deadline.
This is a major problem for banks since the money they lend out is an asset that they hope to grow in value through interest payments. But this asset becomes non-performing when repayment is postponed or skipped, which affects the bank's .
Borrowers are given a 90-day grace period to meet their repayment commitments, as per the rules published by the RBI. If these conditions are not satisfied, the loan asset is reclassified as non-performing, and the bank will no longer receive any revenue from that asset.
Let us understand NPA with an example -
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Let's assume that Mr. A, a small business owner, goes to XYZ Bank and borrows INR 50,0000 to grow his company. According to the terms of the loan, Mr. A is required to pay back the money in equal monthly payments over five years at an interest rate of 10%.
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Mr. A pays his debt in whole and on time for the first two years. But his cash flow takes a major hit when his business starts losing money because of unanticipated market conditions.
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This puts Mr. A in a position where he can't pay back his debt.
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Mr. A's debt is considered a Non-Performing Asset (NPA) by XYZ Bank after he has been 90 days late with his payments.
Effect of this non payment on the Bank:
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The bank's profitability is impacted since it ceases recognising the interest from Mr. A's loan as income, which means less money coming in.
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The quality of the bank's assets declines as a result of nonperforming loans (NPAs), which show that the loans are not performing as expected and could result in losses.
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XYZ Bank's financial health has taken a further hit as the bank must now set aside a percentage of its earnings to cover future losses from Mr. A's loan.
Nonperforming Assets and Their Effects on Financial Markets and the Economy
The problem of non-performing assets (NPAs) is a major obstacle in the economy as a whole, not only for specific banks. The crucial credit cycle of lending, repaying, and borrowing can be disrupted when a bank's portfolio has a high amount of nonperforming assets. The bank's newfound emphasis on paying back its depositors,the principal source of its borrowed funds,is the root cause of this disturbance. To meet their depositors commitments, banks may borrow more money if they have a lot of nonperforming assets. As a result, both economic growth and project development experience a halt as these institutions grow wary of funding new initiatives.
Effects on the Economy and Financial Markets:
Non-performing assets (NPAs) represent a significant challenge not just for individual financial institutions but also for the broader economic landscape. The presence of a high volume of NPAs within a bank's portfolio can disrupt the essential credit cycle of lending, repayment, and borrowing. This disruption stems from the bank's shifted priority towards repaying its depositors, the primary source of its borrowed funds. In scenarios where banks are burdened with substantial NPAs, they may resort to borrowing additional funds to fulfill depositor obligations. Consequently, these institutions become hesitant to finance new projects, leading to a slowdown in economic growth and project development.
Economic and Banking Sector Issues:
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Credit Flow Disruption: A surge in NPAs can significantly hinder the smooth flow of credit within the economy. Banks, facing liquidity constraints, become more cautious, limiting their lending activities primarily to high-quality borrowers or sectors deemed less risky. This cautious approach can stifle innovation and growth in other potentially profitable sectors.
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Banking Stability and Capital Erosion: High levels of NPAs can erode a bank's capital base, making it difficult to meet its financial obligations and potentially leading to a banking crisis. This erosion of capital also limits the bank's ability to lend, further constricting the flow of money into the economy.
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Impact on Economic Growth:The reluctance of banks to fund new projects due to NPAs can result in a slowdown in economic activity. Investment in infrastructure, industry, and services is crucial for economic growth, and a reduction in these investments can lead to lower GDP growth rates.
Factors Leading to NPAs
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Economic Factors: Economic downturns, price escalation of raw materials, and natural calamities can significantly affect the repayment capacity of borrowers.
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Management Issues:Inefficient management, poor decision-making, and technical problems can lead to project failures and subsequently, NPAs.
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Regulatory and Policy Changes:Sudden changes in government policies, including excise duties and import tariffs, can adversely affect business operations, leading to NPAs.
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Fraud and Mismanagement:White-collar crimes such as fraud and misappropriation by senior officials can also contribute to the rise in NPAs.
The cumulative impact of NPAs on the economy and the banking sector underlines the importance of robust risk management practices, effective loan recovery mechanisms, and prudent lending policies. By addressing the root causes of NPAs and implementing strategic measures to mitigate their impact, banks can maintain their financial health and contribute more effectively to economic growth.
