"The high level of NPAs in banks and financial institutions has been a matter of grave concern to the public as bank credit is the catalyst to the economic growth of the country and any bottleneck in the smooth flow of credit, one cause for which is the mounting NPAs, is bound to create adverse repercussions in the economy. NPAs are not therefore the concern of only lenders. I consider that forum like this, comprising of representatives of a major section of the beneficiaries of the financial system, should equally get concerned in a serious way on what they can do to address the gravity of the NPA problem of banks. I would rather urge them to lend a helping hand in the ongoing efforts of banks, and financial institutions to recover bad debts and arrest fresh accretions of NPAs.

"The prudential norms on income recognition, asset classification and provisioning thereon, are implemented from the financial year 1992-93, as per the recommendation of the Committee on the Financial System (Narasimham Committee I). These norms have brought in quantification and objectivity into the assessment and provisioning for NPAs. We at the central bank constantly endeavour to ensure that our prescriptions in this regard are close to international norms. We are neither strict nor lax but just correct in tune with our needs and capabilities.

"Under the prudential norms laid down by RBI

• Income should not be recognised on NPAs on accrual basis but should be booked only when it is actually received in respect of such accounts.

• An asset is considered as "non-performing" if interest or installments of principal due remain unpaid for more than 180 days (the lag would get reduced to 90 days from March 31, 2004 to conform to international norms). Any NPA would migrate from sub-standard to doubtful category after 18 months (as against 12 months under international norms). It would get classified as loss asset if it is irrecoverable or only marginally collectible.

• The banks should make full provision for loss assets, 100 per cent of the unsecured portion of the doubtful asset plus 20 to 50 per cent of the secured portion (depending on the period for which the account is doubtful), and a general 10% (it is 20 per cent under international norms) of the outstanding balance in respect of sub-standard assets."

"Detailed guidelines have been issued by RBI in October 2000 on valuation and provisioning for investment portfolio including credit substitutes"

"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.

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

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.

"A glance through the statistics on the movement of NPAs of public sector banks since introduction of prudential norms in 1992-1993 will help us to understand the extent to which the public sector banks have made progress in reducing their NPA levels

"The level of gross and net NPAs has been sliding down over the years. Gross NPA had come down from 23.18% in 1992-93 to 12.40% in 2000-01. Net NPA also moved down from 14.46% in 1993-94 to 6.74% in 2000-01. Still the NPA level can be considered of staggering magnitude in absolute terms costing the public sector banks more than Rs.5000 crores annually by way of loss of interest income, besides servicing and litigation costs. To be fair, I have to state that a major portion of the NPAs was a legacy of the pre-prudential days, when banks were accounting for interest as income on accrual basis even when the underlying advances were not performing.

"It will be interesting to have a look at the movement of NPAs (gross and net), as a percentage of advances, group-wise over the last four years. This will give an idea of where banks, as different groups, stand in regard to their NPAs

"It may be observed that the malady of high level of NPAs eroding the profitability of banks is not confined to public sector banks alone, but it is equally present in the private sector banks too. While some of the foreign banks loan portfolio had been affected by a few large accounts turning NPA, it is a matter of concern that some of the new private sector banks which started off on a clean slate had acquired so quickly such a large level of NPAs

"One of the trigger points in the proposed Prompt Corrective Action (PCA) mechanism [which was widely circulated by RBI through the public domain] is the level of net NPAs. When the trigger point under the mechanism is activated by the performance of a bank, the mandatory actions would follow by way of restriction on expansion of risk-weighted assets, submission and implementation of capital restoration plan, prior approval of RBI for opening of new branches and new lines of business, paying off costly deposits and special drive to reduce the stock of NPAs, review of loan policy, etc.

"The most important business implication of the NPAs is that it leads to the credit risk management assuming priority over other aspects of bank's functioning. The bank's whole machinery would thus be pre-occupied with recovery procedures rather than concentrating on expanding business.

"As already mentioned earlier, a bank with high level of NPAs would be forced to incur carrying costs on a non-income yielding assets. Other consequences would be reduction in interest income, high level of provisioning, stress on profitability and capital adequacy, gradual decline in ability to meet steady increase in cost, increased pressure on net interest margin (NIM) thereby reducing competitiveness, steady erosion of capital resources and increased difficulty in augmenting capital resources.

"The lesser appreciated implications are reputational risks arising out of greater disclosures on quantum and movement of NPAs, provisions etc. The non-quantifiable implications can be psychological like 'play safe' attitude and risk aversion, lower morale and disinclination to take decisions at all levels of staff in the bank.

"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.

"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.