FINAL REPORT

ON

MANAGEMENT OF

IN BANKS

SUBMITTED BY

MAYANK VERMA
(04BS1211)

SUBMITTED TO

PROF. P.C Verma

(Chairman Placement, IBS-GURGAON)

A REPORT SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS OF MBA

PROGRAM OF ICFAI BUSINESS SCHOOL, GURGAON
 Table Of Contents
• Acknowledgement 3
• Objective Of the Study 4
• Proposed Methodology 5
• Introduction 6
• Meaning of NPAs 8
• The Emergence of NPA in 11
Indian Banking & Financial
Institutions and its Dimensions
• Global Developments and NPAs 17
• Why NPAs have become an 18
issue for banks and financial
institutions in India?
• RBI Guidelines on income 24
recognition (interest income on
NPA)
• Management of NPAs 27
• Excess Liquidity? No problem, 43
but no lending please!!!
• Comparative analysis – NPA in 45
India vs. NPA in other Asian
countries
• Conclusion 51
• Bibliography 57

ACKNOWLEDGEMENT

2
The objective of the Management Research Project (MRP) is to widen
the knowledge base or deepen the understanding of the latest trends
and developments in the chosen field of management, gain experience
in application of concepts, tools and techniques and to develop an
overall managerial perspective.

An understanding study like this will never be possible with the efforts
of a single person and gracious help from various sources will
contribute tremendously towards the completion of this project work.

With all my dedication and regards I take this opportunity to express

my profound sense of gratitude and word of thanks to my faculty guide
Prof. P.C. Verma (Chairman Placement, IBS – Gurgaon) who has
given me the opportunity to undertake this study and has given me her
valuable advice from time to time which has made my training period
an educative, enriching and informative one.

Mayank Verma
04 BS 1211
IBS – Gurgaon.

OBJECTIVE OF THE STUDY

During the MRP, I will critically analyze the following:

3
• The need for managing NPA’s

• Strategies to deal with the NPA problem

• Public sector vs. Private sector banks – a comparative picture

• Effect of priority sector lending on management of NPA’s

• Risk management from a regulatory perspective

• Risk management practices in Banks

• Comparative analysis – NPA in India vs. NPA in other Asian

countries

• Emerging trends and challenges in risk management

4
 PROPOSED METHODOLOGY

I would commence working on this project by collecting secondary

data available from various sources such as magazines, journals,
newspapers and various websites.

Another approach that I would adopt is to collect as much primary

data as possible from fellow batch mates who have done their summer
training with various banks. I would also try to gather live information
(facts and figures from various banks) in order to get the complete
picture of how the banks manage their NPA’s.

During the course of the study if I come across certain limitations of

banks regarding their strategy towards NPA management, I would try
to recommend certain suggestions in this report.

INTRODUCTION

5
Banking sector reforms in India has progressed promptly on aspects
like interest rate deregulation, reduction in statutory reserve
requirements, prudential norms for interest rates, asset classification,
income recognition and provisioning. But it could not match the pace
with which it was expected to do. The accomplishment of these norms
at the execution stages without restructuring the banking sector as
such is creating havoc. This research paper deals with the problem of
having non-performing assets, the reasons for mounting of non-
performing assets and the practices present in other countries for
dealing with non-performing assets.

During pre-nationalization period and after independence, the banking

sector remained in private hands Large industries who had their control
in the management of the banks were utilizing major portion of
financial resources of the banking system and as a result low priority
was accorded to priority sectors. Government of India nationalized the
banks to make them as an instrument of economic and social change
and the mandate given to the banks was to expand their networks in
rural areas and to give loans to priority sectors such as small scale
industries, self-employed groups, agriculture and schemes involving
women.

To a certain extent the banking sector has achieved this mandate. Lead
Bank Scheme enabled the banking system to expand its network in a
planned way and make available banking series to the large number of
population and touch every strata of society by extending credit to
their productive endeavors. This is evident from the fact that
population per office of commercial bank has come down from 66,000
in the year 1969 to 11,000 in 2004. Similarly, share of advances of

6
public sector banks to priority sector increased form 14.6% in 1969 to
44% of the net bank credit. The number of deposit accounts of the
banking system increased from over 3 crores in 1969 to over 30 crores.
Borrowed accounts increased from 2.50 lakhs to over 2.68 crores.

It's a known fact that the banks and financial institutions in India face
the problem of swelling non-performing assets (NPAs) and the issue is
becoming more and more unmanageable. In order to bring the
situation under control, some steps have been taken recently. The
Securitisation and Reconstruction of Financial Assets and Enforcement
of Security Interest Act, 2002 was passed by Parliament, which is an
important step towards elimination or reduction of NPAs.

Meaning of NPAs

7
An asset is classified as non-performing asset (NPAs) if dues in the form
of principal and interest are not paid by the borrower for a period of
180 days. However with effect from March 2004, default status would
be given to a borrower if dues are not paid for 90 days. If any advance
or credit facilities granted by bank to a borrower become non-
performing, then the bank will have to treat all the advances/credit
facilities granted to that borrower as non-performing without having
any regard to the fact that there may still exist certain advances /
credit facilities having performing status.

Difficulties with the non-performing assets:

1. Owners do not receive a market return on their capital. In the worst
case, if the bank fails, owners lose their assets. In modern times, this
may affect a broad pool of shareholders.

2. Depositors do not receive a market return on savings. In the worst

case if the bank fails, depositors lose their assets or uninsured balance.
Banks also redistribute losses to other borrowers by charging higher
interest rates. Lower deposit rates and higher lending rates repress
savings and financial markets, which hampers economic growth.

3. Non performing loans epitomize bad investment. They misallocate

credit from good projects, which do not receive funding, to failed
projects. Bad investment ends up in misallocation of capital and, by
extension, labour and natural resources. The economy performs below
its production potential.

4. Non performing loans may spill over the banking system and
contract the money stock, which may lead to economic contraction.
This spillover effect can channelize through illiquidity or bank

8
insolvency; (a) when many borrowers fail to pay interest, banks may
experience liquidity shortages. These shortages can jam payments
across the country, (b) illiquidity constraints bank in paying depositors
e.g. cashing their paychecks. Banking panic follows. A run on banks by
depositors as part of the national money stock become inoperative. The
money stock contracts and economic contraction follows (c)
undercapitalized banks exceeds the banks capital base.

Lending by banks has been highly politicized. It is common knowledge

that loans are given to various industrial houses not on commercial
considerations and viability of project but on political considerations;
some politician would ask the bank to extend the loan to a particular
corporate and the bank would oblige. In normal circumstances banks,
before extending any loan, would make a thorough study of the actual
need of the party concerned, the prospects of the business in which it
is engaged, its track record, the quality of management and so on.
Since this is not looked into, many of the loans become NPAs.

The loans for the weaker sections of the society and the waiving of the
loans to farmers are another dimension of the politicization of bank
lending.

Most of the depositor’s money has been frittered away by the banks at
the instance of politicians, while the same depositors are being made
to pay through taxes to cover the losses of the bank.

Why such huge levels of NPAs exist in the Indian banking

system (IBS)?

9
The origin of the problem of burgeoning NPAs lies in the quality of
managing credit risk by the banks concerned. What is needed is having
adequate preventive measures in place namely, fixing pre-sanctioning
appraisal responsibility and having an effective post-disbursement
supervision. Banks concerned should continuously monitor loans to
identify accounts that have potential to become non-performing.

The Emergence of NPA in Indian Banking &

Financial Institutions and its Dimensions

10
Undoubtedly the world economy has slowed down, recession is at its
peak, globally stock markets have tumbled and business itself is
getting hard to do. The Indian economy has been much affected due to
high fiscal deficit, poor infrastructure facilities, sticky legal system,
cutting of exposures to emerging markets by FIIs, etc.

Further, international rating agencies like, Standard & Poor have

lowered India's credit rating to sub-investment grade. Such negative
aspects have often outweighed positives such as increasing forex
reserves and a manageable inflation rate.