Strategies Adopted by the Government to Tackle Non-Performing Assets
To mitigate the challenge of Non-Performing Assets (NPAs), the government has introduced several key initiatives aimed at enhancing the recovery process and minimising future occurrences of NPAs:
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Implementation of Debt Recovery Tribunals: The government has initiated the appointment of nodal officers for recovery purposes within banks. These officers are stationed at both head offices and zonal offices to streamline the recovery process.
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Establishment of Asset Reconstruction Companies (ARCs): ARCs have been set up to act as resolution agents for banks. Their primary role is to facilitate the restructuring and resolution of NPAs, thereby aiding banks in managing and recovering distressed assets.
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Conducting Activity-Wise Analysis of NPAs: A meticulous approach is adopted towards analysing NPAs on an activity basis. This ensures that new loans are sanctioned with greater scrutiny and due diligence, preventing the accumulation of future NPAs.
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Enhancing Credit Monitoring Mechanisms: Banks are encouraged to maintain robust credit monitoring mechanisms. This involves the establishment of dedicated units responsible for the early detection of distress signals in loan accounts, allowing for timely intervention before an account becomes non-performing.
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Strengthening Recovery Laws: The legal framework surrounding NPAs has been fortified to expedite the recovery process. By enhancing the laws related to asset recovery, the government aims to reduce the financial losses associated with NPAs and improve the overall health of the banking sector.
These government-led initiatives are critical steps towards addressing the challenges posed by NPAs, ensuring the stability and resilience of the financial system.
Types of NPA’S
The Reserve Bank of India (RBI) delineates assets into four primary categories for the purpose of asset classification: standard asset, sub-standard asset, doubtful asset, and loss asset. Within this framework, a standard asset is regarded as performing, while the other three categories are classified under non-performing assets (NPAs). Here's a closer look at each classification:
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Standard Asset: This category includes assets that are considered performing, meaning they generate consistent income and repayments are made on time. These assets are associated with normal risk levels and do not fall into the NPA category. The RBI specifies that standard assets do not require any special provisioning.
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Sub-standard Asset:Classified as non-performing if it has been in such a status for a period of 12 months or less. These assets are characterised by inadequate security valuation, meaning the net worth of the borrower or guarantor is insufficient to cover the bank's dues fully.
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Doubtful Asset:Any asset that has remained in non-performing status for more than 12 months falls under this category. The extended period of non-performance raises doubts regarding the asset's recoverability.
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Loss Asset: This classification is reserved for assets that have been non-performing for over 36 months. Upon financial audit or inspection by the RBI, these assets are identified as ones where full write-off has not occurred, rendering them essentially unrecoverable.
This classification system helps in assessing the risk and health of the assets held by financial institutions, guiding them in making informed decisions regarding provisioning and asset management.
Differentiating Between Gross and Net NPAs
When a commercial bank extends loans and the recovery of those loans, constituting assets for the bank, surpasses the 90-day mark, it falls under the category of gross non-performing assets (GNPA).
On the other hand, when commercial banks set aside provisions to cover their debts, deducting this amount from the unpaid loans yields the net non-performing assets (NNPA).
Let's explore the key differences between GNPA and NNPA:
Meaning:
GNPA: Represents the total outstanding debts that the institution failed to recover from borrowers who were contractually obligated to repay.
NNPA: Signifies the amount obtained after deducting provisions for unpaid or doubtful debts from the total loan portfolio.
Calculation of GNPA and NNPA:
GNPA: Comprises the aggregate value of defaulted loans across all borrowers within the financial institution.
NNPA: Arises when provision amounts are subtracted from GNPA, resulting in the residual value representing the net exposure to non-performing assets.
Default Period:
Financial institutions typically set a recovery timeline for debt assets, allowing a grace period for borrowers to commence repayment with interest. Once this grace period expires, any outstanding debts are classified as GNPA. Conversely, NNPA calculations do not account for any grace periods; outstanding debts are recognized immediately.
Effects:
GNPA: Exerts a significant impact on the equity valuation of the company, potentially diminishing its share value.
NNPA: Influences the liquidity and profitability of the financial institution, impeding its operational capabilities in the event of low cash flows.
Understanding these distinctions between gross and net NPAs is crucial for assessing the financial health and risk exposure of banking institutions, guiding stakeholders in making informed decisions regarding asset management and provisioning.
For Example-
Suppose XYZ Bank extends a loan of INR100,000 to a borrower. After a certain period, it becomes evident that the borrower is unable to repay the loan, and the account is classified as non-performing.
