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CAUSES AND CONSEQUENCES OF NON-PERFORMING ASSETS

CAUSES AND COSEQUENCES OF NON-PERFORMING ASSETS

Quick Bytes 1.Causes of Non-Performing Assets- Internal & External 2.Consequences of Non-Performing Assets 3.Consequences on Quality of Lending 4.Consequences on Profitability 5.Consequences on capital Adequacy 6.Consequences on other factors

Introduction: By the late 1980s, the state of the Indian financial sector was precarious. Failing profitability, dubious loan portfolio, lack of credit discipline, politicized appointment of chief executives, loss making rural branches, deteriorating customer service was the principal maladies. By the 1990, many of the nationalized banks had to run through their capital. Banks were saddled with an alarming level of bad loans. The massive funds blocked in such sticky loans could not be recycled due to non-recovery of dues in Advances. This led to the erosion of banks profitability as they require higher provisions. The reasons for growing NPAs, as revealed by the Reserve Bank of India study group conducted recently, which examined 800 top NPA accounts in 17 banks, are as follows: Diversion of funds , mostly for expansion/ diversification/ modernization, taking up new projects or helping/ promoting associate concerns; Time/ cost overrun during the project implementation stage; Factors internal to business like product/ marketing etc failure, inefficient management, Strained labour relations and inappropriate technology/ technical problems and product obsolescence; Changes in the macro environment like recession, infrastructural bottle necks etc; Changes in Government policies( export-import duties); Non payment in other countries; Other systemic deficiencies like delay in release of sanctioned limits by banks. It is also revealed that the internal factors outweighed the external factors in accounts turning bad.
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This handout is updated till 31st March 2011

CAUSES AND CONSEQUENCES OF NON-PERFORMING ASSETS

CAUSES OF ASSETS BECOMIMNG NON-PERFORMING: The various causes that make an asset Non-Performing can be broadly classified into External Causes and Internal Causes. (i) The External Causes are those which are attributable to reason, which are beyond the control of the borrower or the management. (ii) The Internal Causes are those which are within the control of the borrower or management and attributable to them. External Causes The following could be termed as External Causes for an account becoming an NPA: (i)Adverse Government Policy guidelines affecting the production/marketing sales of the product. (ii) Natural calamity leading to destruction of assets. (iii) Closure of factory due to strikes, court orders. (iv) Recession in the Industry. (v) Adverse change in the projected demand due to factors like environmental regulations, change of fashion, change in consumer needs etc. (Vi) Inputs/ power shortage (Vii) Price escalation Internal Causes The Internal Causes for an account becoming NPA could be any or many of the following: (I)Management: (a) Willful default. (b) Dishonesty of partners, directors, proprietor etc. (c)Dispute among partners, directors etc. (d) Lack of proper organizational set up and control. (e) Lack of farsightedness/ hesitation for modernization (ii) Marketing: a. Inadequate product base. b. Lack of distribution channels. c. Irregular delivery. d. Inappropriate pricing. e. Unhealthy competition
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CAUSES AND CONSEQUENCES OF NON-PERFORMING ASSETS

(iii) Financial: a) Faulty costing and pricing. b) Lack of resources. c) Diversion of funds for unproductive expenditure. d) Costly outside borrowings. e) Increased cost of production. (iv) Production: a) b) c) d) e) f) g) h) Inappropriate technology. Lack of production planning and control. Frequent machine breakdowns. Poor labour productivity. Inferior quality of finished goods. Faulty inventory planning. Poor quality control. Improper site/ location

CONSEQUENCES OF NON-PERFORMING ASSETS Whenever an asset becomes Non-Performing its consequences on the bank can be manifold and they can be broadly classified into 4 categories: (i) Consequences on Quality of Lending. (ii) Consequences on Profitability. (iii) Consequences on Capital Adequacy. (iv) Consequences on other factors. (i)Consequences of NPA on Quality of Lending The most important consequence of an asset becoming NPA is the effect on the quality of the advances portfolio. The health of the Advances portfolio is measured in terms of its capacity to generate income. Ideally all advances, properly appraised and sanctioned, should remain performing till recovery of all the dues. However, due to various factors described above, accounts become non-performing. Thus, the health and quality of the lending portfolio is measured by the level of non-performing assets. The higher level of NPA would render lending portfolio less healthy. Higher percentage of NPA to total Advances reflects poorly on the quality of appraisal, follow-up and recovery. Thus, the level of NPA provides a quantitative picture of the qualitative aspects of Credit Administration & Credit Management. (ii) Consequences of NPA on Profitability