Under such a situation, it goes without saying that banks are no

exception and are bound to face the heat of a global downturn. One
would be surprised to know that the banks and financial institutions in
India hold non-performing assets worth Rs. 1,10,000 crores. Bankers
have realized that unless the level of NPAs is reduced drastically, they
will find it difficult to survive.

Non-performing Asset (NPA) has emerged since over a decade as an

alarming threat to the banking industry in our country sending
distressing signals on the sustainability and endurability of the affected
banks. The positive results of the chain of measures effected under
banking reforms by the Government of India and RBI in terms of the
two Narasimhan Committee Reports in this contemporary period have
been neutralised by the ill effects of this surging threat. Despite various
correctional steps administered to solve and end this problem, concrete
results are eluding. It is a sweeping and all pervasive virus confronted
universally on banking and financial institutions. The severity of the

11
problem is however acutely suffered by Nationalised Banks, followed by
the SBI group, and the all India Financial Institutions.

As at 31.03.2003 the aggregate gross NPA of all scheduled commercial

banks amounted to Rs.75,005 Crore. Table No.I gives the figures of
gross and net NPA for the years 1997-2001. It shows an increase of
Rs.13,068 Crore or more than 25% in the last financial year, indicating
that fresh accretion to NPA is more than the recoveries that were
effected, thus signifying a losing battle in containing this menace.

Table No. I

%-age
%-age
of
NPA Statistics - All of Net
Total Gros Net Gross
Scheduled Commercial Net NPA to
Advanc s Advanc NPA to
Banks........................... NPA net
es NPA es total
....... (Amount in Crores) advance
advanc
Year s
es
5081 2573
1997-98 352697 325522 14.4 7.3
5 4
5872 2789
1998-99 399496 367012 14.7 7.6
2 2
6040 3021
1999-2000 475113 444292 12.7 6.8
8 1
6388 3263
2000-2001 558766 526329 11.4 6.2
3 2

The apparent reduction of gross NPA from 14.4% to 11.4% between

1998 and 2001 provides little comfort, since this accomplishment is on
account of credit growth, which was higher than the growth of Gross
NPA and not through appreciable recovery of NPA. There is neither
reduction nor even containment of the threat.

12
The gross NPA and net NPA for PSBs as at 31.03.2001 are 12.39% and
6.74% are higher than the figures for SCBs at 11.4%and 6.2%.
Comparative figures for PSBs, SBI Group and Nationalised Banks are as
under.
Table -2 :
%-age of %-age of
NPA of PSBs… Gross Net
Total Gross Net
(Amount in Crores) NPA to NPA to
Advances NPA NPA
Year total net
advances advances
1996-97 244214 43577 20285 17.8 % 9.2 %
1997-98 284971 45563 21232 16.0 % 8.2 %
1998-99 325328 51710 24211 15.9 % 8.1 %
1999-2000 380077 53033 26188 14.00 % 7.9%
2000-2001 442134 54773 27967 12.39 % 6.74%

Table -3:
%-age of %-age of
NPA of Nationalised Gross Net
Total Gross Net
Banks…. (Amount in NPA to NPA to
Advances NPA NPA
Crores) Year total net
advances advances
1997-98 166222 30130 14441 16.88 8.91
1998-99 188926 33069 15759 16.02 8.35
1999-2000 224818 33521 17399 13.99 7.80
2000-2001 264237 34609 16096 12.19 7.01

Further it is revealed that commercial banks in general suffer a

tendency to understate their NPA figures. There is the practice of 'ever-
greening' of advances, through subtle techniques. As per report
appearing in a national daily the banking industry has under-estimated
its non-performing assets (NPAs) by whopping Rs. 3,862.10 Crore as on
March 1997. The industry is also estimated to have under-provided to
the extent of Rs 1,412.29 Crore. The worst "offender" is the public
sector banking industry. Nineteen nationalised banks along with the

13
State Bank of India and its seven associate banks have underestimated
their NPAs by Rs 3,029.29 Crore. Such deception of NPA statistics is
executed through the following ways.

• Failure to identify an NPA as per stipulated guidelines: There

were instances of `sub-standard' assets being classified as
`standard';
• Wrong classification of an NPA: classifying a `loss' asset as a
`doubtful' or `sub-standard' asset; classifying a `doubtful' asset
as a `sub-standard' asset.
• Classifying an account of a credit customer as `substandard' and
other accounts of the same credit customer as `standard',
throwing prudential norms to the winds.
• Essentially arising from the wrong classification of NPAs, there
was a variation in the level of loan loss provisioning actually held
by the bank and the level required to be made. This practice can
be logically explained as a desperate attempt on the part of the
bankers, whenever adequate current earnings were not available
to meet provisioning obligations. Driven to desperation and
impelled by the desire not to accept defeat, they have chosen to
mislead and claim compliance with the provisioning norms,
without actually providing. This only shows that the problem has
swelled to graver dimensions.

The international rating agency Standard & Poor (S & P) conveys the
gloomiest picture, while estimating NPAs of the Indian banking sector
between 35% to 70% of its total outstanding credit. Much of this, up to
35% of the total banking assets, as per the rating agency would be
accounted as NPA if rescheduling and restructuring of loans to make
them good assets in the book are not taken into account. However RBI
has contested this dismal assessment. But the fact remains that the

14
infection if left unchecked will eventually lead to what has been
forecast by the rating agency. This invests an urgency to tackle this
virus as a fire fighting exercise.

Financial institutions have not far lagged behind. NPAs of ten leading
institutions have reported a rise of 11.89 per cent, or Rs 1,929 Crore, to
Rs 18,146 Crore during the year ended March 2000 from Rs 16,217
Crore last year. The NPA statistics of the three leading Financial
Institutions for the last two years are given in Table-5 IDBI tops the list
by notching up bad loans worth Rs 7665 Crore by March 2000. In fact,
its NPAs have gone up by Rs 1,185 Crore from Rs 6,490 Crore in the
previous year. IFCI followed with NPAs of Rs 4,103 Crore, but it reported
fall of Rs 134 Crore from the previous year's level of Rs 4,237 Crore.
ICICI's NPAs went up to Rs 3,959 Crore from Rs 3,623 Crore in the
previous year.

Emergence of NPA as an Alarming Threat to Nationalised Banks

NPA is a brought forward legacy accumulated over the past three
decades, when prudent norms of banking were forsaken basking by the
halo of security provided by government ownership. It is not wrong to
have pursued social goals, but this does not justify relegating banking
goals and fiscal discipline to the background. But despite this
extravagance the malaise remained invisible to the public eyes due to
the practice of not following transparent accounting standards, but
keeping the balance sheets opaque. This artificially conveyed picture of
'all is well' with PSBs suddenly came to an end when the lid was open
with the introduction of the prudential norms of banking in the year
1992-93, bringing total transparency in disclosure norms and
'cleansing' the balance sheets of commercial banks for the first time in
the country.

15
In the peak crisis period in early Nineties, when the first Series of
Banking Reforms were introduced, the working position of the State-
owned banks exhibited the severest strain. Commenting on this
situation the Reserve Bank of India in its web-site has pointed
out as under:
"Till the adoption of prudential norms relating to income recognition,
asset classification, provisioning and capital adequacy, twenty-six out
of twenty-seven public sector banks were reporting profits (UCO Bank
was incurring losses from 1989-90). In the first post-reform year, i.e.,
1992-93, the profitability of the PSBs as a group turned negative with
as many as twelve nationalised banks reporting net losses. By March
1996, the outer time limit prescribed for attaining capital adequacy of
8 per cent, eight public sector banks were still short of the prescribed."

Consequently PSBs in the post reform period came to be classified

under three categories as -
• healthy banks (those that are currently showing profits and hold
no accumulated losses in their balance sheet)
• banks showing currently profits, but still continuing to have
accumulated losses of prior years carried forward in their balance
sheets
• Banks which are still in the red, i.e. showing losses in the past
and in the present.

16
 Global Developments and NPAs

The core banking business is of mobilizing the deposits and utilizing it

for lending to industry. Lending business is generally encouraged
because it has the effect of funds being transferred from the system to
productive purposes which results into economic growth.

