Non-performing Asset Management for Banks in India - Part I

Non-performing assets (NPAs) have been a great worry for India’s public sector banks (PSBs), which are either wholly or partly owned by the Indian government. Increasing provisions for NPAs every year have been a drain on the profitability of these banks. With the countdown started for the adoption of Basel II norms, fear of breaching the minimum level of capital adequacy looms large for some of these banks. Some of them have gone to the public with initial and subsequent offer of equity shares and have improved their Tier I capital. No doubt the banks’ profits are higher as a result of increased levels of credit in a buoyant economy. Some have raised their Tier II capital through bond issuance. Net NPAs of these banks have been decreasing.

However, sooner or later the NPA bubble may burst and mar the balance sheets of these banks unless they prevent further slippage to NPAs by means of better credit monitoring. With the increase in retail credit, and the scope for further increase, banks must improve their credit monitoring systems and practices. It is common knowledge that an account does not become an NPA overnight. There will be advance-warning signals that prudent bankers should heed and act upon.

On Basel II, India’s central bank, the Reserve Bank of India (RBI), has advised that the foreign banks operating in India, and domestic banks with a presence outside India, are to migrate to the standardized approach for credit risk and the basic indicator approach for operational risk with effect from 31 March 2008. All other scheduled commercial banks were encouraged to migrate to these approaches under Basel II in alignment with them but in any case not later than 31 March 2009.

The Basel Committee on Banking Supervision (BCBS) had undertaken the Fifth Quantitative Impact Study (QIS-5) to assess the impact of adoption of the revised Framework. Eleven Indian banks, accounting for about 50% of market share (by assets), participated in the QIS-5 exercise. It transpired from an empirical analysis that the combined capital adequacy ratio of these banks is expected to come down by about 100 basis points when these banks apply Basel II norms.

If the capital adequacy breaches the minimum level, besides the RBI stepping in with various measures of prompt corrective action, a spate of problems would arise for the banks in the international market. Those banks will not be able to increase their asset base etc.

How Can Banks Prevent the Slide in Capital Adequacy?

Banks can improve their capital adequacy in three ways: by increasing the Tier I capital through a public issue or private placement of equity shares, by increasing Tier II capital by issuing bonds/preference shares and, thirdly, by improving their net worth by increased profits.

Profits can be increased by procuring more low and no-cost deposits, by increasing advances, by improving income from other sources and by reducing costs. With better credit appraisal and monitoring, the bank can decrease its amount of NPAs. Fewer NPAs result in less provisioning requirements and improved profits. Provisions can be reduced if slippages to NPAs are arrested. When recoveries are made in NPAs and provisions made are reversed, profits improve.

Before we go into the management of NPAs let us see how the NPA levels of banks in India compared with some developing and developed countries.

It may be observed from the above that there is much to be done by the Indian banks to catch up with developed countries.

NPA Management Systems in Vogue Now

Several institutional mechanisms have been developed in India to deal with NPAs such as tightening of legal provisions; the passing of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act 2002; introduction of debt recovery tribunals (DRTs); lok adalats (public courts); corporate debt restructuring (CDR) mechanism for large advances to corporate borrowers; etc.

However, effective management of NPAs requires appropriate internal checks and balances and effective use of computerization in these banks. Most of the public sector banks in India have brought at least 90% of their branches under the core banking solution. With the existing levels of infrastructure available, the public sector banks can monitor credit and manage NPAs better than they do now.

Most banks have introduced or updated their know your customer (KYC) profiles. Credit rating exercises are generally done by the branches or controlling offices at the time of sanction or review/renewal of existing credit facilities – generally once a year. As far as credit monitoring is concerned, besides regulation of drawing power with the periodical stock statements submitted by the borrower and periodical inspection of stocks by a supervisory official of the branch, banks have reporting systems for accounts with working capital credits of Rs10m and over, by way of continuous surveillance system (CSS) reports and quarterly information systems (QIS). Although these reports are system generated, they receive scant attention either at the branch or at the controlling office. Sometimes these reports are handwritten. There is no proper check of stock statements, QIS or the CSS and the inspection is done in a haphazard manner. Operations in the account need to be checked by the branch officials to ensure that the account shows healthy fluctuations and there is no diversion of funds.

