NPA stands for non-performing assets. According to the Reserve Bank of India (RBI), an NPA refers to a loan or advance that remains overdue for more than 90 days. In simple terms, an asset is classified as non-performing when it stops generating income for the bank.
To align with global standards, the RBI adopted the 90-day overdue rule for identifying NPAs, effective from the financial year ending March 31, 2004. Additionally, NPAs are further categorised based on the duration for which the asset has remained non-performing.
Financial lending institutions play a critical role in the Indian economy. Through loans and other credit facilities, they supply the capital required for businesses to grow and develop. However, despite their crucial contribution to the economy, these institutions are constantly challenged by the threat of NPAs.
Continue reading to learn about the full form of NPA, its various types, and its impact on lending institutions.
What is a non-performing asset?
Non-Performing Assets (NPAs) refer to loans or advances from banks or financial institutions that have stopped generating income for the lender due to the borrower’s failure to pay the principal or interest for at least 90 days. When a debt remains unpaid and overdue beyond a specific time frame, it is classified as a non-performing asset (NPA).
How do non-performing assets work?
Now that you are aware of the meaning of non-performing assets, let us take a closer look at how they work.
Borrowers across the country — whether retail or institutional — avail of loans and credit facilities from financial institutions. When a borrower does not repay the principal and the interest components of such loans for more than 90 days from when they are due, it is automatically classified as a non-performing asset by the lender.
NPAs often have a multi-fold impact on banks and financial institutions. Firstly, a large number of non-performing assets will negatively impact the asset quality, revenue, and profitability of the lender. Moreover, since the funds are locked up in non-performing assets, the entity’s lending capacity decreases significantly. Finally, there is also the possibility of complete write-offs, where NPAs are recorded as a loss in the lender’s books.
Also read: Key Differences Between Asset Vs Equity
Types of non-performing assets (NPA)
Non-performing assets can be broadly classified into three major categories depending on how long they have been marked as such by the lender.
- Substandard assets
Assets that remain as NPA for up to 12 months are classified as substandard assets. Although they have significantly higher credit risk, they do have some recovery prospects. - Sub-Standard Assets
These are non-performing assets (NPAs) that have remained overdue for more than 12 months. They carry a higher risk due to the borrower's weaker credit profile. Banks often apply a haircut (a reduction in market value) to these assets, as the likelihood of full repayment is uncertain. - Doubtful assets
Assets remaining as NPA for over 12 months are classified as doubtful assets. The credit risk of such assets is much higher than that of substandard assets. Their recovery prospects are also very slim. - Loss assets
Assets with very little recovery value or no recovery prospects are deemed to be loss assets. Banks and financial institutions often write off the entire value of these assets or sell them to asset reconstruction companies (ARCs).
What are the Causes of NPA?
Several factors contribute to the rise of NPAs in the financial system:
- Economic Slowdowns: During economic downturns, businesses may struggle financially, making it difficult for them to repay loans.
- Fraudulent Borrowers: Some borrowers intentionally default on loans to evade repayment.
- Lax Lending Practices: Extending credit to uncreditworthy borrowers increases the risk of default, leading to NPAs.
- Inadequate Monitoring: Poor oversight of borrowers' repayment behavior can result in undetected defaults.
- Economic Shifts: Factors like rising interest rates or falling commodity prices can impact borrowers' ability to meet their financial obligations.
Importance of NPAs
Non-performing assets (NPAs) play a crucial role in assessing the health of a bank or financial institution. A rising NPA level indicates that a large portion of a lender’s loans is not yielding returns, affecting its profitability and liquidity. NPAs directly impact the bank’s balance sheet and capital adequacy ratio. Monitoring NPAs helps banks strengthen their credit appraisal processes and reduce future credit risks. For investors and regulators, NPA figures serve as a key performance metric, reflecting the financial stability of the lending institution. Managing NPAs effectively is vital for maintaining trust in the financial system.
NPA provisioning
Provisioning is a financial risk management technique that is widely used to account for non-performing assets and other extraordinary expenses. Here, financial institutions set aside a portion of their profits to cover the losses that may arise due to non-performing assets.