However lending also carries credit risk, which arises from the failure of
borrower to fulfill its contractual obligations either during the course of
a transaction or on a future obligation.

A question that arises is how much risk can a bank afford to take ?
Recent happenings in the business world - Enron, WorldCom, Xerox,
Global Crossing do not give much confidence to banks. In case after
case, these giant corporate became bankrupt and failed to provide
investors with clearer and more complete information thereby
introducing a degree of risk that many investors could neither neither
anticipate nor welcome. The history of financial institutions also reveals
the fact that the biggest banking failures were due to credit risk.

Due to this, banks are restricting their lending operations to secured

avenues only with adequate collateral on which to fall back upon in a
situation of default.

17
Why NPAs have become an issue for banks and
financial institutions in India?
To start with, performance in terms of profitability is a benchmark for
any business enterprise including the banking industry. However,
increasing NPAs have a direct impact on banks profitability as legally
banks are not allowed to book income on such accounts and at the
same time banks are forced to make provision on such assets as per
the Reserve Bank of India (RBI) guidelines.
Also, with increasing deposits made by the public in the banking
system, the banking industry cannot afford defaults by borrower s since
NPAs affects the repayment capacity of banks.
Further, Reserve Bank of India (RBI) successfully creates excess
liquidity in the system through various rate cuts and banks fail to utilize
this benefit to its advantage due to the fear of burgeoning non-
performing assets.

NPA has affected the profitability, liquidity and competitive functioning

of PSBs and finally the psychology of the bankers in respect of their
disposition towards credit delivery and credit expansion.

Impact on Profitability
Between 01.04.93 to 31.03.2003 Commercial banks incurred a total
amount of Rs.31251 Crores towards provisioning NPA. This has brought
Net NPA to Rs.32632 Crores or 6.2% of net advances. To this extent the
problem is contained, but at what cost? This costly remedy is made at
the sacrifice of building healthy reserves for future capital adequacy.

18
The enormous provisioning of NPA together with the holding cost of
such non-productive assets over the years has acted as a severe drain
on the profitability of the PSBs. In turn PSBs are seen as poor
performers and unable to approach the market for raising additional
capital. Equity issues of nationalised banks that have already tapped
the market are now quoted at a discount in the secondary market.
Other banks hesitate to approach the market to raise new issues. This
has alternatively forced PSBs to borrow heavily from the debt market to
build Tier II Capital to meet capital adequacy norms putting severe
pressure on their profit margins, else they are to seek the bounty of the
Central Government for repeated Recapitalisation.

Considering the minimum cost of holding NPAs at 7% p.a. (reckoning

average cost of funds at 6% plus 1% service charge) the net NPA of
Rs.32632 Crores absorbs a recurring holding cost of Rs.2300 Crores
annually. Considering the average provisions made for the last 8 years,
which works out to average of Rs.3300 crores from annum, a sizeable
portion of the interest income is absorbed in servicing NPA. NPA is not
merely non-remunerative. It is also cost absorbing and profit eroding.

In the context of severe competition in the banking industry, the weak

banks are at disadvantage for leveraging the rate of interest in the
deregulated market and securing remunerative business growth. The
options for these banks are lost. "The spread is the bread for the
banks". This is the margin between the cost of resources employed and
the return therefrom. In other words it is gap between the return on
funds deployed(Interest earned on credit and investments) and cost of
funds employed(Interest paid on deposits). When the interest rates
were directed by RBI, as heretofore, there was no option for banks. But
today in the deregulated market the banks decide their lending rates
and borrowing rates. In the competitive money and capital Markets,

19
inability to offer competitive market rates adds to the disadvantage of
marketing and building new business.

In the face of the deregulated banking industry, an ideal competitive

working is reached, when the banks are able to earn adequate amount
of non-interest income to cover their entire operating expenses i.e. a
positive burden. In that event the spread factor i.e. the difference
between the gross interest income and interest cost will constitute its
operating profits. Theoretically even if the bank keeps 0% spread, it will
still break even in terms of operating profit and not return an operating
loss. The net profit is the amount of the operating profit minus the
amount of provisions to be made including for taxation. On account of
the burden of heavy NPA, many nationalised banks have little option
and they are unable to lower lending rates competitively, as a wider
spread is necessitated to cover cost of NPA in the face of lower income
from off balance sheet business yielding non-interest income.

It is worthwhile to compare the aggregate figures of the 19

Nationalised banks for the year ended March 2001, as published by RBI
in its Report on trends and progress of banking in India.
Table 4 - Nationalised banks operational
Year endedYear ended
statistics……….. (Amount in Crores)
Mar. 2000 Mar. 2001
Performance indicator
Earnings - Non-interest 6662.42 7159.41
Operating expenses 14251.87 17283.55
Difference - 7589.45 - 10124.14
Earnings - interest income 50234.01 56967.11
Exp.-Interest expenses 35477.41 38789.64
Interest spread 14756.60 18177.47
Intt. On Recap bonds 1797.88 1795.48
Operating Profit 5405.27 6257.85
Provisions 4766.15 5958.24
Net Profit 639.12 299.61

20
Interest on Recapitalisation Bonds is a income earned from the
Government, who had issued the Recapitalisation Bonds to the weak
banks to sustain their capital adequacy under a bail out package. The
statistics above show the other weaknesses of the nationalised banks
in addition to the heavy burden they have to bear for servicing NPA by
way of provisioning and holding cost as under:

• Their operating expenses are higher due to surplus manpower

employed. Wage costs to total assets is much higher to PSBs
compared to new private banks or foreign banks.
• Their earnings from sources other than interest income are
meagre. This is due to failure to develop off balance sheet
business through innovative banking products.

How NPA Affects the Liquidity of the NationalisedBanks?

Though nationalised banks (except Indian Bank) are able to meet

norms of Capital Adequacy, as per RBI guidelines, the fact that their net
NPA in the average is as much as 7% is a potential threat for them. RBI
has indicated the ideal position as Zero percent Net NPA. Even granting
3% net NPA within limits of tolerance the nationalised banks are
holding an uncomfortable burden at 7.1% as at March 2003. They have
not been able to build additional capital needed for business expansion
through internal generations or by tapping the equity market, but have
resorted to II-Tier capital in the debt market or looking to recapitalistion
by Government of India.

How NPA Affects the Outlook of Bankers towards Credit

Delivery

21
The fear of NPA permeates the psychology of bank managers in the
PSBs in entertaining new projects for credit expansion. In the world of
banking the concepts of business and risks are inseparable. Business is
an exercise of balancing between risk and reward. Accept justifiable
risks and implement de-risking steps. Without accepting risk, there can
be no reward. The psychology of the banks today is to insulate
themselves with zero percent risk and turn lukewarm to fresh credit.
This has affected adversely credit growth compared to growth of
deposits, resulting a low C/D Ratio around 50 to 54% for the industry.
The fear psychosis also leads to excessive security-consciousness in
the approach towards lending to the small and medium sized credit
customers. There is insistence on provision of collateral security,
sometimes up to 200% value of the advance, and consequently due to
a feeling of assumed protection on account of holding adequate
security (albeit over-confidence), a tendency towards laxity in the
standards of credit appraisal comes to the fore. It is well known that
the existence of collateral security at best may convert the credit
extended to productive sectors into an investment against real estate,
but will not prevent the account turning into NPA. Further blocked
assets and real estate represent the most illiquid security and NPA in
such advances has the tendency to persist for a long duration.

Impact of NPAs on banks' profits and lending prowess

"The efficiency of a bank is not always reflected only by the size of its
balance sheet but by the level of return on its assets. NPAs do not
generate interest income for the banks, but at the same time banks
are required to make provisions for such NPAs from their current
profits”

22
NPAs have a deleterious effect on the return on assets in several ways -
• They erode current profits through provisioning requirements
• They result in reduced interest income
• They require higher provisioning requirements affecting profits
and accretion to capital funds and capacity to increase good
quality risk assets in future, and
• They limit recycling of funds, set in asset-liability mismatches, etc

There is at times a tendency among some of the banks to understate

the level of NPAs in order to reduce the provisioning and boost up
bottom lines. It would only postpone the CBI and vigilance to
management senior the subjecting besides internationally, credibility
losing weak as branded getting like consequences, disastrous with
banks of some in happened effect.

