When someone takes a loan from a bank, they agree to pay interest over a certain period of time. However, if they run into some financial trouble and can’t make their payments for more than 90 days, the bank classifies their loan as a Non-Performing Asset or NPA because the loan is no longer generating income for them. If this situation continues for a while, the prospects of the bank recovering the money become slimmer and slimmer.
When a bank has many such non performing assets, it can create a serious problem – not just for the bank, but for the economy as a whole. What are these challenges, and what steps has the government taken to address them? From non performing assets meaning to understanding their effect on banks and investors, we’ll cover it all in this article.
What Are Non-Performing Assets (NPA)?
One of the primary ways banks earn money is by giving out loans and charging interest on them. Banks and other financial institutions lend money to a variety of entities such as individuals, small businesses, and corporations, and for various purposes like buying homes, funding businesses, or developing infrastructure. This interest forms a huge portion of their income. However, when borrowers fail to repay the interest or the principal amount, the asset can become a Non-Performing Asset.
So what are the non performing assets according to the Reserve Bank of India? RBI says that any bank or financial institution can classify an asset as an NPA when the borrower has failed to repay the principal or interest for 90 days or more. As the asset has ceased to generate income for the bank, it can be deemed non performing.
For banks, NPAs are considerable liabilities as the interest they earn on loans is one of their major sources of income. If the quantity of NPAs rises, it has a big impact on the profitability and financial health of the bank, which affects how much more credit they can lend, which in turn affects the economy.
Now that you know non performing assets meaning, take a look at how they work.
How Non Performing Assets (NPA) Work?
Banks and financial institutions lend money to individuals, corporations, and other entities for various purposes. The borrowers make an agreement with the bank to repay the loan along with interest, within a set time frame. When the borrower delays repaying the principal or interest, the loan is marked as overdue. If this delay continues for more than 90 days, the loan is classified as a non-performing asset.
Banks often make sure the borrower pledges some assets as collateral. If the borrower does not repay the loan for a long time, the lender can seize and sell any assets pledged as collateral to recover some money. However, if no assets were pledged, the lender has to write off the loan as a bad debt and lose the entire amount.
This loss of money can have serious consequences for banks, which is why they create provisions to cover the risk of default. Provisioning is a method where banks set aside funds from their earnings to mitigate any losses from non performing assets. NPAs are recorded on the balance sheet of the bank or financial institution, so to maintain financial stability (and also meet regulatory requirements), banks allocate these provisions as a safety measure.
By doing so, banks make sure they can easily manage the losses caused by NPAs without compromising their overall financial health. However, there’s a catch. Remember that provisions are set aside from the bank’s profits, so higher provisioning reduces the lending or investment capacity of the bank, ultimately impacting its profitability and growth. This is why banks work so hard to minimise NPAs. Not only does this help them keep their financial status but also makes sure they operate smoothly and maintain trust among investors and depositors.
Types of Non-Performing Assets
Based on how long the loan remains unpaid, there are three types of non performing assets:
1. Sub-Standard Assets
Assets that stay classified as non performing for less than 12 months are considered sub-standard assets. Because this is the first stage of an NPA, banks have some hope for recovery.
2. Doubtful Assets
When an asset remains as an NPA for more than 12 months, banks classify it as a doubtful asset. Banks consider such assets to have a very high likelihood of default, meaning the chances of recovering the full amount are very slim.
3. Loss Assets
Loss assets are those NPAs that banks or financial institutions deem as irrecoverable. Such loans have almost no chance of being repaid for a variety of reasons. The borrower may have gone bankrupt, the collateral may not be enough, or the borrower’s financial situation is beyond recovery. Banks make 100% provisioning for loss assets, which means they set aside the entire loan amount as a loss.
Examples of Non-Performing Assets
Suppose a small business takes a loan of Rs. 10 lakh at 8% to open a new store in a second location. Now the expansion doesn’t go as planned, and the business incurs heavy losses. The business starts to lag behind on the EMIs and struggles to meet its repayment obligations. It misses payments for more than 90 days, so the bank classifies the loan as a non-performing asset.
If the overdue period is less than 12 months, the loan will first be considered a sub-standard asset. If the business fails to repay for over a year, the loan will be classified as a doubtful asset, which means there is a very high chance of default. The bank will try to recover what it can through loan restructuring, seizing collateral, or selling the business’s assets to cover the outstanding loan.
Impact of NPAs on Investors
NPAs impact not only the lenders but investors and the economy as well. Here’s how:
- Banks and financial institutions set aside funds from their earnings to cover the losses due to NPAs. This lowers their profitability, which directly affects banks and their shareholders.
- A bank with high NPAs will be discouraged from giving out more loans. This impacts the economy as businesses that need heavy debt financing won’t get credit easily for their needs. This credit crunch can cause a rise in unemployment, lower investments, and also reduce a country’s GDP growth rate.
- To maintain their profit margin, banks may even raise their interest rates.
- Investor confidence reduces when banks have high NPAs as it signifies that such banks don’t manage credit risk effectively. This directly leads to banks’ stock prices going down.
Regulations and Guidelines for NPA Management
Over the years, the government and RBI have issued various guidelines and regulations to curb the problems posed by NPAs.
1. Provisioning Norms
Provisioning depends on the type of asset and the category of the bank. For example, the RBI states that banks must set aside a lower percentage of the loan amount in case of sub-standard assets and a higher percentage for doubtful assets.
2. Debt Recovery Tribunal
Set up in 2013, the DRT is a legal body made to handle the recovery of loans that have become non performing. The goal of DRT is to speed up the recovery process by giving banks and financial institutions a more efficient alternative to the court system.
3. Credit Information Bureau
The goal of credit bureaus is to provide accurate credit reports to banks and financial institutions to help them assess the creditworthiness of borrowers. This helps banks assess the risk associated with every borrower and prevents NPAs.
4. Corporate Debt Restructuring
As the name suggests, this measure is all about restructuring the loan in such a way that a company can continue to operate without the burden of unmanageable debt. This can include increasing the time period to pay back the loan or even reducing the interest rates.
5. Strategic Debt Restructuring
Introduced by the RBI in 2015, SDR is also designed to help banks address the problem of NPAs in the corporate sector. However, SDR is a more aggressive form of debt restructuring, as it allows banks to take control of companies by converting bad loans into shares.
6. Mission Indradhanush
The government of India launched Mission Indradhanush to empower public sector banks. The government funded these banks to recapitalise and strengthen their financial health, which helped them easily absorb losses from bad loans, increased their capacity to give out more loans, and also improved their ability to manage future NPAs.
7. Insolvency and Bankruptcy Code
Introduced in 2016, IBC lays down a structured process for the quick resolution of distressed assets and the recovery of due amounts by creditors. If a borrower fails to repay a loan, creditors can quickly start this one-step process to recover their money which makes insolvencies easier to manage and is also particularly helpful for small investors.
Conclusion
NPAs or non performing assets are defined as those loans on which the borrower has not made interest or principal payments for more than 90 days. Such assets pose a big threat to banks and other financial institutions as the money they generate through interest is one of their main sources of income. When interest payments stop coming, banks are forced to make provisions for potential losses.
These provisions are taken from the bank’s profits to cover the risk of default, which reduces not only the bank’s profitability but also its ability to lend further. This has a domino effect, as less credit in the market means less investment in businesses, infrastructure, and spending. Thus the unemployment rate rises and the country’s economic growth slows down. That’s why the government and RBI have put in place various measures to prevent the rise of NPAs.