What are Non-Performing Assets?
A term loan shall be treated as a non-performing asset (NPA) when the payment of interest and/or installment of principal remains overdue for a period of more than 90 days.
A cash credit or demand loan or overdraft account may be treated as Non-Performing Assets if they remain out of order for non-payment of dues or for running irregular. Bills purchased and discounted are considered as non-performing assets if they remain overdue and unpaid for a period of more than 90 days.
Classification of Non-Performing Assets
Banks are required to classify Non-Performing Assets into the following three categories, based on the time period for which the asset remained non-performing and overdue.
- Substandard Assets
- Doubtful Assets
- Loss Assets
Why does a Loan turn Non-Performing Asset?
All the loans immediately after disbursements are classified as standard assets i.e. good loans and unfortunately overtime, some of them turn bad and doubtful, forcing the banks to classify those advances as NPA. The reasons are many.
Mostly, the borrowers turn as defaulters, either intentionally or due to compulsion of circumstances beyond their control. Sometimes, even the banks’ action or inaction leads to failure of borrower’s business. But in most cases, borrowers fail for reasons beyond their control.
Loan default is the result of several wrong steps of the bank and also that of the borrower. Identifying the causes and taking appropriate remedies are not easy and simple, particularly after the loan has turned sticky and irrecoverable.
The reasons can be traced in defective appraisal and sanction or lack of proper supervision and follow up after sanction. It may be the failure to take right recourse after the loan turned bad.
Early Warning Signals of Non-Performing Assets
No loans turn NPA overnight. It is generally a prolonged affair. The failure of the banks to notice the warning signals lead to repayment problems or potential cases of NPA. It can be deteriorating cash position on continuous basis or poor cash management and the resultant liquidity problems or poor risk management. So also the declining profitability and deteriorating asset position or adverse current asset / sales ratio.
While the bank should be and usually be alert to warning signal in financial areas, there are certain non-financial warning signals. It is important for the bank to focus attention and make inquiries and take remedial measures to prevent failure.
1. Evidence of legal action against the borrower by other creditors.
2. Deteriorating relationships with trade suppliers and
3. Indication of speculative tendencies are some of the common signals.
Sometime, acceptance of low profit on sales to create volume or to counter competition, loss of key product lines, franchises, distribution right or supply sources are also the causes of NPA.
Other warning signals of NPA
1. Changes in the timing of seasonal credit requirements and a sharp increase in the size of credit requirement of the borrower.
2. Delay in readjusting to declining market or unfavorable economic policy developments by the borrower.
3. Speculative inventory purchases, inconsistent with normal purchases.
4. Frequent failure to comply with the terms and conditions of the loan agreement with the bank.
5. Another disturbing development of non-performing assets is concurrent outside borrowing, especially, in cases where assets are subsequently pledged to the new lenders to create a secured position in preference to the existing bank.
Causes for the rise of problem loans
Carelessness or inability to study the financial statements before sanction of loans and periodically thereafter are the causes for rise in problem loans. They relate to
1. Deterioration in the cash position,
2. Slowdown in the receivables collections,
3. Sharp increases in the receivables or its percentage to total assets,
4. Rising inventory levels,
5. Slowdown in inventory assets as percentage of total assets,
6. A decline in current assets as percentage of total assets,
7. Revaluation of assets for flimsy purposes,
8. Concentration in non-current assets other than fixed assets (for example due from affiliates or subsidiaries),
9. A high debt-equity ratio,
10. Rising sales and falling profits,
11. Rising levels of bad debts,
12. Assets level rising faster than sales,
13. A rising level of total assets in relation to profits,
14. Significant changes in balance sheet structure.
Each one of them may be a time bomb waiting to explode. A prompt detection will help the bank to contain growth of Non-Performing Assets.
Factors responsible for problem loans
The following are some of the factors contributing for problem loans.
1. Persistent government controls and interference in the affairs of enterprises (controls, licenses, permits).
2. External and internal political pressures (trade restrictions, environmental laws).
3. Production difficulties (strikes, supply shortages).
4. Market disruptions (price collapse).
5. Instability in business environment (recession, high and unstable inflation, interest and exchange rates).
These factors affect the business adversely resulting in operational difficulties, fall in production, loss or reduction in profit, weakening the borrower’s financial position and discipline.
How can a bank prevent growth of Non-Performing Assets?
Steps to be taken by the bank to prevent accounts turning non-performing assets and ways and means to tackle them after the accounts turned NPA are given below.
1. Systematic appraisal of loan proposals.
2. Effective follow up and supervision.
3. Rehabilitation of sick but viable accounts.
4. Compromise settlement with internal arrangement or external intervention.
5. Filing case with Civil Court, Debt Recovery Tribunals, Lok Adalat and proceedings under Sarfaesi Act.
6. Debt restructuring.
7. Debt Asset Swap.
8. Sale of NPA to Asset Reconstruction Companies.
9. Sale of NPA to other banks.
10. Submission of claims to credit Guarantee Corporations / Insurance Companies.
If none of the above steps is workable, the bank will write off the loans.