In the context of crippling effect on a bank's operations in all spheres,

asset quality has been placed as one of the most important parameters
in the measurement of a bank's performance under the CAMELS
supervisory rating system of RBI.

Nationalised banks have reached a dead-end of the tunnel and their

future prosperity depends on an urgent solution of this hovering threat.

23
 RBI guidelines on income recognition
(interest income on NPAs)

Banks recognize income including interest income on advances on

accrual basis. That is, income is accounted for as and when it is earned.
The prima-facie condition for accrual of income is that it should not be
unreasonable to expect its ultimate collection. However, NPAs involves
significant uncertainty with respect to its ultimate collection.
Considering this fact, in accordance with the guidelines for income
recognition issued by the Reserve Bank of India (RBI), banks should not
recognize interest income on such NPAs until it is actually realized.
The Accounting Standard 9 (AS 9) on `Revenue Recognition' issued by
the Institute Of Chartered Accountants of India (ICAI) requires that the
revenue that arises from the use by others of enterprise resources
yielding interest should be recognized only when there is no significant
uncertainty as to its measurability or collectability.
Also, interest income should be recognized on a time proportion basis
after taking into consideration rate applicable and the total amount
outstanding.

Is RBI guidelines on NPAs and ICAI Accounting Standard 9 on revenue

recognition consistent with each other?

In view of the guidelines issued by the Reserve Bank of India (RBI),

interest income on NPAs should be recognised only when it is actually
realised.
As such, a doubt may arise as to whether the aforesaid guidelines with
respect to recognition of interest income on NPAs on realization basis

24
are consistent with Accounting Standard 9, `Revenue Recognition'. For
this purpose, the guidelines issued by the RBI for treating certain
assets as NPAs seem to be based on an assumption that the collection
of interest on such assets is uncertain.
Therefore complying with AS 9, interest income is not recognized based
on uncertainty involved but is recognized at a subsequent stage when
actually realized thereby complying with RBI guidelines as well.
In order to ensure proper appreciation of financial statements, banks
should disclose the accounting policies adopted in respect of
determination of NPAs and basis on which income is recognized with
other significant accounting policies.

RBI guidelines on classification of bank advances

Reserve Bank of India (RBI) has issued guidelines on provisioning
requirement with respect to bank advances. In terms of these
guidelines, bank advances are mainly classified into:

Standard Assets: Such an asset is not a non-performing asset. In

other words, it carries not more than normal risk attached to the
business.

Sub-standard Assets: It is classified as non-performing asset for a

period not exceeding 18 months

Doubtful Assets: Asset that has remained NPA for a period exceeding
18 months is a doubtful asset.

Loss Assets: Here loss is identified by the banks concerned or by

internal auditors or by external auditors or by Reserve Bank India (RBI)
inspection.

25
In terms of RBI guidelines, as and when an asset becomes a NPA, such
advances would be first classified as a sub-standard one for a period
that should not exceed 18 months and subsequently as doubtful
assets.
It should be noted that the above classification is only for the purpose
of computing the amount of provision that should be made with respect
to bank advances and certainly not for the purpose of presentation of
advances in the banks balance sheet.

The Third Schedule to the Banking Regulation Act, 1949, solely governs
presentation of advances in the balance sheet.

Banks have started issuing notices under Securitisation Act, 2002

directing the defaulter to either pay back the dues to the bank or else
give the possession of the secured assets mentioned in the notice.
However, there is a potential threat to recovery if there is substantial
erosion in the value of security given by the borrower or if borrower has
committed fraud. Under such a situation it will be prudent to directly
classify the advance as a doubtful or loss asset, as appropriate.

RBI guidelines on provisioning requirement of bank advances

As and when an asset is classified as an
NPA, the bank has to further sub-classify it into sub-standard, loss and
doubtful assets. Based on this classification, bank makes the necessary
provision against these assets.

Reserve Bank of India (RBI) has issued guidelines on provisioning

requirements of bank advances where the recovery is doubtful. Banks
are also required to comply with such guidelines in making adequate
provision to the satisfaction of its auditors before declaring any
dividends on its shares.

26
In case of loss assets, guidelines specifically require that full provision
for the amount outstanding should be made by the concerned bank.
This is justified on the grounds that such an asset is considered
uncollectible and cannot be classified as bankable asset.

Also in case of doubtful assets, guidelines requires the bank concerned

to provide entirely the unsecured portion and in case of secured portion
an additional provision of 20%-50% of the secured portion should be
made depending upon the period for which the advance has been
considered as doubtful.

For instance, for NPAs which are up to 1-year old, provision should be
made of 20% of secured portion, in case of 1-3 year old NPAs up to
30% of the secured portion and finally in case of more than 3 year old
NPAs up to 50% of secured portion should be made by the concerned
bank.

In case of a sub-standard asset, a general provision of 10% of total

outstandings should be made.
Reserve Bank of India (RBI) has merely laid down the minimum
provisioning requirement that should be complied with by the
concerned bank on a mandatory basis. However, where there is a
substantial uncertainty to recovery, higher provisioning should be
made by the bank concerned.

27
 Management of NPAs
"The quality and performance of advances have a direct bearing on the
profitability and viability of banks. Despite an efficient credit appraisal
and disbursement mechanism, problems can still arise due to various
factors. The essential component of a sound NPA management system
is quick identification of non-performing advances, their containment at
minimum levels and ensuring that their impingement on the financials
is minimum.”

The approach to NPA management has to be multi-pronged, calling for

different strategies at different stages a credit facility passes through.
RBI's guidelines to banks (issued in 1999) on Risk Management
Systems outline the strategies to be followed for efficient management
of credit portfolio. I would like to touch upon a few essential aspects of
NPA management in this paper.

Excessive reliance on collateral has led Indian banks nowhere except to

long drawn out litigation and hence it should not be sole criterion for
sanction. Sanctions above certain limits should be through Committee
which can assume the status of an 'Approval Grid'.

It is common to find banks running after the same borrower/borrower

groups as we see from the spate of requests for considering proposals
to lend beyond the prescribed exposure limits. I would like to caution
that running after niche segment may be fine in the short run but is
equally fraught with risk. Banks should rather manage within the
appropriate exposure limits. A linkage to net owned funds also needs to
be developed to control high leverages at borrower level.

28
Exchange of credit information among banks would be of immense help
to them to avoid possible NPAs. There is no substitute for critical
management information system and market intelligence.

We have come across cases of excellent appraisal and compliance with

sanction procedures but no control at disbursement stage over
compliance with the terms of sanction. To overcome this problem a
mechanism for independent review of compliance with terms of
sanction has to be put in place.

Close monitoring of the account particularly the larger ones is the

primary solution. Emerging weakness in profitability and liquidity,
recessionary trends, recovery of installments / interest with time lag,
etc., should put the banks on caution. The objective should be to assess
the liquidity of the borrower, both present and future prospects. Loan
review mechanism is a tool to bring about qualitative improvement in
credit administration. Banks should follow risk rating system to reveal
the risk of lending. The risk-rating process should be different from
regular loan renewal exercise and the exercise should be carried out at
regular intervals. It is not enough for banks to aspire to become big
players without being backed by development of internal rating
models. This is going to be a pre-requisite under the New Capital
Adequacy framework and if a bank wants to be an international player,
it shall have to go for such a system.

Banks should ensure that sanctioning of further credit facilities is done

only at higher levels. A quick review of all documents originally
obtained and their validity should be made. A phased programme of
exit from the account should also be considered.