1. Gross Non-Performing Asset (GNPA):
The outstanding loan amount of INR 100,000 constitutes the GNPA. This is the total value of the loan that has defaulted and is not being repaid by the borrower.
2. Net Non-Performing Asset (NNPA):
Now, let's assume that XYZ Bank has set aside a provision of INR20,000 to cover potential losses on this loan. After deducting this provision from the outstanding loan amount, we get:
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INR100,000 (GNPA) - INR20,000 (Provision) =INR80,000 (NNPA)
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Therefore, the NNPA in this scenario is INR80,000. This represents the net exposure of the bank to non-performing assets after accounting for provisions made to cover potential losses.
In this example, the GNPA reflects the total value of the defaulted loan, while the NNPA accounts for the outstanding loan amount after provisions have been deducted. This differentiation helps banks assess their risk exposure more accurately and make informed decisions regarding provisioning and asset management.
Considerations Before Assessing Non-Performing Assets
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Temporary Nature of Deficiency:Instances where stock statements or outstanding balances are temporarily unavailable or deficient for a period not exceeding 90 days do not entail any liability.
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Review of Credit Limits:An account will be classified as holding non-performing assets if its regular or ad hoc credit limits have not been reviewed or renewed within 90 days from the due date or the date of ad hoc sanction.
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Regularisation Before Balance Sheet Date:If overdue amounts are repaid, and accounts are regularized from genuine sources before the balance sheet date, they will not be categorized as non-performing assets.
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Impact on Multiple Facilities: If any facility extended to the borrower, whether it's cash credit or a term loan, is classified as a non-performing asset, all facilities provided to that borrower will be deemed as non-performing assets. Additionally, their classification (e.g., substandard or doubtful) will be consistent across all facilities.
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Government-Backed Credits:In instances where the central government guarantees credit, any overdue amounts will be deemed non-performing assets immediately upon repudiation of the guarantee.
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Treatment of Specific Instruments:Bank fixed deposits, life insurance policies, UTIs, and NSCs are considered self-liquidating and, therefore, are exempt from classification as non-performing assets.
Protection of Financial Stability through Provision for Non-Performing Assets
Banking and financial institutions are the lifeblood of every economy since they hold the public's savings. The problem is that you can't be profitable with just the money coming in from deposit accounts. Banks provide a wide range of services, one of which is lending money at interest rates, in order to maximise their profits. These loans unfortunately become non-performing assets (NPAs) when borrowers do not return them within the timeframe that the Reserve Bank of India has mandated.
The Reserve Bank of India introduced provisioning as a measure to maintain economic stability and maintain public faith in financial institutions. What this means is that every fiscal quarter, banks will put some of their profits into a reserve fund. The institution's balance sheet and its ability to withstand losses caused by non-performing assets are both strengthened by this fund. Financial institutions, whether banks or NBFCs, must have the vision to set aside cash for provisioning since even assets that look good now might turn into liabilities tomorrow.
Institutions can protect their financial health and resilience in the face of economic risks and anticipated asset degradation by setting aside funds to cover nonperforming assets (NPAs). Banks and NBFCs strengthen their ability to withstand market volatility and keep the faith of their stakeholders by carefully following RBI regulations and setting aside funds.
Norms For Provisioning
1. Based on the classification of assets
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S.no.
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category
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Period
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NPA
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Provisioning
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1.
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standard
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Nil
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Non NPA
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0.25% 1% 2% 0.40% On gross amount
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2.
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Sub-standard
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Nil
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NPA up to 12 months
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Secured exposure
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15%
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Unsecured exposure
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25%
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Unsecured exposure: infrastructure loan
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20%
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3.
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Doubtful
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Upto 1 year
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NPA up to 24 months
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Unsecured – 100%
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Realisable value of assets- 25%
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Up to 3 years
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NPA up to 48 months
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Unsecured- 100%
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Realisable value of assets-40%
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Over 3 years
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NPA above 48 months
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100%
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4.
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Loss
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Nil
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Nil
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100%
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2. Based on standard advances
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S.no.
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Sector
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provisioning
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-
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Advances in agriculture and SME
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0.25%
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-
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Commercial real estate
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1%
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-
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Housing loan at teaser rates
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2%
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-
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Housing loan 1 year from the date of reset higher rates
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0.40%
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-
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Restructuring accounts
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2%
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-
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Gross account for advances other than the above-listed
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0.40%
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3. Other relevant norms
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Country-based risk provision should lie between 0.25% to 100%
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Voluntary provisions for advances at rates higher than the prescribed regulations could be made by the banks upon the approval of the board of directors.
