ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846
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Non-performing Assets of Commercial Banks

K G K Subba Rao (kgksubbarao@gmail.com) is former adviser, Reserve Bank of India, Mumbai.

The restructuring of loans of commercial banks permitted by the Reserve Bank of India under the corporate debt restructuring scheme enabled the banks to upgrade the loans of some of the potentially viable units from the substandard to the standard category. In view of the recent directives of the RBI—realistic assessment of the restructured assets and standardisation of the asset classification—there is a reversal of entries in some cases, which attracted higher provisioning, resulting in losses or a dip in profits of the commercial banks.

Prudential norms in respect of the financial sector (commercial banks, in particular) were envisaged in the early 1990s by the committee on financial system set up in 1991 and various norms were introduced for its smooth functioning.1 These norms covered among other things, capital adequacy, income recognition, and provisioning for bad debts, which were expected to improve the productivity, profitability and efficiency of the commercial banks. Although there have been modifications of these norms over the years, the objective was to clean up the accounts of institutions. Even so, deregulation and liberalisation measures, increasing competition among commercial banks for retaining their share in the market, enormous growth in cross-border transactions, and speculative deals in forward exchange contracts and derivative markets were predominant during the last decade, which changed the portfolio behaviour of the banks.

The implementation of Basel norms over different periods aimed at insulating the institutions from credit, liquidity, and speculative risks have been in vogue for nearly two decades,2 compelling banks to suitably adjust their portfolios for necessary compliance. The global financial crisis in 2008, which created ripples in the financial system of this country as well, had an impact on the operations of the commercial banks and the private corporate sector (PCS) in particular. These unprecedented developments prompted the Reserve Bank of India (RBI) to introduce measures to help tide over the crisis by inducting the corporate debt restructuring (CDR) scheme, indirectly affecting the asset quality of commercial banks.

Fluctuations in non-performing assets (NPAs) will have an impact on other variables in the current and capital accounts of the commercial banks. A hike in the NPAs will, ipso facto, result in an increase in the provisioning norms for the purpose, and lead to consequent changes in the profit and loss account. The profit/loss adjusted under reserves may result in decumulation of reserves and net worth of these entities, affecting the capital to risk-weighted assets ratio (CRAR) stipulated under Basel norms. In the calculation of the CRAR, risk weights are assigned to off-balance sheet (OBS) transactions with speculative deals, which are higher than those pertaining to balance sheet transactions. When OBS transactions exceed balance sheet transactions, the risk weights will also correspondingly increase, inflating the denominator in the CRAR, and reducing the ratio. Even so, the income from OBS transactions could enhance other income and profits of the banks, and is found to be advantageous for banks (particularly, foreign banks) with a comfortable CRAR to take a tolerable risk in speculative deals.

Apart from these multiple effects on the accounts of banks, the write-off of bad debts, recoveries and upgradation of loans of restructured assets from substandard to standard categories and vice versa will have an impact on the stock and composition of NPAs in the portfolio of commercial banks. The debt waiver schemes of the central and state governments for the small and marginal farmers announced periodically will influence the stock of NPAs under “agriculture,” and also the aggregate stock. In the loan portfolio of commercial banks, NPAs are essentially the loans which do not generate income as per the terms and conditions laid down on the repayment schedule. Depending upon the overdues of principal and/or interest, these are classified under three categories: (i) substandard assets, (ii) doubtful assets, and (iii) loss assets.

Details regarding norms for income recognition, asset classification, and provisioning applicable to commercial banks were elucidated in the RBI circular (July 2015), salient aspects of which are summarised in the Annexure (p 35). Against this background, the analysis of NPAs during the last decade will provide an insight into the pile-up of bad loans in the portfolio of commercial banks.

 

Trends in NPAs

The trends in gross NPAs to gross advances of commercial banks can be analysed for three time periods: (i) 1996–97 to 2000–01; (ii) 2001–02 to 2007–08; and (iii) 2008–09 to 2017–18. Table 1 provides these details.

It may be observed from Table 1 that the share of NPAs to total advances was relatively high in the 1990s, possibly because there was no back-up of legislative measures for recovery of loans. The share was even higher at 20% for some of the years in the early phase of the reform period. The second phase was characterised by the setting up of Debt Recovery Tribunals, enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act, and the establishment of Asset Reconstruction Companies (ARC) to offload bad loans at a discount.3 In the third phase, the strategy for restructuring of corporate debt was undertaken. Thus, it is interesting to note that the share of NPAs in gross advances declined over different time periods. Although measures for recovery of bad loans were also enforced in the third phase, the CDR scheme implemented during this phase mitigated the declining trend, in view of the conversion of some substandard loans to the standard category for the companies deemed viable. These loans could be effectively regarded as a threat to the profits of commercial banks, if the performance does not lead to expected returns. Such restructured loans should be considered as stressed assets along with other NPAs.4Table 2 provides the details, by supplementing the data on restructured assets.