29
Measures for faster legal process

Lok Adalats
Lok Adalat institutions help banks to settle disputes involving accounts
in "doubtful" and "loss" category, with outstanding balance of Rs.5 lakh
for compromise settlement under Lok Adalats. Debt Recovery Tribunals
have now been empowered to organize Lok Adalats to decide on cases
of NPAs of Rs.10 lakhs and above. The public sector banks had
recovered Rs.40.38 crore as on September 30, 2001, through the forum
of Lok Adalat. The progress through this channel is expected to pick up
in the coming years particularly looking at the recent initiatives taken
by some of the public sector banks and DRTs in Mumbai.For more
details about Lok Adalats please refer to page Lok Adalat

Debt Recovery Tribunals

The Recovery of Debts due to Banks and Financial Institutions
(amendment) Act, passed in March 2000 has helped in strengthening
the functioning of DRTs. Provisions for placement of more than one
Recovery Officer, power to attach defendant's property/assets before
judgement, penal provisions for disobedience of Tribunal's order or for
breach of any terms of the order and appointment of receiver with
powers of realization, management, protection and preservation of
property are expected to provide necessary teeth to the DRTs and
speed up the recovery of NPAs in the times to come.

Though there are 22 DRTs set up at major centres in the country with
Appellate Tribunals located in five centres viz. Allahabad, Mumbai,
Delhi, Calcutta and Chennai, they could decide only 9814 cases for
Rs.6264.71 crore pertaining to public sector banks since inception of

30
DRT mechanism and till September 30, 2003.The amount recovered in
respect of these cases amounted to only Rs.1864.30 crore.
Looking at the huge task on hand with as many as 33049 cases
involving Rs.42988.84 crore pending before them as on September 30,
2001, I would like the banks to institute appropriate documentation
system and render all possible assistance to the DRTs for speeding up
decisions and recovery of some of the well collateralised NPAs involving
large amounts. RBI on its part has suggested to the Government to
consider enactment of appropriate penal provisions against obstruction
by borrowers in possession of attached properties by DRT receivers,
and notify borrowers who default to honour the decrees passed against
them.

Circulation of information on defaulters

The RBI has put in place a system for periodical circulation of details of
willful defaults of borrowers of banks and financial institutions. This
serves as a caution list while considering requests for new or additional
credit limits from defaulting borrowing units and also from the directors
/proprietors / partners of these entities. RBI also publishes a list of
borrowers (with outstanding aggregating Rs. 1 crore and above)
against whom suits have been filed by banks and FIs for recovery of
their funds, as on 31st March every year. It is our experience that these
measures had not contributed to any perceptible recoveries from the
defaulting entities. However, they serve as negative basket of steps
shutting off fresh loans to these defaulters. I strongly believe that a real
breakthrough can come only if there is a change in the repayment
psyche of the Indian borrowers.

Recovery action against large NPAs

After a review of pendency in regard to NPAs by the Hon'ble Finance
Minister, RBI had advised the public sector banks to examine all cases

31
of willful default of Rs 1 crore and above and file suits in such cases,
and file criminal cases in regard to willful defaults. Board of Directors
are required to review NPA accounts of Rs.1 crore and above with
special reference to fixing of staff accountability.
On their part RBI and the Government are contemplating several
supporting measures including legal reforms, some of them I would like
to highlight.

Asset Reconstruction Company:

An Asset Reconstruction Company with an authorised capital of
Rs.2000 crore and initial paid up capital Rs.1400 crore is to be set up
as a trust for undertaking activities relating to asset reconstruction. It
would negotiate with banks and financial institutions for acquiring
distressed assets and develop markets for such assets.. Government of
India proposes to go in for legal reforms to facilitate the functioning of
ARC mechanism

Legal Reforms
The Honourable Finance Minister in his recent budget speech has
already announced the proposal for a comprehensive legislation on
asset foreclosure and securitisation. Since enacted by way of
Ordinance in June 2002 and passed by Parliament as an Act in
December 2002.

Corporate Debt Restructuring (CDR)

Corporate Debt Restructuring mechanism has been institutionalised in
2001 to provide a timely and transparent system for restructuring of
the corporate debts of Rs.20 crore and above with the banks and
financial institutions. The CDR process would also enable viable
corporate entities to restructure their dues outside the existing legal
framework and reduce the incidence of fresh NPAs. The CDR structure

32
has been headquartered in IDBI, Mumbai and a Standing Forum and
Core Group for administering the mechanism had already been put in
place. The experiment however has not taken off at the desired pace
though more than six months have lapsed since introduction. As
announced by the Hon'ble Finance Minister in the Union Budget 2002-
03, RBI has set up a high level Group under the Chairmanship of Shri.
Vepa Kamesam, Deputy Governor, RBI to review the implementation
procedures of CDR mechanism and to make it more effective. The
Group will review the operation of the CDR Scheme, identify the
operational difficulties, if any, in the smooth implementation of the
scheme and suggest measures to make the operation of the scheme
more efficient.

Credit Information Bureau

Institutionalisation of information sharing arrangements through the
newly formed Credit Information Bureau of India Ltd. (CIBIL) is under
way. RBI is considering the recommendations of the S.R.Iyer Group
(Chairman of CIBIL) to operationalise the scheme of information
dissemination on defaults to the financial system. The main
recommendations of the Group include dissemination of information
relating to suit-filed accounts regardless of the amount claimed in the
suit or amount of credit granted by a credit institution as also such
irregular accounts where the borrower has given consent for disclosure.
This, I hope, would prevent those who take advantage of lack of system
of information sharing amongst lending institutions to borrow large
amounts against same assets and property, which had in no small
measure contributed to the incremental NPAs of banks. More
information on CIBIL schme given in a separate page.

Proposed guidelines on willful defaults/diversion of funds

33
RBI is examining the recommendation of Kohli Group on willful
defaulters. It is working out a proper definition covering such classes of
defaulters so that credit denials to this group of borrowers can be made
effective and criminal prosecution can be made demonstrative against
willful defaulters.

Corporate Governance
A Consultative Group under the chairmanship of Dr. A.S. Ganguly was
set up by the Reserve Bank to review the supervisory role of Boards of
banks and financial institutions and to obtain feedback on the
functioning of the Boards vis-à-vis compliance, transparency,
disclosures, audit committees etc. and make recommendations for
making the role of Board of Directors more effective with a view to
minimising risks and over-exposure. The Group is finalising its
recommendations shortly and may come out with guidelines for
effective control and supervision by bank boards over credit
management and NPA prevention measures. The report of the group is
now published and discussed in another page.

Special Mention Accounts - Additional Precaution at the

Operating Level
In a recent circular, RBI has suggested to the banks to have a new
asset category - `special mention accounts' - for early identification of
bad debts. This would be strictly for internal monitoring. Loans and
advances overdue for less than one quarter and two quarters would
come under this category. Data regarding such accounts will have to
be submitted by banks to RBI.

However, special mention assets would not require provisioning, as

they are not classified as NPAs. Nor are these proposed to be brought
under regulatory oversight and prudential reporting immediately. The

34
step is mainly with a view to alerting management to the prospects of
such an account turning bad, and thus taking preventive action well in
time. An asset may be transferred to this category once the earliest
signs of sickness/irregularities are identified. This will help banks look
at accounts with potential problems in a focused manner right from the
onset of the problem, so that monitoring and remedial actions can be
more effective. Once these accounts are categorised and reported as
such, proper top management attention would also be ensured.

Borrowers having genuine problems due to temporary mismatch in

funds flow or sudden requirements of additional funds may be
entertained at the branch level, and for this purpose a special limit to
tide over such contingencies may be built into the sanction process
itself. This will prevent the need to route the additional funding request
through the controlling offices in deserving cases, and help avert many
accounts slipping into NPA category.

Introducing a `special mention' category as part of RBI's `Income

Recognition and Asset Classification norms' (IRAC norms) would be
considered in due course.

Credit Risk Management:

Quite often credit risk management (CRM) is confused with managing

non-performing assets (NPAs). However there is an appreciable
difference between the two. NPAs are a result of past action whose
effects are realized in the present i.e. they represent credit risk that
has already materialized and default has already taken place.

35
On the other hand managing credit risk is a much more forward-looking
approach and is mainly concerned with managing the quality of credit
portfolio before default takes place. In other words, an attempt is made
to avoid possible default by properly managing credit risk.

Considering the current global recession and unreliable information in

financial statements, there is high credit risk in the banking and lending
business.
To create a defense against such uncertainty, bankers are expected to
develop an effective internal credit risk models for the purpose of credit
risk management.