Reserve Bank of India has asked banks to introduce Watch/Special Watch category accounts to segregate accounts, which show signs of sickness. An account has to pass through this stage before it is classified as NPA. But, in practice, this does not often happen. This can lead to surprises at the end of the year for controlling offices, statutory auditors and the RBI, who then point out that an account has become an NPA, that provision needs to be made and a memorandum of change in provision given by the auditor or the central bank. It often transpires that the account had not passed through the Watch category stage. It is possible that the branch management either overlooked it, or thought that the statutory auditor would also overlook it. The branch management fights last minute duels with the auditor or RBI justifying lower provision. The controller, namely the RBI, does not agree and ultimately provision is made for a higher amount as insisted by the RBI. In the interest of corporate governance and proper disclosure, it is necessary that the systems are more transparent and reflect the true state of affairs.

Banks now have a monthly NPA recovery management information system (MIS), which gives the NPA level at the beginning and end of the month, and includes other additions, cash recoveries and upgrades during the month. This MIS is not system-generated but prepared manually. Budgets are given for branches for cash recovery and the position is monitored at the end of the month. Identification of staff lapses and accountability when an account becomes bad is still a relative term with PSBs. There is still no foolproof system at PSBs for identification of staff lapses. But how can you prevent an account becoming an NPA when it throws early warning signals and how can you manage an NPA better?

Why and How Does an Account Become an NPA?

An account does not become an NPA overnight. It gives signals sufficiently in advance that steps can be taken to prevent the slippage of the account into NPA category. An account becomes an NPA due to causes attributable to the borrower, the lender and for reasons beyond the control of both. The following is a list of factors attributable to the borrower, which could account for the borrower’s accounts becoming non-performing assets:

• Financial losses for two years consecutively.
• Poor management and marketing strategy, poor assessment of demand, over capacity for the product, lack of commitment, entering a declining market, price war, etc.
• Diversion of funds within and outside the business or project. Sometimes funds are diverted for another project.
• Differences and disputes among promoters/directors.
• The bandwagon effect. People with little experience in the field enter a profession just because others have succeeded recently. This is common in the construction, real estate and hospitality industries.
• High cost base evidenced by labour costs, low productivity, distribution costs, raw material cost, high reorganization cost.
• Inadequate financial control demonstrated by poor debt management/structure.
• Inadequate information which is demonstrated by the following – poorly prepared budgets or no budgets, no costing/unit costs, limited analysis/planning for stocks, capital expenditure not planned/budgeted.
• Time and cost overrun due to poor supervision and control over the project by the promoters.
• Increasing low margin sales, debtor provisions, currency losses, creditor pressure, and short-term debt. Emphasis on cash sales with little regard for profit.
• Borrowing to pay operational expenses like electricity, wages, etc.
• Recurrence of problems previously resolved.
• Maintenance of expensive offices/keeping premises in a continuous state of neglect.
• Short term loans/ad hoc loans/excess over limits continuing beyond due date.
• Qualified audit opinion.
• Unable to comply with loan covenants.
• Liquidity ratios reveal deteriorating trends.
• Increase in creditors days outstanding.
• Speculative investments

However, there are also external factors over which the borrower has no control and these could also lead to non-performing assets. These external factors could include:

• Delay in financial closure.
• Delay in realization of receivables.
• Exchange rate fluctuations.
• Depressed capital market.
• General recession in the particular industry.
• Changes in personal habits of promoters/key people.

Fraud is also a contributory factor to cases of NPAs. The following are all signs of fraud that need to be recognised in order to prevent NPAs.

• Sales/inventory/assets overstated, liabilities understated.
• Audits cease.
• Abnormally large fund transfers.
• Significant cash balances in non-interest earning accounts.
• Management overrides internal controls.
• Sale of assets to related parties.
• Unusual supplier relationships.
• Staff working unusually long working hours.
• Any sign of deceit, inappropriate attitude and reaction to questions.

There are also causes of NPAs that are directly attributable to the bank, such as:

• First class project in the hands of a second-class promoter. Poor credit appraisal.
• Delayed and inadequate credit dispensation. Denial of genuine request for ad hoc facilities can kill an account.
• Defective documentation.
• Not heeding warning signals portrayed in the operation of the account.
• Lack of expertise to finance and monitor peculiar types of advances, such as against tobacco, tea etc.

While factors external to the bank could include:

• Lack of free exchange of information among bankers, FIs.
• Unrealistic discretionary powers to grant advances or inability to take possession of securities.

Causes that are beyond the control of both the borrower and the bank include:

• Delayed receipt of government subsidies. Changes in government policies. Political uncertainties.
• Non-compliance of pollution and environmental policies due to sudden changes.
• Law and order problems. Court judgments and injunction orders.
• Inadequate infrastructure facilities particularly water.

Having seen why and how an account becomes an NPA, part two of this article will look at the warning signs that will allow a lender to take remedial steps against NPAs.