 

It can be observed from Table 2 that when the restructured loans are taken into account, the share of total stressed assets to advances increased gradually from 5.5% in 2008–09 to 24.8% in 2017–18.5 The recent trends in key financial variables which have borne the impacts of NPAs can be examined in Table 3.

The data reveal that profitability ratios, which hovered over 1% in each of the years, declined overtime, albeit slightly with reference to assets. Groupwise disaggregation of banks indicated that public sector banks incurred losses, with the ratio being negative in the last two years. But with reference to equity, there had been a steep fall from 14.6% in 2011–12 to 4.2% in 2016–17. Provisioning ratio declined from 52.5% to 43.5% in the years under reference, although the stressed ratio showed an increase. The CRAR remained broadly stable in the range of 13%–14% in each of the years, with commercial banks maintaining a higher ratio than that stipulated by Basel norms.

An analysis of NPAs of priority sectors versus non-priority sectors of commercial banks revealed that the share of NPAs of priority sectors has been declining in recent years (from 46.9% in 2011–12 to 23.3% in 2016–17), while that of the non-priority sectors was increasing (from 53.1% in 2011–12 to 76.7% in 2016–17). Thus, currently three-fourth of the NPAs pertain to the non-priority sector, partly reflecting the stressed advances also (Table 4).

 

Debt Profile and Leverage Ratios

Although a slight digression in the context of the CDR scheme, it would be relevant to touch upon the pattern of credit/debt of the PCS, as reflected in the studies on banking statistics and the company finances of the RBI, and also the shifts thereof in recent years.

It may be observed from Table 5 that the share of bank credit to PCS declined over the years, from 37.7% in 2010–11 to 32.3% in 2016–17. The studies on company finances also revealed the same trends: the share of bank borrowings in total borrowings declined from 60.8% in 2010–11 to 53.6% in 2015–16. In a milieu of rationing of credit by the commercial banks to the PCS, the companies resort to borrowings from other financial institutions and also from the rest of the world (external commercial borrowings).6

 

Thus, even though the share of bank borrowings of PCS declined over the years, the NPAs associated with them need careful scrutiny. The RBI studies on company finances provide further interesting tabulations of bank borrowings to total borrowings classified by leverage (debt–equity) ratios. Table 6 provides these details. Considering the top strata of companies with debt–equity ratio greater than four, the share of bank borrowings hovered in the range of 60%–70% from 2012–13 to 2014–15, but declined steeply to 46.1% in 2015–16. It is also observed that, even in respect of companies with a negative net worth, the share of bank borrowings was significant, ranging from 40%–50%. Even so, the companies with high debt–equity ratios and negative net worth need to be monitored from the point of view of restructured advances. As per the data released by the RBI under Central Repository Information on Large Credits (CRILC), the share of NPAs of large borrowers in total advances was as high as 86% at the end of March 2016 (Financial Stability Report 2016).

 

Recent Policy Decisions

The RBI has taken important steps to clean up the balance sheets of commercial banks during 2015–16, insisting on a more vigorous asset quality review and providing a realistic picture of NPAs and provisioning ratios for the existing stock of restructured loans that are showing signs of stress. In order to prevent banks from liberally restructuring loans, the RBI cautioned that units not found viable would henceforth be treated as substandard assets for the purpose of provisioning,7 culminating in the 15% norm prescribed for substandard assets. Thus, the twin factors—reclassification of the NPAs and the hike in provisioning ratios—triggered ripples in the operations of commercial banks, from 2015–16 onwards. As per the indications hinted in the RBI Financial Stability Report, the profits of the banks plummeted in 2017–18, with even some of the public sector banks incurring losses; the consolidated accounts of the banks for this year are a pointer to this casualty.8 The steep decline in profitability could be adduced to the strict provisioning norms in respect of restructured loans, wherein asset classification could be an upgradation from substandard to the standard category or vice versa. Even in the case of restructured loans deemed as standard assets, provisioning norms were hiked from 2.75% to 5% during 2015–16.