How important is credit rating in assessing the risk of default

for lenders?
Fundamentally Credit Rating implies evaluating the creditworthiness of
a borrower by an independent rating agency. Here objective is to
evaluate the probability of default. As such, credit rating does not
predict loss but it predicts the likelihood of payment problems.

Credit rating has been explained by Moody's a credit rating agency as

forming an opinion of the future ability, legal obligation and willingness
of a bond issuer or obligor to make full and timely payments on
principal and interest due to the investors.

Banks do rely on credit rating agencies to measure credit risk and

assign a probability of default.

Credit rating agencies generally slot companies into risk buckets that
indicate company's credit risk and is also reviewed periodically.

36
Associated with each risk bucket is the probability of default that is
derived from historical observations of default behavior in each risk
bucket.

However, credit rating is not fool-proof. In fact, Enron was rated

investment grade till as late as a month prior to it's filing for Chapter 11
bankruptcy when it was assigned an in-default status by the rating
agencies. It depends on the information available to the credit rating
agency. Besides, there may be conflict of interest which a credit rating
agency may not be able to resolve in the interest of investors and
lenders.

Stock prices are an important (but not the sole) indicator of the credit
risk involved. Stock prices are much more forward looking in assessing
the creditworthiness of a business enterprise. Historical data proves
that stock prices of companies such as Enron and WorldCom had
started showing a falling trend many months prior to it being
downgraded by credit rating agencies.

Usage of financial statements in assessing the risk of default for

lenders
For banks and financial institutions, both the balance sheet and income
statement have a key role to play by providing valuable information on
a borrower’s viability. However, the approach of scrutinizing financial
statements is a backward looking approach. This is because; the focus
of accounting is on past performance and current positions.

The key accounting ratios generally used for the purpose of

ascertaining the creditworthiness of a business entity is that of debt-
equity ratio and interest coverage ratio. Highly rated companies
generally have low leverage. This is because; high leverage is followed

37
by high fixed interest charges, non-payment of which results into a
default.

Capital Adequacy Ratio (CAR) of RBI and Basle committee on

banking supervision (BCBS)

Reserve Bank of India (RBI) has issued capital adequacy norms for the
Indian banks. The minimum CAR which the Indian Banks are required to
meet at all times is set at 9%. It should be taken into consideration that
the bank's capital refers to the ability of bank to withstand losses due
to risk exposures.

To be more precise, capital charge is a sort of regulatory cost of

keeping loans (perceived as risky) on the balance sheet of banks. The
quality of assets of the bank and its capital are often closely related.
Quality of assets is reflected in the quantum of NPAs. By this, it implies
that if the asset quality was poor, then higher would be the quantum of
non-performing assets and vice-versa.
Market risk is the risk arising due to the fluctuations in value of a
portfolio due to the volatility of market prices.

Operational risk refers to losses arising due to complex system and

processes.
It is important for a bank to have a good capital base to withstand
unforeseen losses. It indicates the capability of a bank to sustain losses
arising out of risky assets.

The Basel Committee on Banking Supervision (BCBS) has also

laid down certain minimum risk based capital standards that apply to
all internationally active commercial banks. That is, bank's capital

38
should atleast be 8% of their risk-weighted assets. This infact helps
bank to provide protection to the depositors and the creditors.

Basel Committee on Banking Supervision - Formulation of

BASEL II - Need for
Revision of the 1988 Accord

A decade after the current accord was published in 1988, banking

environment has undergone globally several changes and has turned
risks inherent to banking operations more complex. There were
banking crisis like the collapse of the Bearings Bank and the South
Asian Crisis. The need to amend and update the current accord and
make it more comprehensive to reflect the changed circumstances was
then felt necessary.

Capital is envisaged as a provision or buffer to meet potential losses

and to act as an motivation factor to the owners of the business to
manage it prudently. The current accord recognises the importance of
capital and is intended to meet and arrest the situation when the
capital of a bank erodes and falls below 8% of the basket of assets
measured according to perceived potential riskiness. In the new accord
the extent of capital at 8% is not revised. In fact it retains the
requirement of minimum capital without change. Its approach however
focuses more on introducing risk-sensitivity. An effective risk analysis
and risk management system are thus in-built in the second accord.

The 1988 accord focussed on capital adequacy of banks to shield

against failure and insolvency of the banks, putting depositors to
distress. The profile banking risks and risk-management tools, banking
supervision and market discipline were all underwent profound changes

39
in the decade after the current accord was introduced, necessitating its
review and updation.

Such risks cannot be mitigated exclusively through possession of

adequate capital, but it is also necessary to supplement same through
effective supervision and market discipline. The second accord is
therefore perceived on the strength of three pillars giving equal
importance to all the three.

1988 accord initiates a simple bucket approach with a flat 8%

stipulation for capitalising to cover risks. Risk factor is different not only
between various types of credit-assets, but also between different
corporate accounts. It does not recognise credit mitigation supports
like collateral and guarantee. The 'one size fits all' approach of the
current accord needs to be revised to bring about 'flexibility, menu of
approaches, & incentives for better risk management'

The current accord recognised only credit-risk arising out of potential

failure counter-parties. Banks in fact are beset with several other types
of risks like market risk, operational risks, liquidity and settlement risks,
which when develops into hazardous level can shake the entire
structure of the bank system. The failure of the Barings Bank in 1993
despite possessing capital adequacy of more than 8% on account of
market/operational risks brings out the importance of effectively
safeguarding against these risks

Gist of BASEL II in a nutshell

Threats posed by risk-prone assets held by the bank are to be

counterbalanced not only through holding prescribed minimum capital,
but also to be supplemented by effective supervisory review of capital

40
adequacy and acceptance of market discipline implying public
disclosure to allow market participants to assess key information about
a bank's risk profile and level of capitalisation. These constitute the
three pillars under the second accord. Thus the underlying implication
of the new accord is greater risk sensitivity. The new accord embodies
the principles of "flexibility, menu of approaches, and incentives for
better risk management" as against the current accord's prescription of
"one size fits all".

Banks with advanced risk-management tools would be permitted to use

their own internal system for evaluating credit risk by the process of
"internal Ratings Based Approach" instead of the standard risk weight
for each category of assets. Such ratings under the standard Approach
are done by external credit rating agencies. The use of IRB approach
will be subject to approval by the supervisors based on the standards
established by the Committee.

Towards extending the profile of risk-sensitivity, the new accord

intends to cover all types of risks to which the banks are exposed in
addition to credit risk. This category of market risks are grouped under
"operational risks".

Operational risks are to be met through three different approaches –

• Basic Indicator,
• Standardised, and
• Advanced Measurement (AMA).

In the basic indicator approach, the measure is a bank's average

annual gross income over the previous three years. This average,

41
multiplied by a factor of 0.15 set by the Committee, produces the
capital requirement.

In the standardised approach, gross income again serves as a

proxy for the scale of a bank's business operations and thus the
likely scale of the related operational risk exposure for a given
business line. However, rather than calculate capital at the firm level
as under the basic indicator approach, banks must calculate a
capital requirement for each business line. This is determined by
multiplying gross income by specific supervisory factors determined
by the Committee. The total operational risk capital requirement for
a banking organisation is the summation of the regulatory capital
requirements across all of its business lines. As a condition for use of
the standardised approach, it is important for banks to have
adequate operational risk systems that comply with the minimum
criteria outlined in CP3.

In the AMA, banks may use their own method for assessing their
exposure to operational risk, so long as it is sufficiently
comprehensive and systematic. The extent of detailed standards
and criteria for use of the AMA are limited in order to accommodate
the rapid evolution in operational risk management practices that
the Committee expects to see over the coming years.

• Supervisory Review: The second pillar of the New Accord is

based on a series of guiding principles, all of which point to the
need for banks to assess their capital adequacy positions relative
to their overall risks, and for supervisors to review and take
appropriate actions in response to those assessments. These

42
 elements are increasingly seen as necessary for effective
management of banking organisations and for effective banking
supervision, respectively.

