Non-Performing Assets (NPA) – Definition, Causes and Impact

What is NPA (Non-Performing Asset)?

Non-Performing Asset (NPA) refers to loans or advances that have not been serviced by the borrower for at least 90 days. In other words, NPAs are loans that are not generating any income for the lender because the borrower has failed to make payments on both the principal and interest of the loan. NPAs are a major concern for banks and financial institutions as they can impact their profitability and stability.

Understanding the concept of NPAs is crucial for anyone looking to invest in the banking sector or borrow from banks. By taking proactive measures to address NPAs, banks can mitigate risks and maintain healthy financials.

Classification for Non-Performing Assets (NPAs)

The below table gives the different classification of non-performing assets:

Causes of Non-Performing Assets (NPAs)

Non-Performing Assets or NPAs have become a major concern for banks and financial institutions in India. NPAs arise due to various reasons, some of which are as follows:

1. Economic downturns

   Economic slowdowns, recession, and slowdown in industrial growth lead to a decrease in demand for goods and services. This, in turn, affects the cash flows of companies, and they may default on their loans.

2. Borrower default

   Borrowers may default on their loans due to various reasons such as financial difficulties, fraud, or mismanagement. This leads to NPAs.

3. Inadequate credit appraisal

   Sometimes, banks and financial institutions do not carry out proper credit appraisal while sanctioning loans. This may lead to the borrower defaulting on the loan, and it becoming an NPA.

How does Non-Performing Asset (NPA) Work?

After a prolonged period of default, the lender forces the borrower to liquidate the assets that were pledged as collateral in the debt agreement. If assets were not pledged, then the lender writes it off as bad debt and sells it to a collection agency at a discount. A loan can be classified as a non-performing asset at any point during the term of the loan or at its maturity.

An example: Let’s assume that a company took a loan of ₹ 20 million. If the company fails to pay the interest ₹100,000 per month for three consecutive months, the lender categorises this loan as non-performing asset, listing it as an NPA on its balance sheet. A loan can also be categorised as non-performing if a company makes all interest payments but fails to pay off the principal at maturity.

What are the types of Non-performing Assets?

Term loans are the most commonly known non-performing assets.

Here are some other examples:

1. Overdraft and cash credit left out of order for more than 90 days
2. Agricultural advances whose interest or principal installment payments remain overdue
3. Expected payment that’s overdue for more than 90 days on any type of account
4. And ofcourse, term loans

Difference between Non-performing Asset (NPA) and Non-performing loan (NPL)

Why do banks worry about an account turning into an NPA?

There are numerous reasons why banks worry about their accounts turning into NPAs, but we’ll discuss the major ones:

• Revenue Loss: When an account turns into an NPA, it become a stressed account, and banks have to stop charging interest on it.
• Brand Image: A higher number of NPAs reflects badly on the image of the bank.
• Higher Provisions: The RBI imposes a certain set of rules on the banks to make provisions at a higher rate if an account turns into NPA.
• RBI Action: In some cases, the RBI may take harsh actions.
• Stock Market Crash: The bank’s stock market prices may fall if it’s listed with NPAs.

What are the Impacts of Non-Performing Assets (NPAs)?

When accounts turn into NPAs, the impact is as follows:

1. Banks do not have sufficient funds for other development projects, thus impacting the economy.
2. The curb in further investments may lead to the rise of unemployment.
3. Banks are forced to increase interest rates to maintain a profit margin.

Impact of NPA on borrowers

• CIBIL Score: The NPA impacts the borrower’s creditworthiness, thus hurting their CIBIL score.
• Brand Image: An NPA impacts the goodwill of the borrower.
• Future Funding Issues: Banks will be apprehensive about sanctioning a loan to a borrower whose account is an NPA.
• Impact on other Group Entities: An NPA doesn’t only impact the borrower but also the other group entities.

How to Calculate Gross NPA ratio and Net NPA

The Gross NPA is the amount obtained on adding the principal amount and the interest over that principal amount on it.

Gross NPA = ^{(Amount1 + Amount2 + ….. + Amount N)}⁄_{Gross Advances}

where, Amount 1 to Amount( n) is the amount loaned to persons 1 to n.

Gross Advances is the outstanding loan amount

Net NPA= ^{(Gross NPA – Provisions)}⁄_{Gross Advances}

Where ‘Provisions’ is the amount kept reserved by the bank or financial institution in advance for bad loans or any loss that might happen due to non-repayment of those loans.

NPAs are not favourable for banks as they are non-performing. A high number of NPAs means that too many loans have become non-functional or are not generating any interest income for the bank. However, the banks have the choice to either keep the NPAs in their books, hoping that they will recover or make provisions for them. Or, they can write it off entirely as a bad debt. NPAs in India have grown in the last few years and are impacting the economy. Therefore, it is the need of the hour for government and banks to improve their practices to arrest the growth of NPAs.

Steps taken to manage and reduce NPA levels

The Reserve Bank of India (RBI) has put in place various measures to manage and reduce the NPA levels in the banking system. Some of the steps taken by banks and financial institutions to manage and reduce NPA levels are as follows:

1. Loan restructuring

   Banks and financial institutions can restructure the loan terms and conditions to help the borrower repay the loan. This may include extending the repayment period or lowering the interest rate.

2. Asset reconstruction companies (ARCs)

   ARCs are specialized entities that buy NPAs from banks and financial institutions. ARCs then try to recover the money owed by the borrower by selling the assets or business of the borrower.

3. Recovery mechanisms

   Banks and financial institutions use various recovery mechanisms such as recovery agents, SARFAESI Act, Debt Recovery Tribunal (DRT), and Lok Adalats to recover the money owed by the borrower.

4. Write-offs

   Banks and financial institutions may write-off the loan if they are unable to recover the money owed by the borrower. This helps in cleaning up the balance sheet of banks and financial institutions.