The situation would be worse for the second category of restructured loans classified as substandard, which would attract a higher provisioning. The extent of burden in this regard depends upon the conversion ratio of the restructured advances into standard and substandard categories. Even so, this ratio would vary across time depending upon the reshuffling of accounts, that is, if the repayment of principal and interest as per the terms and conditions of the banks are not forthcoming. Prima facie, these warning signals are indicative that the results of commercial banks may be far from satisfactory. Although the above results are a corollary of the shock treatment of the RBI, it is expected that the banks will fine-tune their operations, minimising the impending risks associated with the NPAs.

Another far-reaching policy measure inducted by the RBI is the “scheme for sustainable structuring of stressed assets,” according to which a portion of the stressed assets could be converted into equity of the company.9 The implication of this measure appears to be that, with a high stake in equity, the returns thereof are expected to offset the bad debts that could have been incurred otherwise. While this could improve the leverage ratios of the companies in the short run, and may be beneficial to both the bank and the company, the viability of the company could be at stake if the bank decides to withdraw the capital at a later date. The implications of this policy measure are to be studied by an analysis of the financial results of such companies. Thus, the above measures are expected to bring about a metamorphic change in the performance of commercial banks.

Taking cognisance of the continuous increase in bad debts, the RBI further initiated stringent measures in February 2018, as per which the lenders should identify incipient stress in loan accounts and classify the stress accounts into three categories of special mention accounts (SMA), depending upon the default of payments and report the data to the RBI under CRILC. The resolution plan thereof would entail downgrading or upgrading of the loan accounts without loss of time. The loan classification and reclassification would be an ongoing exercise. This will have a drastic effect on the provisioning ratio and the profitability of the banks would get further eroded, unless continuous vigilance and monitoring of these accounts is ensured (RBI circular, 12 February 2018).

Need for a Database on NPAs

In retrospect, commercial banks will have to perform a balancing act in the coming years with better management of credit risks, particularly in respect of restructured advances and provisions thereof, in view of the stringent measures imposed during the last two years. In order to maintain the stipulated CRAR norms, care should also be taken to ensure that there is no erosion of capital for any eventual decline in profits. If the repayments are not forthcoming as per the terms and conditions, and the assisted units are not found to be viable, steps need to be taken for fast recovery.10

It is time to have a relook and review the database on NPAs of commercial banks, which could be more useful in the context of the developments taking place in the banking sector. The basic statistical
returns (BSR) information system can be tapped by the generation of tabulations needed for the purpose, suitably modifying the formats in data collection. As the BSR system covers account-wise information from all bank branches on a census basis, the data collected therein and the tabulations thereof will give a fairly good picture on the credit operations of commercial banks. Although information on asset quality is collected in the schedules, the tabulations on these aspects are not generated and published in the annual BSR publications of the RBI. Only in respect of small borrowal accounts, the data collected on NPAs were being published in the erstwhile surveys of small borrowal accounts conducted periodically.

With the revamping of the information system in 2013, the account-wise details have become available in respect of both small and large borrowal accounts. As such, this source of information is expected to be very useful for generating the tabulations even in respect of the NPAs. The formats need slight modifications in view of the recent developments mentioned above. The asset classification in the BSR formats covers traditionally four categories: (i) standard, (ii) substandard, (iii) doubtful, and (iv) loss assets.11 In view of the growing importance of restructured loans, one more classification of restructured advances under categories (i) and (ii) needs to be added. The two-way tabulations of NPAs by various classificatory characters, particularly for large borrowal accounts, will provide a useful database for monitoring and analytical purposes as well. Specifically, the two-way tabulations by size of credit limit and size of NPAs for the PCS can be used for identifying the concentration of NPAs in the top strata of large borrowal accounts.

The companies in this segment could be identified and collated with the information on leverage ratios from the balance sheets of the respective companies. Analysis by the range of leverage ratios would be necessary, specifically for the group of companies with high debt–equity ratio greater than or equal to 4:1, or where the net worth of the companies is found to be negative. A second modification in the BSR format is to introduce the codes of priority and non-priority sectors for each occupation, to generate tabulations of priority and non-priority sectors. The third modification is the inclusion of information on the portion of loan converted into equity. This is necessary in the context of RBI policy measures initiated in this regard. Finally, information as to whether the loan is under the consortium arrangement or not needs to be collected for the generation of additional tabulations necessary for this category. Thus, the BSR database can be a reliable source even for the NPAs, which should be a single repository of information on the NPAs. Presently, the RBI has been collecting these data in the prescribed returns and disseminating it through various annual publications; these can be dispensed with, to avoid duplication of efforts and controversy in estimates.