By setting aside some of their profits to account for NPAs, lending institutions can keep their financial statements clean and write off loans if they become uncollectible. The Reserve Bank of India determines the provisioning norms for banks, which vary depending on the type of NPA, their size, and the location of the lender.
GNPA and NNPA
GNPA is an acronym for Gross Non-Performing Assets. It represents the total amount of NPAs before any provisioning is made.
NNPA, meanwhile, is an acronym for Net Non-Performing Assets. It represents the amount of NPAs in the lender's books after they have made provisions for such losses.
NPA ratios
The Gross NPA Ratio (GNPAR) and Net NPA Ratio (NNPAR) are two of the most commonly used metrics in this category. These ratios provide insights into the asset quality and financial health of financial institutions.
The GNPAR is determined by dividing the gross NPAs by the gross advances (before provisions) made by the bank during a specific period. The resulting figure is multiplied by 100 to arrive at the percentage value.
The NNPAR is determined by dividing the net NPAs by the net advances (after provisions) made by the bank during a specific period. The resulting figure is multiplied by 100 to arrive at the percentage value.
Example of an NPA
Assume a person borrows Rs. 1,00,000 from a bank. According to the terms of the agreement, they need to repay the loan in one year, along with 10% interest on the principal.
However, they default on the payment of monthly EMIs from the very first instalment. About 90 days after the due date, the bank will mark the Rs. 1,00,000 loan as an NPA. The bank can either attempt to recover its dues from the borrower or write it off completely.
Management of NPA
Managing non-performing assets (NPAs) is essential for the financial stability and profitability of banks. When loans turn into NPAs, banks take several steps to recover the dues and improve their asset quality. One of the first measures includes identifying stressed assets early through effective credit monitoring and follow-ups with borrowers. Early warning systems help banks take timely action before an account becomes an NPA.
Banks also implement restructuring strategies such as loan rescheduling, reducing interest rates, or extending repayment periods to help borrowers repay their dues. For more severe cases, recovery can be pursued through legal means under the SARFAESI Act or through debt recovery tribunals (DRTs). In recent years, the Insolvency and Bankruptcy Code (IBC) has become a powerful legal tool for resolving large NPAs efficiently.
Another key approach includes setting up Asset Reconstruction Companies (ARCs) to purchase bad loans and recover dues independently. Effective NPA management not only reduces losses but also enhances a bank’s creditworthiness and strengthens investor confidence.
Advantages of NPA Classification
- Enhanced Transparency: NPA classification provides a clear picture of a bank's loan portfolio and associated risks in financial statements.
- Timely Corrective Measures: Recognizing NPAs allows banks to take necessary actions, such as loan restructuring or asset recovery.
- Regulatory Compliance: Reporting NPAs ensures adherence to banking policies and industry standards, reinforcing regulatory oversight.
- Informed Decision-Making: It helps investors, regulators, and stakeholders assess a bank’s financial stability and risk exposure.
Challenges Associated with NPAs
Here are some of the major challenges that arise due to non-performing assets (NPAs):
- Reduced profitability: Banks earn less interest income from NPAs, as these loans stop generating returns, directly affecting their profitability.
- Increased provisioning: Financial institutions must allocate higher funds for provisioning against bad loans, which reduces their net profits.
- Lower credit availability: High NPAs limit a bank’s ability to issue new loans, leading to a slowdown in credit flow to productive sectors of the economy.
- Operational strain: Recovery of NPAs involves lengthy legal and recovery procedures, adding to the bank’s operational burden.
- Loss of investor confidence: A high level of NPAs can impact investor sentiment, leading to a drop in stock prices and reduced market valuation.
- Regulatory pressure: Banks with high NPAs may face tighter scrutiny and compliance measures from regulatory bodies like the RBI.
How to calculate gross non-performing assets ratio and net non-performing assets?
Comparing Gross NPA and Net NPA ratios serves as pivotal indicators in evaluating a bank's financial well-being. Let's delve into their calculation methodologies.
What is the gross NPA ratio?
The Gross NPA ratio, also known as the GNPA ratio, is computed by dividing the total amount of gross Non-Performing Assets (NPAs) by the aggregate value of assets held by the bank. Gross NPAs encompass loans categorized as non-performing for over 90 days. The total assets encompass all holdings of the bank, comprising loans, cash reserves, and investments. The formula for calculating the Gross NPA ratio is:
Gross Non-Performing Asset Ratio = Total Gross NPAs / Total Assets |
Consequently, a heightened Gross NPA ratio suggests a significant proportion of loans remain unpaid, signaling potential financial turbulence for the bank.