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CAUSES AND CONSEQUENCES OF NON-PERFORMING ASSETS

(i)The direct outcome of an account becoming NPA is two-fold: (a) Loss of income by way of interest etc. (b) Provisioning requirement. (ii) As per extant guidelines, when an account becomes NPA, income by way of interest etc. cannot be recognized on accrual basis. In other words, branch can not debit the interest to the account and credit it to Profit & Loss account, if the amount is not recovered within stipulated period. Any such Income credited to Profit & Loss account but not realized as above, should be reversed to the debit of Profit & Loss and credited to respective advance a/c. .Therefore, an immediate outcome of an account becoming NPA is the loss of income to the Bank by way of interest etc. (iii) Further, as per norms for provisioning prescribed by RBI, bank will have to provide for certain percentage of outstanding amount against the loss that may arise, due to the classification of an account as NPA. Such provisioning requirement, as per the regulatory norms may vary from 10% to 100% of balance outstanding, depending upon the classification of an asset as substandard, doubtful or loss and also on the realizable value of securities available. Such provisions have to be made from the Gross Profit made in a year which includes interest income from other standard assets. (iv) To illustrate the point, assume that an account with outstanding balance of Rs. 10,00,000/- is treated as NPA. Assuming that the average rate of interest on the a/c is 12%, the loss of income by way of interest in a year would be about Rs. 1,20,000/- (Approx.). If the account is classified as substandard a further provision of Rs. 1/- lac @ 10% will have to be made from the Gross Profit. Therefore, the net Profit would be reduced by Rs. 1,20,000/-+ 1,00,000/- = 2,20,000/- on account of the a/c being treated as NPA. (iii) Consequences of NPA on Capital Adequacy (i)As per RBIs guidelines, all commercial banks with international presence should achieve the capital adequacy norms of 8% (Ratio of unimpaired capital of free reserves to aggregate of weighted risk assets) by the end of March, 1995. In case of other banks (with no international branches), they should achieve the ratio of 8% by March, 1996. Banks were required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) norm of 8 percent on an ongoing basis up to the year ending 31 March 1999. With effect from the year ending 31 March 2000, banks are required to maintain a minimum CRAR of 9 percent on an ongoing basis. (ii) The unimpaired capital & reserves can be strengthened either by issue of fresh capital or by retaining profits. While the issue of fresh capital will depend upon statutory guidelines, market conditions, performance of the
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CAUSES AND CONSEQUENCES OF NON-PERFORMING ASSETS

bank etc. the addition to reserves is directly related to the profitability of the bank. The profitability in turn is dependent on the income earning capacity, which is dominated by interest income from Advances. (iii) If the Non-Performing Assets are more, the income generating capacity gets reduced and consequently the profitability is affected thus affecting the capital adequacy of the bank. (iv) The effect of not achieving the capital adequacy norm is that risk weighted assets like advances cannot be increased without a corresponding increase of at least 9 % in unimpaired capital and reserves. (iv) Consequences of NPA on other factors Besides the three major consequences of NPA, there are some other ramifications of increase in NPA. Some of them are given below: (i) International banks insist on all banks having equal prudential norms for doing business with them. Therefore, banks having large NPA would find it difficult to have banking relations with them, like opening of LCs, negotiation of documents under LCs, opening lines of credit etc. (ii) RBI has modified the guidelines on issue of licenses for opening of new branches, whereby only those banks whose NPA levels are below the desired level will be allowed to open new branches. (iii) High level of NPA prevents the banks from obtaining a good credit rating which in turn, would impair its ability to issue shares on high premium (iv) In present competitive environment, market analysts, press media, business channels, critically comment upon the performance of Corporate and specifically Banks and Financial Institutions. Health of Assets, level of net and gross NPAs and consequently the profitability of Bank is always under scanner of Market. This has direct bearing on the stock price of share having bearing on the capacity of the Bank to raise fresh capital as well as the confidence of all stake holders viz. Investor (Retail) FIIs, Corporate and Banks consultants. The huge level of NPA also affects the Return on Assets, Net worth, Autonomy, Business expansion, image of the Bank etc. RBI has taken action on the following areas of concern to contain the increasing NPAs among the Banks: Restriction on expansion of Risk weighted assets Capital restoration plan Approval for opening new branches New lines of business
This handout is updated till 31st March 2011

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CAUSES AND CONSEQUENCES OF NON-PERFORMING ASSETS

Paying off costly deposits Drive to reduce NPA To conclude, Bank credit is the catalyst to economic growth of the country. Any bottleneck in the smooth flow of credit like NPA will have serious repercussions in the economy.

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