What is Non performing assets and why it is important to know?

WHAT ARE NON-PERFORMING ASSETS, AND WHY IS IT IMPORTANT TO KNOW?

• What is Non- Performing Assets (NPA)?

A nonperforming asset (NPA) refers to a classification for loans or advances in default or arrears. A loan is in arrears when principal or interest payments are late or missed. A loan is in default when the lender considers the loan agreement to be broken and the debtor cannot meet his obligations.

A nonperforming asset (NPA) is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days. NPAs can be classified as standard assets, substandard assets, doubtful assets, or loss assets, depending on the length of time overdue and probability of repayment.

1. Standard Assets: They are NPAs that have been past due for anywhere from 90 days to 12 months, with a normal risk level.
2. Substandard assets: Assets which has remained NPA for a period less than or equal to 12 months.
3. Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.
4. Loss assets: As per RBI, “Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted, although there may be some salvage or recovery value.”

·       Types of Non-Performing Assets (NPA):- Although the most common nonperforming assets are term loans, there are other forms of nonperforming assets as well.

             - Overdraft and cash credit(OD/CC) accounts left out-of-order for more than 90 days

             - Agricultural advances whose interest or principal installment payments remain overdue for two crop/harvest seasons for short duration crops or overdue one crop season for long duration crops

             - Expected payment on any other type of account is overdue for more than 90 days

• How NPAs Work?

Nonperforming assets are listed on the balance sheet of a bank or other financial institution. After a prolonged period of non-payment, the lender will force the borrower to liquidate any assets pledged as part of the debt agreement. If no assets were pledged, the lender might write off the asset as a bad debt and then sell it at a discount to a collection agency.

In most cases, debt is classified as nonperforming when loan payments have not been made for a period of 90 days. While 90 days is the standard, the amount of elapsed time may be shorter or longer depending on the terms and conditions of each loan. A loan can be classified as a nonperforming asset at any point during the loan term or at its maturity.

Banks may attempt to collect the outstanding debt by foreclosing on whatever property or asset has been used to secure the loan. For example, if an individual takes out a second mortgage and that loan becomes an NPA, the bank will generally send foreclosure notice on the home because it is being used as collateral for the loan.

For example, assume a company with a $10 million loan with interest-only payments of $50,000 per month fails to make a payment for three consecutive months. The lender may be required to categorize the loan as nonperforming to meet regulatory requirements. Alternatively, a loan can also be categorized as nonperforming if a company makes all interest payments but cannot repay the principal at maturity.

Carrying nonperforming assets, also referred to as nonperforming loans, on the balance sheet places a significant burden on the lender. The nonpayment of interest or principal reduces the lender's cash flow, disrupting budgets and decreasing earnings. Loan loss provisions, set aside to cover potential losses, reduce the capital available to provide subsequent loans to other borrowers. Once the actual losses from defaulted loans are determined, they are written off against earnings. Carrying a significant amount of NPAs on the balance sheet over a period of time is an indicator to regulators that the financial fitness of the bank is at risk.

• Significance of NPAs

Both the borrower and the lender need to be aware of performing versus non-performing assets. For the borrower, if the asset is non-performing and interest payments are not made, it can negatively affect their credit and growth possibilities. It will then hamper their ability to obtain future borrowing.

For the bank or lender, interest earned on loans acts as a main source of income. Therefore, non-performing assets will negatively affect their ability to generate adequate income and, thus, their overall profitability. Banks need to keep track of their non-performing assets because too many NPAs will adversely affect their liquidity and growth abilities.

Non-performing assets can be manageable, but it depends on how many there are and how far they are past due. In the short term, most banks can take on a fair amount of NPAs. However, if the volume of NPAs continues to build over a period of time, it threatens the financial health and future success of the lender.

 The NPA is considered an important parameter to judge the performance and financial health of banks. If a bank has a high NPA ratio, its performance is considered weak than that of a bank with a lower NPA ratio. It creates a bad effect on the goodwill and equity value of the bank.

• The auditors or RBI mostly detect nPAs.

When loans and advances are not repaid within the stipulated timeline, it affects a bank’s balance sheet. NPAs create a financial burden on the lender. For instance, a substantial number of NPAs over a period of time reflect that the bank's financial health is in bad shape. Phased with NPAs, the lenders have options to recover their losses that includes taking possession of any collateral or selling off the loan at a significant

• Preventive Measures To Stop NPAs

1. Taking a person/corporation’s Credit Information Bureau (India) Limited (CIBIL) score into consideration before lending.
2. Compromise or use various settlement schemes.
3. Use alternative dispute resolution mechanisms for faster settlement of dues, such as use Lok Adalats and Debt Recovery Tribunals.
4. Actively circulate information of defaulters.
5. Take strict action against large NPAs.
6. Use Asset Reconstruction Company.
7. Legal Reforms such as the implementation of the Insolvency and Bankruptcy Code have already taken place.
8. Corporate Debt Restructuring (CDR).
9. Propose guidelines on wilful defaults/diversion of funds.
10. Special Mention Accounts – Additional Precaution at the Operating Level.

• Latest Measures by RBI

The main proposals are:

1. Lenders’ Committee with strict timelines for a resolution plan must be formed early.
2. Lenders must be given incentives to agree to collectively and quickly plan– if a resolution plan is already underway, then there must be better regulatory treatment; if no agreement can be reached, accelerated provisioning must be done.
3. Improvement in current restructuring process: large value restructurings must be independently evaluated mandatorily, focusing on viable plans and a fair sharing of losses (and future possible upside) between promoters and creditors.
4. Future borrowing for non-cooperative borrowers with lenders must be made more expensive in resolution.
5. Asset sales must be given more liberal regulatory treatment.

1. If the loss is fully disclosed, lenders must be allowed to spread their losses on sale for over two years.
2. It will not be construed as restructuring if takeout financing/refinancing is made possible over a longer period.
3. If specialized entities are acquiring ‘stressed companies’, leveraged buyouts must be allowed.
4. Steps must be taken to facilitate the better functioning of Asset Reconstruction Companies.
5. Sector-specific Companies/Private equity firms must be helped to play an active role in the stressed assets market.
6. Formation of Joint Lenders’ Forum: If an account is reported to the Central Repository of Information on Large Credits (CRILC) as SMA-2, all lenders should form a lenders’ committee to be called Joint Lenders’ Forum (JLF) under a convener and frame a joint Corrective Action Plan (CAP) for early resolution of the stress in the account. This would also include Rectification; Restructuring, Recovery of the asset.