Notes

1 Report of the Committee on the Financial System, RBI.

2 Basel III norms are being implemented by the commercial banks presently; these are more stringent, compared to Basel I and Basel II norms, and insist on a capital conservation buffer (CCB) at 2.5%. The latest measures stipulate CRAR at 9%, with Tier 1 capital (capital plus reserves) at 7%. With the addition of CCB, the CRAR norm would be 11.5%.

3 In the post-reform period, subsequent to 2000, recoveries of loans were made more feasible by establishment of institutions to offload bad debts at a discount. These legislative measures and enactments were not there in the earlier period. These are briefly touched upon in the article. For details on these aspects, reference may be made to the previous issues of the RBI publication “Trend and Progress of Banking in India.”

4 The extent to which the restructured loans turn out to be bad is not known. According to a guesstimate in the banking circles, roughly one quarter of the restructured loans turn out to be bad in course of time.

5 The share of NPAs (including the restructured assets) may turn out to be higher or lower, depending upon the reclassification in the ensuing years. Further, if loans written off are also considered, the share of stressed assets will be slightly high.

6 The data on borrowing from the rest of the world (in particular, the external commercial borrowings (ECB) are not shown separately in the accounts of the companies. Even so, the evidence available from the RBI data on ECBs reveals that the rate of growth of ECBs outstripped the borrowings from banks for the PCS.

7 These changes are metamorphic policy measures aimed at overhauling the pile-up of NPAs in the portfolio of the banks. These are reckoned as a switch over from “band aid” approach to one of “deep surgery.”

8 The government has been pumping capital into the public sector banks to tide over the crisis. As per press reports, the government infused more than ₹81,000 crore capital in public sector banks in the past 15 years. It is also planned to infuse another ₹70,000 crore over the next four years in a phased manner. Be that as it may, the capital gets eroded with higher provisioning for bad debts and losses thereof.

9 For details, reference may be made to the RBI circular to all commercial banks (DBR No. BP.BC.103/21–04–132/2015–16), 13 June 2016, under “notifications” in the RBI website: rbi.org.in.

10 A case in point is the consortium advance given to Kingfisher Airlines, in respect of which recovery efforts are still being made even after a long time, after the airlines became defunct.

11 See the formats of BSR1 Returns on credit, in the “Handbook of Instructions” for filling up the returns (Occasional Publications in RBI website: www.rbi.org.in).

References

Reserve Bank of India (1991): Report of the Committee on the Financial System (Chairman: M Narasimham).

— (2013): “Two Decades of Credit Management: Looking and Moving Ahead,” Speech delivered by K C Chakravarthi, Deputy Governor, RBI at BANCON, on 16 November, RBI Bulletin, December.

— (2018): Financial Stability Report, June.

Annexure

Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances (see RBI Circular, RBI/2015–16/101, 1 July 2015).

1 Non-performing asset (NPA): An NPA is a loan or an advance, where

1.1 Interest and/or instalment of principal remains overdue for a period of more than 90 days in respect of a term loan.

1.2 The account remains out of order in respect of overdrafts/cash credit. An account is deemed as out of order, if the outstanding balance remains continuously in excess of the sanctioned limit or drawing power for 90 days.

1.3 The bill remains overdue for 90 days in respect of bills purchased and discounted.

2 Interest Payments: In case of interest payments, an account is deemed as NPA, if interest due and charged during any quarter is not serviced fully within 90 days from the end of the quarter.

3 Income Recognition: Income is to be booked in the accounts only when it is received, and not on accrual basis.

4 Classification of assets

4.1 Substandard assets: A substandard asset is one, which remained as NPA for a period of less than or equal to 12 months.

4.2 Doubtful assets: An asset will be classified as doubtful if it remained in the substandard category for a period of 12 months.

4.3 Loss assets: An asset is considered as a loss asset, if the recovery chances are remote as per auditors and RBI inspection reports, without the asset actually being written off.

5 Provisioning norms

5.1 Loss assets: 100% of the outstanding amount, in case of unsecured advances.

5.2 Doubtful assets: 100% in case of unsecured advances. However, in respect of secured advances, provisions vary in the range of 25%–100%, depending upon the period for which the asset remained doubtful.

Period for which Advance Provisioning Remained Doubtful Requirement

(1) Up to one year 25%

(2) One to two years 40%

(3) More than three years 100%

5.3 Substandard assets 15%

(In the case of restructured advances, if they are deemed standard category, the provisioning requirement is hiked from 2.75% in 2013 to 5% in 2015–16 in a phased manner. In the case of restructured advances classified as substandard, the rates are gradually hiked up to 15% in a phased manner.)

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