Also read: What are non-current assets
What is net NPA?
Net NPA is determined by deducting the provisioned value from the total gross NPAs. Provisions represent funds allocated by banks to mitigate losses arising from NPAs. The formula for computing the Net NPA ratio is:
Net Non-Performing Asset = Total Gross NPAs – Provision |
Net NPA provides insight into the actual losses incurred by the bank due to NPAs. Elevated levels of Net NPA imply substantial losses stemming from NPAs, indicating potential financial distress for the bank.
Significance of NPAs
Understanding the distinction between performing and non-performing assets is crucial for both borrowers and lenders in India. For borrowers, if an asset becomes non-performing due to missed interest payments, it can hurt their credit rating and limit future borrowing opportunities, ultimately affecting their financial growth.
For banks and financial institutions, interest income from loans is a primary revenue source. When assets turn non-performing, it reduces the lender’s income potential and impacts profitability. Monitoring NPAs is vital, as a high volume of non-performing assets can strain a bank’s liquidity and growth capacity.
While a manageable level of NPAs is often sustainable in the short term, an increasing volume of overdue NPAs can threaten the financial stability and long-term viability of the institution. Maintaining control over NPAs is therefore essential for safeguarding the lender’s financial health and growth prospects.
Other mutual fund related topics you might find interesting |
|||
|
|
|||
Factors that can lead to NPA
Several internal and external factors can lead to loans turning into non-performing assets (NPAs). Here are some common causes:
- Poor financial planning by borrowers: Borrowers may fail to assess their repayment capacity, leading to defaults.
- Business failure: Economic downturns, industry-specific slowdowns, or mismanagement can result in business losses, making it difficult for companies to repay loans.
- Lack of proper credit appraisal: Inadequate due diligence or faulty risk assessment by lending institutions can lead to loans being granted to high-risk borrowers.
- Diversion of funds: Borrowers sometimes misuse loan amounts for purposes other than intended, affecting their ability to repay.
- Delays in project execution: In infrastructure and business loans, delays in project completion can disrupt cash flow and repayment schedules.
- Natural calamities: Events like floods, droughts, or pandemics can severely impact the repayment ability of individuals and businesses, especially in agriculture.
- Wilful default: Some borrowers intentionally avoid repaying loans, despite having the capacity to do so.
Impact of non-performing assets on operations
Listed below are some important points to remember regarding the impact of non-performing assets on operations of a firm:
- Financial stability: Elevated NPAs can undermine the financial standing of the lender by diminishing interest income and necessitating larger provisions for potential losses. Consequently, this can impair both stability and liquidity.
- Constrained lending capacity: Financial entities might adopt a more cautious approach towards disbursing fresh loans due to the inherent risk associated with existing NPAs. This caution can curtail their capacity to foster economic expansion through lending activities.
- Regulatory adherence: Financial institutions are bound by regulatory frameworks governing NPA management. Failure to uphold prescribed NPA thresholds can result in penalties, constraints, or regulatory intervention.
- Investor trust: Prolonged elevation of NPA levels can corrode investor trust, leading to depreciation in the financial institution's stock value and market capitalisation. This, in turn, impacts shareholder returns and influences broader market sentiment.
Key takeaways
- Definition and classification: NPAs are loans or advances not repaid for over 90 days, affecting a bank’s income.
- Types of NPAs: Substandard (up to 12 months), Doubtful (over 12 months), and Loss assets (little to no recovery prospects).
- Impact on banks: High NPA levels reduce asset quality, revenue, and lending capacity, potentially leading to write-offs.
- Financial ratios: Gross and Net NPA ratios provide insights into a bank’s asset quality and financial health.
- Provisioning: Banks set aside profits to cover NPA losses, adhering to RBI norms to maintain clean financial statements.
Conclusion
With this, you must now be aware of what NPA is and the significant challenges it presents. Financial institutions must manage NPAs effectively to reduce their impact on their balance sheets, maintain financial stability, and sustain growth.