• Market Discipline: The purpose of pillar three is to complement

the minimum capital requirements of pillar one and the
supervisory review process addressed in pillar two. The
Committee has sought to encourage market discipline by
developing a set of disclosure requirements that allow market
participants to assess key information about a bank's risk profile
and level of capitalisation. The Committee believes that public
disclosure is particularly important with respect to the New
Accord where reliance on internal methodologies will provide
banks with greater discretion in determining their capital needs.
By bringing greater market discipline to bear through enhanced
disclosures, pillar three of the new capital framework can
produce significant benefits in helping banks and supervisors to
manage risk and improve stability.

The main objective here is to build a sort of support system to take

care of unexpected financial losses thereby ensuring healthy financial
markets and protecting depositors.

Excess liquidity? No problem, but no lending

please!!!

43
One should also not forget that the banks are faced with the problem of
increasing liquidity in the system. Further, Reserve Bank of India (RBI)
is increasing the liquidity in the system through various rate cuts.
Banks can get rid of its excess liquidity by increasing its lending but,
often shy away from such an option due to the high risk of default.

In order to promote certain prudential norms for healthy banking

practices, most of the developed economies require all banks to
maintain minimum liquid and cash reserves broadly classified into Cash
Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR).

Cash Reserve Ratio (CRR) is the reserve which the banks have to
maintain with itself in the form of cash reserves or by way of current
account with the Reserve Bank of India (RBI), computed as a certain
percentage of its demand and time liabilities. The objective is to ensure
the safety and liquidity of the deposits with the banks.

On the other hand, Statutory Liquidity Ratio (SLR) is the one which
every banking company shall maintain in India in the form of cash, gold
or unencumbered approved securities, an amount which shall not, at
the close of business on any day be less than such percentage of the
total of its demand and time liabilities in India as on the last Friday of
the second preceding fortnight, as the Reserve Bank of India (RBI) may
specify from time to time.

A rate cut (for instance, decrease in CRR) results into lesser funds to be
locked up in RBI's vaults and further infuses greater funds into a
system. However, almost all the banks are facing the problem of bad
loans, burgeoning non-performing assets, thinning margins, etc. as a
result of which, banks are little reluctant in granting loans to corporate.

44
As such, though in its monetary policy RBI announces rate cut but, such
news are no longer warmly greeted by the bankers.

High cost of funds due to NPAs

Quite often genuine borrowers face the difficulties in raising funds from
banks due to mounting NPAs. Either the bank is reluctant in providing
the requisite funds to the genuine borrowers or if the funds are
provided, they come at a very high cost to compensate the lender’s
losses caused due to high level of NPAs.
Therefore, quite often corporates prefer to raise funds through
commercial papers (CPs) where the interest rate on working capital
charged by banks is higher.

With the enactment of the Securitisation and Reconstruction of

Financial Assets and Enforcement of Security Interest Act, 2002, banks
can issue notices to the defaulters to pay up the dues and the
borrowers will have to clear their dues within 60 days. Once the
borrower receives a notice from the concerned bank and the financial
institution, the secured assets mentioned in the notice cannot be sold
or transferred without the consent of the lenders.

The main purpose of this notice is to inform the borrower that either
the sum due to the bank or financial institution is paid by the borrower
or else the former will take action by way of taking over the possession
of assets. Besides assets, banks can also takeover the management of
the company. Thus the bankers under the aforementioned Act will have
the much needed authority to either sell the assets of the defaulting
companies or change their management.

45
But the protection under the said Act only provides a partial solution.
What banks should ensure is that they should move with speed and
charged with momentum in disposing off the assets. This is because as
uncertainty increases with the passage of time, there is all possibility
that the recoverable value of asset also reduces and it cannot fetch
good price. If faced with such a situation than the very purpose of
getting protection under the Securitisation Act, 2002 would be defeated
and the hope of seeing a must have growing banking sector can easily
vanish.

Comparative Study with Other Countries.

I. China:

46
 (a) Causes:
(i) The State Owned Enterprises (SOE’s) believe that there the
government will bail them out in case of trouble and so they continue
to take high risks and have not really strived to achieve profitability
and to improve operational efficiency.

(ii) Political and social implications of restructuring big SOE’s force the
government to keep them afloat

(iii) Banks are reluctant to lend to the private enterprises because while
an NPA of an SOE is financially undesirable, an NPA of a private
enterprise is both financially and politically undesirable

(iv) Courts are not reliable enforcement vehicles.

(b) Measures:
(i) Reducing risk by strengthening banks, raising disclosure standards
and spearheading reforms of the SOE’s by reducing their level of debt

(ii) Laws were passed allowing the creation of asset management

companies, foreign equity participation in securitization and asset
backed securitization

(iii) The government which bore the financial loss of debt ‘discounting’.
Debt/equity swaps were allowed in case a growth opportunity existed

(iv) Incentives like tax breaks, exemption from administration fees and
clear cut asset evaluation norms were implemented. The AMCs have
been using leases, transfers, restructuring, debt- for-equity swaps and
asset securitization, among other methods, to dispose of non-
performing loans

47
II. Korea:
(a) Causes:
(i) Protracted periods of interest rate control and selective credit
Allocations gave rise to an inefficient distribution of funds

(ii) Lack of monitoring..... Banks relied on collaterals and guarantees in

the allocation of credit, and little attention was paid to earnings
performance and cash flows,

(b) Measurers:
(i) The speedy containment of systemic risk and the domestic credit
crunch problem with the injection of large public funds for bank
recapitalization

(ii) Corporate Restructuring Vehicles (CRVs) and Debt/Equity Swaps

were used to facilitate the resolution of bad loans

(iii) Creation of the Korea Asset Management Corporation (KAMCO) and

a NPA fund to fund to finance the purchase of NPAs

(iv) Strengthening of Provision norms and loan classification standards

based on forward-looking criteria (like future cash flows) were
implemented

(v) The objective of the central bank was solely defined as maintaining
price stability. The Financial Supervisory Commission (FSC) was created
(1998) to ensure an effective supervisory system in line with universal
banking practices.

III. Japan:

48
 (a) Causes:
(i) Investments were made real estate at high prices during the boom.
The recession caused prices to crash and turned a lot of these loans
bad

(ii) Legal mechanisms to dispose bad loans were time consuming and
expensive and NPAs remained on the balance sheet

(iii) Expansionary fiscal policy measures administered to stimulate the

economy supported industrial sectors like construction and real estate,
which may further exacerbated the problem

(iv) Weak corporate governance coupled with a no-bankruptcy doctrine

(v) Inadequate accounting systems.

(b) Measures:
(i) Amendment of foreign exchange control law (l997) and the threat of
suspension of banking business in case of failure to satisfy the capital
adequacy ratio prescribed

(ii) Accounting standards – Major business groups established a private

standard-setting vehicle for Japanese accounting standards (2001) in
line with international standards
(iii) Government Support - The government’s committed public funds to
deal with banking sector weakness.

III. Pakistan :
(a) Causes:

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 (i) Culture of "zero equity" projects where there was minimal due
diligence was done by banks in giving loans coupled with collusive
lending and poor corporate governance

(ii) Poor entrepreneurship

(iii) Chronic over-capacity/lack of competitive advantage

(iv) Directed lending where the senior management of the public sector
banks gave loans to political heavy weights/ military commanders.

(b) Measures:
(i) The top management of the banks was changed and appointment of
independent directors in the board of directors

(ii) Aggressive settlements were done by banks with their defaulting

borrowers at values well below the actual debt outstanding and/or the
amount awarded through the court process..... i.e., large haircuts/ write
offs

(iii) Setting up of Corporate and Industrial Restructuring Corporation

(CIRC) to take over the non-performing loan portfolios of nationalized
banks on certain agreed terms and conditions and issue government
guaranteed bonds earning market rates of return
(iv) The Banking Companies (Recovery of Loans, Advances, Credits and
Finances) Act, 1997 was introduced in February 1997. Special banking
courts have been established under this Act to facilitate the recovery of
non-performing loans and advances from defaulted

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 Conclusion

To conclude with, till recent past, corporate borrowers even after

defaulting continuously never had any real fear of bank taking any
action to recover their dues despite the fact that their entire assets
were hypothecated to the banks. This is because there was no legal Act
framed to safeguard the real interest of banks.

