CHAPTER I

MEANING AND EMERGENCE OF NON PERFORMING ASSET

All is flux, nothing stays still. Nothing endures but change1 The description is very apt as far as Indian banking is concerned. The source of flux in banking includes competition, consolidation, information technology, product and geographical expansion and regulation. Fluctuations of interest rates, exchange rates and commodity prices combined with rational self interest of lenders, borrowers and authorities influence the forces of change which call for financial innovation to meet the existing and emerging problems. The banking system, which is the lifeline of any economy, has in our country not been able to effectively adjust to the changes and has not been in the best of health for quite some time. One of the major reasons cited for this state of health has been the persistence of Non Performing Advances (NPAs) in banks books.2 This has been discussed at several occasions by analyst and economist tracking the Indian banking sector, particularly, Public Sector Banks (PSBs). The increased and devastating effect of NPAs on the economy has made the problem of NPAs an issue of debate, and of national priority.3

Joseph F. Sinky Jr., Commercial Bank Financial management, Pretice Hall International Inc., US., 1998, Preface, p, XXVII
2

Management of Non Performing Advances, T.V. Gopalakrishnan, 2004 Edition, Northern Book center
3

Management of Non Performing Assets in Banks, Sugan C.jain, 2005 Edition, RSBA publishers, paper published by Dr. S.B. Kamashetty

Banking industry is a major sector of the economy that has achieved renewed focus after financial sector reforms and the entry of private sector banks. This sector is the foundation of modern economic development and linchpin of development strategy. It forms the core of the financial sector of an economy. Through mobilization of resources and their better allocation, banks play an important role in the development process of underdeveloped countries.4 They improve the allocation of resources by lending money to priority sector of the economy.5 These banks provide a meeting ground for the savers and investors among various indicators of financial stability; banks non-performing loan assumes critical importance since it reflects on the asset quality, credit risk and efficiency in the allocation of resources to productive sectors. A common perspective is that the problem of banks non-performing loans is ascribed to political, economic, social, technological, legal and environmental issues. 6 Since the economy and the banking system are interdependent for their functioning and growth, a problem in one sector affects the other. The presence of huge Non performing Advances in Banks and their continued unmitigated increases in absolute terms, has had an adverse impact on the banking system, the fiscal exercise of the Government and the economy in general. Finance links the present and future economy. So banks which function as intermediaries are an important source of financial resources, have always to be sound and stable and enjoy public confidence for the efficient and effective discharge of this vital intermediating function.7

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International Journal of Economic Practices and Theories, Vol. 1, No. 2, 2011 (October), e-ISSN 2247 7225 www.ijept.org last updated on 10/12/2011

The Banks

in

India

face

the

problems

of

swelling

non-

performing assets (NPAs) and the issue is becoming more and more unmanageable. The NPAs have direct impact on banks profitability, liquidity and equity. The NPAs of Indian Banks are relatively huge by international standard. Therefore the biggest ever challenge that the banking industry now faces is management of NPAs. It is true that banks have to restrict their lending operations to secured advances only with adequate collateral securities. In this connection banks must be aware of the problems and recovery legislations of NPAs Nonperforming assets means an dvance where payment of interest or repayment of instalments of principal or both remains for a period of more than 180 days.8 The magnitude of NPAs have a direct impact on banks profitability as legally they 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 RBI guidelines. The Indian Banking sector is facing a serious situation in view of the mounting NPAs which are the tune of Rs.56,000 crores in March 2002. NPA is an important parameter in the analysis of financial performance of banks. The reduction of NPAs is necessary to improve profitability of the banks and comply with capital adequacy norms.9

GENESIS AND HISTORICAL PERSPECTIVE

Non-Performing Assets (NPAs) have been plaguing the Indian financial sector for a long time, but were not in the public domain until the early nineties. By that time, a significant number of loan assets involving uncertainty with respect to ultimate

http://wimbledonmashow.com/problems-and-recovery-of-npa-at-branch-banks/ 10/12/2011
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collection had piled up, creating concerns with the opinion-makers about the health of the Indian banking and financial sectors. NPAs reflect natural waste in any economy. In advanced economies, the financial markets are well-developed and segmented, with various players operating in identified niches, catering to various user/risk segments. This constitutes an effective institutional mechanism for targeting risks to players with an appetite for such risks. Commercial banking is conducted in a highly risk-managed and mitigated ambience, unlike its Indian counterparts who are often required to take unmitigated risks as a part of business policy.10 The Indian banking sector has played a commendable role in fuelling and sustaining growth in the economy. In the recent past a large part of the banking sectors growth has been on the back of financing consumption, as reflected in the growth of retail banking. While the progress on this front is likely to continue, sustaining this growth in the coming years may require focus on the supply side capacity building. A growth driver in this phase would involve financing the

emerging Small & Medium Enterprises (SMEs) sector of the economy. As such, banks would have to gear up for the challenges of managing growth and consequent risks in the SME sector financing.11 Addressing this issue and putting in place a suitable risk mitigation mechanism is going to be a fairly daunting challenge. One way of ensuring focus would be to free up capital both financial and human and make them available for sustaining the growth in assets and profitability. Farming out the banks Non- Performing Assets

10

http://203.115.117.202/Arcil1/knowledge_centre/publications/papers/NPA_S1_EmergingChallenges.pdf last updated on 10/12/2011

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(NPA) portfolio to asset-recovery companies, which specialize in this segment of the financial sector, could be an option worth evaluating.12 The origination of NPAs in the Indian banking landscape can be broadly discussed in two stages:13 A. pre-liberalization era; and B. post-liberalizing era.

