Non Performing Assets: A macroeconomic concern

Fahid Fayaz Darangay

As per RBI, an asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank. A ‘non-performing asset’ (NPA) was defined as a credit facility in respect of which the interest and/ or instalment of principal has remained ‘past due’ for a specified period of time. The specified period was reduced in a phased manner as under:
year ending March 31 specified period
1993 four quarters
1994 three quarters
1995 onwards two quarters
An amount due under any credit facility is treated as ‘past due’ when it has not been paid within 30 days from the due date. Due to the improvements in the payment and settlement systems, recovery climate, upgradation of technology in banking system, etc., it was decided to dispense with ‘past due’ concept, with effect from March 31, 2001. Accordingly, as from that date, a Non-performing Asset (NPA) shall be an advance where
i. interest and/or instalment of principal remain overdue for a period of more than 180 days in respect of a Term Loan,
ii. the account remains ‘out of order’ for a period of more than 180 days, in respect of an Overdraft/Cash Credit (OD/CC),
iii. the bill remains overdue for a period of more than 180 days in the case of bills purchased and discounted,
iv. interest and/or instalment of principal remains overdue for two harvest seasons but for a period not exceeding two half years in the case of an advance granted for agricultural purposes, and
v. any amount to be received remains overdue for a period of more than 180 days in respect of other accounts.
With a view to moving towards international best practices and to ensure greater transparency, it has been decided to adopt ’90 days’ overdue norm for identification of NPAs, from the year ending March 31, 2004. Accordingly, with effect from March 31, 2004, a non-performing asset (NPA) shall be a loan or an advance where;
i. interest and/ or instalment 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’ for a period of more than 90 days, 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,
iv. interest and/or instalment of principal remains overdue for two harvest seasons but for a period not exceeding two half years in the case of an advance granted for agricultural purposes, and
v. any amount to be received remains overdue for a period of more than 90 days in respect of other accounts.
A cross-country comparison of the identification and measurement of NPAs was published by the Financial Stability Institute (FSI) of the Bank for International Settlement (BIS). The findings reveal considerable differences across jurisdictions in applicable accounting standards which are exacerbated by divergent prudential frameworks that govern NPAs’ identification and measurement:

1. The report highlights that both accounting and prudential requirements affect identification and measurement of NPAs with practices varying across countries. While International Financial Reporting Standards (IFRS) is the prevailing global standard, a number of jurisdictions do not follow IFRS which can lead to differences in determining both the volume of impaired assets and also their associated provisions. Even in jurisdictions that apply IFRS, the judgmental nature of the collateral valuation process, particularly with respect to estimating collateral values under the Net Present Value (NPV) approach, can lead to vastly different provisioning outcomes across IFRS reporting jurisdictions. For instance, impaired assets under IFRS-9 require a more granular assessment of credit risk in comparison to International Accounting Standards (IAS) 39. Under IFRS-9, applicable entities must now place financial instruments in three distinct stages — performing, underperforming and nonperforming — rather than the unimpaired and impaired categories under IAS 39. There are subtle differences between the treatment of ‘forborne’ exposures under IFRS and existing US Generally Accepted Accounting Principles (GAAP). Under IFRS-9, a financial asset that has been renegotiated (forborne) cannot be automatically upgraded to a higher quality status without evidence of demonstrated payment performance under the new terms over a period of time. IFRS-9 requires write-offs if the entity has no reasonable prospects of recovering a financial asset in its entirety or even a portion of it. Under the current US GAAP, the asset is required to be written off in the period in which it is deemed uncollectible.
2. NPA identification: There are four main reasons for key differences across surveyed jurisdictions. First, there is no uniform definition of an NPA across sampled countries, including both entry (into impairment) and exit (from impairment) criteria. Second, certain asset classes (such as foreclosed collateral) are exempt from the NPA designation in a number of jurisdictions. Third, several respondents explicitly consider collateral in the NPA identification process while others determine the credit quality of an exposure without considering collateral support. Finally, all jurisdictions have prescribed both quantitative (past due) and qualitative criteria, the extent to which supervisors rely on past-due criteria to place an exposure on the NPA status varies across jurisdictions.
3. The role of asset classification frameworks in NPA identification: Regulatory asset classification frameworks are commonly used in Latin America and Caribbean (LAC) regions, the US and some EU-single supervisory mechanism (SSM) jurisdictions. The US and nearly all (10 of the 11) surveyed jurisdictions in Asia require banks to use an asset classification system to classify credit exposures into various risk buckets (with the most common being: normal, special mention (or watch), substandard, doubtful and loss), based on criteria developed by the prudential regulator. In LAC countries, the risk buckets for credit exposure vary substantially across countries ranging from five to 16
4. In Asia there is convergence around the use of a five-bucket risk framework with the three most severe asset classification categories (substandard, doubtful and loss) considered as NPAs. Therefore, the sub-standard category (or its equivalent) is considered the entry point of the NPA designation, with the over 90-days-past-due threshold typically serving as quantitative backstop. The qualitative criteria are more forward looking that allow supervisors to place exposures in the sub-standard category even if the loans do not satisfy 90-days-past-due criteria or are not impaired under applicable accounting rules.
5. The US applies a similar five-bucket risk framework but there is no specific link between its regulatory classification system and the designation of an NPA.
6. In the LAC region, some countries use a fivebucket risk framework while others employ a more granular breakdown, both for the performing and the lowest quality asset classification categories. In general, countries employing more than five buckets typically require greater risk differentiation within the severe asset classification categories. Supervisors combine the past-due criterion typically set at 90- days for a commercial loan to be considered nonperforming with qualitative information tracking the borrower’s ability to repay based on various indicators.
7. With regard to the application of cross default clauses, respondents in a majority of Asian jurisdictions as well as half of the LAC countries noted that multiple loans granted to the same borrower with at least one NPA were all treated as NPAs. In the EU-SSM jurisdictions, if 20 per cent of the exposures of a debtor is 90 days or more past due all exposures of this debtor must also be classified as non-performing exposure (NPE).
   As of March 31, 2018, provisional estimates suggest that the total volume of gross NPAs in the economy stands at Rs 10.35 lakh crore. About 85 per cent of these NPAs are from loans and advances of public sector banks. For instance, NPAs in the State Bank of India are worth Rs 2.23 lakh crore.
   In the last few years, gross NPAs of banks (as a percentage of total loans) have increased from 2.3 per cent of total loans in 2008 to 9.3 per cent in 2017 (Figure 1). This indicates that an increasing proportion of a bank’s assets have ceased to generate income for the bank, lowering the bank’s profitability and its ability to grant further credit.
   Escalating NPAs require a bank to make higher provisions for losses in their books. The banks set aside more funds to pay for anticipated future losses; and this, along with several structural issues, leads to low profitability. Profitability of a bank is measured by its Return on Assets (RoA), which is the ratio of the bank’s net profits to its net assets. Banks have witnessed a decline in their profitability in the last few years (Figure 2), making them vulnerable to adverse economic shocks and consequently putting consumer deposits at risk.
   Some of the factors leading to the increased occurrence of NPAs are external, such as decreases in global commodity prices leading to slower exports. Some are more intrinsic to the Indian banking sector.
   A lot of the loans currently classified as NPAs originated in the mid-2000s, at a time when the economy was booming and business outlook was very positive. Large corporations were granted loans for projects based on extrapolation of their recent growth and performance. With loans being available more easily than before, corporations grew highly leveraged, implying that most financing was through external borrowings rather than internal promoter equity. But as economic growth stagnated following the global financial crisis of 2008, the repayment capability of these corporations decreased. This contributed to what is now known as India’s Twin Balance Sheet problem, where both the banking sector (that gives loans) and the corporate sector (that takes and has to repay these loans) have come under financial stress.
   When the project for which the loan was taken started underperforming, borrowers lost their capability of paying back the bank. The banks at this time took to the practice of ‘evergreening’, where fresh loans were given to some promoters to enable them to pay off their interest. This effectively pushed the recognition of these loans as non-performing to a later date, but did not address the root causes of their unprofitability.
   Further, recently there have also been frauds of high magnitude that have contributed to rising NPAs. Although the size of frauds relative to the total volume of NPAs is relatively small, these frauds have been increasing, and there have been no instances of high profile fraudsters being penalised.
   Among the major public sector banks, State Bank of India (SBI) had the highest amount of NPAs at over Rs 1.86 lakh crore followed by Punjab National Bank (Rs 57,630 crore), Bank of India (Rs 49,307 crore), Bank of Baroda (Rs 46,307 crore), Canara Bank (Rs 39,164 crore) and Union Bank of India (Rs 38,286 crore).
   Among private sector lenders, ICICI Bank had the highest amount of NPAs on its books at Rs 44,237 crore by the end of September, followed by Axis Bank (Rs 22,136 crore), HDFC Bank (Rs 7,644 crore) and Jammu & Kashmir Bank (Rs 5,983 crore).
   Gross non-performing asset value of public sector banks in India from financial year 2018 to 2020 (in trillion Indian rupees)
   The disruptions led by the coronavirus pandemic has further deteriorated the health of the Indian banking industry, which was already reeling under severe stress in the previous years. India’s NPA ratio is one of the highest among comparable countries and further, it is expected to reach 11-11.5 per cent by the end of the current fiscal year 2020-21, said a report by Care Ratings. The FY21 GNPA numbers would move significantly ahead from the current 8.5 per cent level, but would be lower due to the one-time restructuring scheme, the report added. However, it is estimated that the additions to the GNPAs would primarily take place from SMA 1 and SMA 2 corporate loans under moratorium and not eligible for restructuring.
   Lower-rated corporates not eligible for the restructuring scheme already stressed companies which could face liquidity constraints in a challenging economy, and banking exposure to unsecured personal loans, are also the reasons for higher bank NPAs this fiscal. The Reserve Bank has permitted a one-time restructuring of loans across three segments – corporate loans, MSME loans, and personal loans.
   However, before the loan restructuring was announced by RBI, a Finacial Stability Report released in the month of July showed that the gross NPA ratio of all SCBs may increase from 8.5 per cent in March 2020 to 12.5 per cent by March 2021 under the baseline scenario. It had added if the macroeconomic environment worsens, the ratio may further escalate to 14.7 per cent under the very severely stressed scenario.
   On the projection of a skyrocketing NPAs, RBI Governor Shaktikanta Das had said that the country’s financial system is sound but lenders should desist from extreme risk aversion during the Covid-19 pandemic and beyond. Shaktikanta Das had added that the top priority right now for banks and financial intermediaries should be for augmenting capital levels and improve resilience.
   He had also underlined that financial sector stability is a prerequisite for giving confidence to businesses, investors, and consumers, thus, banks have to remain extremely watchful and focused.