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The process of planning strategies for containing NPAs so far is
primarily by RBI and Government of India. Even 10 years after
deregulation, the initiative has not shifted to PSBs, who are exclusively
looking to RBI/GOI for ready-made solutions. On its part RBI has taken
every conceivable steps at its level. RBI has also pointed out as under:-

"Any solution to the overhang problem of large magnitude requires

well-crafted medium to long-term actions, devoted to specific definition
of goals and negotiation of the process rather than ad hoc
approaches.”

Needless to mention, a lasting solution to the problem of NPAs can be

achieved only with proper credit assessment and risk management
mechanisms. For instance, in a situation of liquidity overhang, the
enthusiasm of the banking system to increase lending could
compromise on asset quality, raising concerns about adverse selection,
and the potential danger of addition to the stock of NPAs. It is,
therefore, necessary that the banking system is equipped with
prudential norms to minimise, if not completely avoid the problem.

As regards internal factors leading to NPAs, the onus for containing the
same rests with the banks themselves. This would necessitate
organisational restructuring, improvement in managerial efficiency,
skill upgradation for proper assessment of credit-worthiness and a
change in the attitude of the banks towards legal action, which is
traditionally viewed as a measure of the last resort.

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The above remarks of RBI, in effect, are explicitly, addressed towards
the individual banks. Now what are the internal factors? Has any PSB at
its level identified these factors?

Have the PSBs conducted micro-analysis on the overhang problem of

NPA relating to principal categories of advances- selecting cases of
concentration of NPAs at specific locations, areas, or Branches acutely
suffering this problem. The problem at length was earlier posed by me
on this website in the article Focus at Anomalies at the Credit Delivery
Centre -- A Detached Survey of NPA from within the Credit Agency. It
needs courage and tenacity on the part of the top management to
order such a probe/review, as this may also result in bringing out many
skeletons hiding deep inside the cupboards.

More than conducting such a probe, drawing the right

conclusions/solutions and disseminating that knowledge widely
amongst all credit-decision takers at every level is the type of action
that is needed in the Knowledge Management era. But Banks have not
yet come forward. When it comes for assessment, they prefer to
underestimate the load of NPA through subtle statistics based on NPA
level as a percentage of the ever growing aggregate credit. They
suffer, but feel shy of expressing the magnitude of their problem or
look deep towards finding the contributory factors. Today the pattern of
business strategy is to invest bulk of resources in government
securities, lend minimum and thereafter present NPA as a percentage
of the total assets. You can see this in the data presented. For SBI
group NPA is only 2% and for Nationalised banks it is 2.16% (of total
assets). Does it not give a rosy picture. But if I tell you that SBI has an
accumulated overhang of NPA at Rs.14430 Crores (out of aggregate
advance of Rs.120806.46 Crores), the magnitude of the threat is
brought back. Similarly if I point that PNB was loaded with a fresh

53
accretion of Rs.868.19 during year 2001-2002, resulting in a overhang
of Rs.3126.77 Crores (Gross NPA ) out of total credit outstandings at
Rs.34369.42 Crores as at 31.03.2002.

In an effort to find the crystallised thinking of the Banks on the subject,

I searched, by way of test cases, the websites of SBI (the market leader
amongst PSBs) and PNB (the largest and the oldest of the Nationalised
Banks). SBI has not published detailed statistics of the movement of
NPAs as per guidelines of RBI on its website. It has however
enunciated its policy of NPA Management in the following words:

"The Bank's NPA management has assumed critical importance and is

receiving focussed attention at all levels. At the corporate level, a Task
Force comprising top executives monitors all NPAs above Rs.5 crore. At
Local Head Office level, the Circle Management Committee monitors all
NPAs above Rs.1 crore. The NPA management policy lays stress, inter
alia, on early identification of problem loans, effective response to
early warning signals, appropriate recovery strategy including one-time
settlement. Other measures taken by the Bank include upgradation of
appraisal skills of the officers dealing in credit through special training
programmes and an effective credit audit mechanism, which throws
warning signals for taking action to prevent performing assets turning
into non-performing ones. For close monitoring of cases with Debt
Recovery Tribunals (DRT), the Bank has nominated nodal officers in the
DRT cells in the LHOs. The Bank has nine specialized Rehabilitation and
Recovery branches to focus on BIFR cases and large value accounts
especially in doubtful and loss categories. As a part of cleansing its
balance sheet, the Bank has written off NPA accounts with high level of
provision and the outstandings are held in Advances under Collection
Account for further follow up.”

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"Under the RBI-OTS scheme (ended on 30th September 2001), the
Bank approved one-time settlement for Rs.1,059 crore in respect of
3.31 lakh accounts. Also under SBI-OTS scheme (ended on 31st
December 2001), which was for settlement of NPAs with outstandings
up to Rs.1 crore, the Bank approved OTS for Rs.32.94 crore in respect
of 0.19 lakh accounts. Similarly, under the RBI-OTS-II scheme for
settlement of small loans up to Rs.25,000, the Bank approved OTS for
Rs. 21.02 crore in respect of 16,000 accounts and recovered Rs.16.84
crore. At end-March 2002, the Bank's gross and net NPA stood at
11.95% and 5.63%, respectively, as against 12.93% and 6.03%,
respectively in the previous year."

The above narrative does not specify the quantum of Gross/Net NPA in
terms of amount. But as the aggregate credit of SBI is stated officially
as Rs.120806.46 Crores and Gross NPA at 11.95%, it is possible to
calculate and arrive at its Gross NPA in terms of amount as at
31.03.2002 at Rs.14430 Crores approximately. But the amount
provided by SBI against this overhang and the amount of its net NPA
cannot be ascertained. As also Recoveries in NPA and fresh additions to
NPAs in the year. To this extent there is lack of transparency.

The policy statement of SBI is merely an attempt to catch the bull by

seizing its tail instead of its horns, i.e. through an action at the terminal
level in place of at the originating root. A generalised statement saying
"The NPA management policy lays stress, inter alia, on early
identification of problem loans, effective response to early warning
signals, appropriate recovery strategy including one-time settlement.
Other measures taken by the Bank include upgradation of appraisal
skills of the officers dealing in credit through special training
programmes and an effective credit audit mechanism, which throws
warning signals for taking action to prevent performing assets turning

55
into non-performing ones." Upgradation of appraisal skill is a innocuous
statement. What are the specific ingredients, the overlooking of which
result in NPA? Could not SBI one of the Global-sized organisations
impart KM management tools in tackling this problem and bring out
guidelines for grass-root level implementation? Why not take the rank
and file into confidence to add knowledge inputs through research and
investigation on a wider scale from the base level?

Individual banks are not firm with finding a policy towards a lasting
solution. They are happy if comparative figures depict some progress
by way of percentage reduction of Gross/Net NPA. Otherwise there is
no commitment or concern for a permanent solution.

So much emphasis was laid about shortcomings of the legal system.

But now the Securitisation & Asset Reconstruction Act is on the statute
book. Will this solve the problem?

However with the introduction of Securitisation Act, 2002 banks can

now issue notices to their defaulters to repay their dues or else make
defaulters face hard and tough actions under the aforementioned Act.
This enables banks to get rid of sticky loans thereby improving their
bottomlines. Also a hallmark of a good business is approaching it with a
fresh, new perspective and requires management that is fully awake,
fully alive and of course fully focused on making things better.

Also, the passing of the Securitisation Act, 2002 came as a bonanza for
investors in banking sector stocks that in turn resulted into an
improvement in their share prices.

I would suggest 3 ways of solving this problem of NPAs.

They are

56
 (i) recapitalization of banks with Government aid,
(ii) disposal and write off of NPAs,
(iii) increased regulation.

BIBLIOGRAPHY

Journals
Chartered Financial Analyst, October 2005

57
ICFAI Finance Journal

Newspapers
Economic Times
Business Standard
Financial Express

Websites
www.rbi.org
www.icicibank.com
www.indiabudget.nic.in
www.indiainfoline.com

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