P RUDENTIAL N ORMS FOR A SSET C LASSIFICATION, I NCOME R ECOGNITION AND P ROVISIONING Ritika Jain

W HAT ARE N PA ’ S ? An 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; i. interest and/ or installment of principal remain overdue for a period of more than 90 days in respect of a term loan, ii. the account remains ‘out of order’, in respect of an Overdraft/Cash Credit (OD/CC), iii. the bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted,

C ONTD … iv. the installment of principal or interest thereon remains overdue for two crop seasons for short duration crops, v. the installment of principal or interest thereon remains overdue for one crop season for long duration crops, vi. the amount of liquidity facility remains outstanding for more than 90 days, in respect of a securitization transaction undertaken in terms of guidelines on securitization dated February 1, vii. 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.

A SSET C LASSIFICATION Categories of NPAs Banks are required to classify nonperforming assets further into the following three categories based on the period for which the asset has remained nonperforming and the realisability of the dues:  Substandard Assets  Doubtful Assets  Loss Assets

A SSET C LASSIFICATION Assets Sub- Standard Assets Standard Assets NPA Performing Assets Loss Assets Doubtful Assets

S TANDARD A SSETS Standard Assets are one which do not pose any problem relating to timely realization of interest and recovery of loan and which do not carry more than normal risk attached to the business. They are not NPAs

S UBSTANDARD A SSETS With effect from 31 March 2005, a substandard asset would be one, which has remained NPA for a period less than or equal to 12 months. In such cases, the current net worth of the borrower/ guarantor or the current market value of the security charged is not enough to ensure recovery of the dues to the banks in full. The credit weaknesses of these assets are well defined. There is possibility of under recovery of the advances including interest due. Such under recovery will cause loss to the bank if deficiencies are not corrected

D OUBTFUL A SSETS With effect from March 31, 2005, an asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that were classified as substandard. These advances are so weak that collection in full is considered highly improbable

L OSS A SSETS A loss asset is one where loss has been identified by the bank or internal/external auditors or by the RBI inspections but the amount has not been written off, wholly or partly They are considered un-collectible and of such little value and their continuance as a Bankable Asset is not warranted, even if there are some salvage or recovery value

P RUDENTIAL N ORMS The following are the provisioning requirements in respect of each class of assets (advances made by bank) which are also called Prudential Norms: 1) Standard assets:- A performing Assets with just normal risk attached – 0.40%

P RUDENTIAL N ORMS 2) Sub-standard Assets :- (i) A general provision of 15 percent on total outstanding (ii) The ‘unsecured exposures’ which are identified as ‘substandard’ would attract additional provision of 10 per cent, i.e., a total of 25 per cent on the outstanding balance.

P RUDENTIAL N ORMS 3) Doubtful Asset :- i. 100 percent of the extent to which the advance is not covered by the realizable value of the security to which the bank has a valid recourse and the realizable value is estimated on a realistic basis. ii. In regard to the secured portion, provision may be made on the following basis, at the rates ranging from 25 percent to 100 percent of the secured portion depending upon the period for which the asset has remained doubtful: Period for which the advance has remained in ‘doubtful’ category: Provision requirement(%) Up to one year25 One to three years40 More than three years100

P RUDENTIAL N ORMS 4) Loss Assets Loss assets should be written off. If loss assets are permitted to remain in the books for any reason, 100 percent of the outstanding should be provided for.

I NCOME R ECOGNITION Income recognition means considering the income earned by a bank during a particular period. Usually a bank prepares its P/L a/c on accrual basis. But on the basis of the recommendations of Narasimham Committee, the RBI has issued guidelines to all banks to recognize income on performing assets on accrual basis and income on non performing assets on cash basis from the financial year and onwards Thus bank should consider interest only when it is received. Consequently, banks which have wrongly recognized income in the past should reverse the interest if it was recognized as income during the current year or make a provision for an equivalent amount if it was recognized as income in the previous year(s)

R EASONS OF N PA The major causes of high NPA are: i. Business failures ii. Poor Assessment of risk/ credit worthiness of the borrowers iii. Diversion of funds/ Misappropriations of funs iv. Willful Defaulters

R EASONS OF N PA 1) Business Failures: The business failures may be caused by: a) Managerial Deficiency b) Unfavorable external environment Managerial Deficiencies: The primary cause of business failure is mismanagement, which indeed accounts for more than 50% of all business failure. Numerous specific managerial faults can cause the firm to fail. Few of them are as:-

C ONTD ….  Poor Management  Poor Production management  Poor marketing management  Poor financial management poor Human Resource Unfavorable External Environment :  Shortage of key inputs like power and basic raw materials  Development of new technology  Shifts in consumer preferences  Natural calamities etc

R EASONS OF N PA 2 ) Poor assessment of risk/credit worthiness of the borrowers: In the past, most of the banks did not have sound appraisal systems and had not given much importance to NPAs. This had resulted in higher incidence of NPAs 3) Diversion of funds/Misappropriation of funds: Diversion of funds also mostly for expansion/diversification/ modernization, taking up new projects and for promoting associate concerns is also responsible for industrial sickness and NPAs

R EASONS OF N PA 4) Willful Defaulters: Some of the entrepreneurs lack honesty and are not very serious about the repayment of loans, leading to higher levels of NPAs

S YMPTOMS OF NPA Delay or default in payment to supplier Irregularity in the bank accounts Irregularity in payment to banks and financial institutions Non-submission of information to banks and financial institutions Frequent requests to banks and financial institutions for additional credit Decline in capacity utilization Excessive turnover of personnel Extension of accounting period Accumulation of inventories

R ECOVERY MEASURES Reminder Systems Personal Visits Recovery Camps Recovery Agent Restructuring/ Rehabilitation Corporate debt restructuring Loan Compromise Security Adjustment Recalling of Advances Securitization and Reconstruction of Financial assets and Enforcement of Security Interest Act 2002 (SARFAESI ) Filing Suits Write off

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