A. PRE-LIBERALIZATION ERA:
In the context of accretion to NPAs in the banking system, the contributory factors during this period were mainly the following:14 i. Down-swings in agricultural sectors triggered by monsoon vagaries,

bringing about all-round economic and demand recessions.15 ii. Industrial licensing: The scale of the economy in relation to international

standards was compromised, leading to high capital costs per unit of production. This was often said to be offset by lower labour costs. However, in reality labour productivity, coupled with application of automation, outweighed the benefit from lower labour costs in the Indian context.16 Sector-wise reservation: Reservation of major sectors for investment by the Government of India (GoI) in the public sector structure in post-independence days became a necessity owing to various reasons, among others, non-availability of private

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capital. In later years many of these Public Sector Units (PSUs) (though they might have served their socio- economic objectives) became commercially unviable in the absence of a proper growth plan when faced with burgeoning employee costs during their lifecycle. As a result, down-stream integration of SMEs with these PSUs led them to a sticky situation with their bankers owing to a longer receivable cycle/non-realization of receivables. In addition, reservation in some of these sectors led to setting up of uneconomical facilities, and improper quality and product pricing (price-quality matrix issues) despite subsidization by the GoI. 17 iii. Controlled interest rate: In the controlled interest rate regime, banks were

not in a position to price the risk premium. This led to cross-subsidization across the risk profile of the loan assets. Although additional collaterals were taken for risky loan assets, in the absence of a conducive legal system, the banks were not in a position to realize value from these collaterals.18 iv. Tariff protection: In the absence of a long-term tariff policy, it was

difficult for the banking system to appraise project viability with any degree of certainty during the loan pay-back period.19 v. Role of Developmental Financial Institutions (DFIs): The DFIs played a

predominant role in the growth financing during the pre-liberalization era. This model became unsustainable as they started facing difficulties in raising funds. In a way, the DFIs in India played the role of Venture Capital (VC) funding without capturing the possible upside of the model. The success of DFIs can, therefore, be compared only with VC funding. However, because of non-availability of a favourable legal

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environment, coupled with various extraneous factors, they are often discredited with the failures.20

B. POST-LIBERALIZING ERA:
Indias macroeconomic policies were conservative until the early eighties. Accompanied by some liberalization in the form of de-licensing of select industries, permitted changes in product- mix within the overall capacity(broad-banding) and creeping relaxation of imports during mideighties, the Indian economy registered an average growth rate of 5.3 percent per annum (sixth fiveyear plan) and 5.8 percent per annum (seventh five-year plan), much higher than the Hindu rate of average growth of 3.5 percent per annum during the previous three decades. In fact, there was a miniindustrial boom in the early part of the seventh five-year plan (1985-88). However, a growing fiscal deficit triggered a macroeconomic crisis in 1991.21 With the commencement of reform of the economy in 1991, banks were to follow the Basel Capital Accord. Consequently, the Reserve Bank of India (RBI) issued the first set of comprehensive guidelines for Income Recognition and Assets Classification (IRAC) in April 1992. The central bank, with a cautious move, adopted a time-based provisioning method and averted a near crisis situation by not imposing a write-off of the entire loan asset impairment amount based on present value of realizable cash flow upon recognition of NPA.22

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With a stable political scenario during post-commencement of reforms, and against the back-drop of hyped-up demand projections endorsed by several leading strategists, the Indian economy once again experienced a quick capacity build-up during the mid-nineties. On the face of a liquidity crisis, many of these projects had to borrow at abnormally high rates of interest.23 However, towards the end of the decade, the mistake was realized as those loan assets started showing signs of impairment. The volume of NPAs in the system reached a peak level, requiring focused attention. Many banks set up taskforces, special asset management groups, etc. to deal with the situation in a focused manner by creating a type of bad bank within the bank. By that time the entire South-East Asian region was reeling under an economic crisis triggered by the high level of NPAs in the banking system. Many specialists and experts were, by then, seriously raising concerns about the possibility of India heading for a crisis.24 The net upshot was that by the mid-nineties the banking industry became riskaverse towards corporate lending activity. Many banks took a strong position in government securities. Propelled by the growth in the retail sector, the banking sector registered a decent credit growth during the subsequent period. In the late-nineties, during a declining interest rate regime, the banking sector was sitting on a sizeable capital gain. As such, in order to tackle the NPA stock problem, the banking sector generally adopted a provide and hold strategy. As a result, net NPAs in the system declined significantly, which was also due to setting up of a selfhelp mechanism, namely Corporate Debt Restructuring (CDR), under the aegis of the RBI. The CDR

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forum has done a commendable job during the period since inception in 2002 to restrict the flow of NPAs in the system.25

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