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Suppose the non-performing asset balance value exceeds Rs. 5 crores and above. In that case, the financial institution needs to formulate a policy for annual stock audit by an external agency in respect of immovable properties valuation to be carried out once every 3 years by approved value.
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PCR, i.e. provisioning coverage ratio, indicates the extent of funds a bank has kept aside to cover losses occurring from loss of assets.
Conclusion
The idea that only banks need to worry about non-performing assets (NPAs) and setting aside money for them isn't true anymore. The Reserve Bank of India (RBI) now says non-banking financial companies (NBFCs) should also do this. This is to protect all places where people put their money and get loans. Every financial place relies on its assets. When they lend money, they hope to get it back with some profit. But sometimes, things don't go as planned. The RBI wants all financial places to set aside some money from their earnings each quarter just in case their assets don't perform well. This way, they can keep running smoothly even if some loans don't work out.
TaxPartner can assist in navigating these complexities. Our expert team offers tailored solutions to ensure compliance with RBI guidelines on asset provisioning. We provide strategic advice on optimizing provisioning practices, helping financial institutions maintain stability and mitigate risks associated with non-performing assets. With TaxPartner's guidance, financial institutions can streamline their provisioning processes, enhance financial performance, and bolster regulatory compliance.
FAQ’S
What is a Non-Performing Asset (NPA)?
A non-performing asset is a defaulting asset that is not returned to the financial institution within the specified time limit prescribed by the Reserve Bank of India.
How is an NPA classified?
A non-performing asset is classified as a sub-standard, doubtful, or loss asset.
What are the main causes of an asset becoming non-performing?
The main causes that make an asset non-performing are economic slowdowns and recession, default on the borrower's end, and inadequate credit appraisal.
How does an NPA affect a bank's financial health?
A non-performing asset weakens the bank's financial stability and impacts negatively on the bank's financial stability. It ultimately shook the trust and confidence of the customers and investors in the bank.
What is provisioning in the context of NPAs?
The Reserve Bank of India advises every banking or non-banking institution to keep a certain amount aside from their profits in a particular quarter for non-performing assets so that the assets that might turn into losses for the bank in the future don't impact the overall stability of the bank; this helps the bank in maintaining customer trust and support.
Why is provisioning important for financial institutions?
Provisioning helps a bank in mitigating the future risk that might arise from the defaulted loans and their non-performance.
How are provisioning norms decided?
Reserve Bank of India, through its circular relating to income recognition and asset classification, lays down the norms related to the provisioning of non-performing assets.
What are the different categories of provisioning for NPAs?
The non-performing assets are provisioned based on their classification, i.e. provisioning for standard, substandard, doubtful, and loss assets.
Can an NPA be converted back into a performing asset?
Yes, a non-performing asset can be converted to a standard asset upon the repayment of the entire arrears of the interests and the principal amount of all the credit facilities availed by the borrower.
What measures are taken by banks to prevent the rise of NPAs?
Banks can take the aid of debt recovery tribunals, credit information bureaus, lok adalats, a compromise settlement, the SARFAESI Act, and asset reconstruction companies to prevent the rise of non-performing assets.
What are non-performing assets and their provisions?
A non-performing asset is a loan or advance that is overdue for 90 days or more, i.e. the time limit for its procurement is complete, the bank gives an additional 90 days to the borrower to pay back the interest, and the principal, but the borrower failed to pay back both. Reserve Bank of India, to safeguard the liquidity of banks in case of non-performing assets, given the criteria of provisioning in which every financial institution keeps a certain amount of money aside from their profits every quarter for non-performing assets.
What is the provision for non-performing assets?
Provision is the amount kept aside from the profits of every quarter by a banking organization or a non-banking organization to prevent the liquidation and money flow in the accounts of borrowers who are also the creditors in the scenario of a non-performing asset.
What are non-performing assets with examples?
Loans, mortgages, commercial loans, credit card debts, etc., are some examples that can be non-performing assets if not paid on time.
What is the NPA provision of RBI?
Reserve Bank of India, in its master circular for income recognition and asset classification, defines a non-performing asset as a non-productive asset that has ceased to generate income for the financial institution.
What is a non-performing asset provision for doubtful debts?
Doubtful debts are one of the classifications for non-performing assets. These are those assets that have been non-performing for more than 12 months.
