Non-performing assets (NPAs), also known as non-performing loans (NPLs), are loans or advances that have stopped generating interest income or are not being repaid by borrowers as per the agreed-upon repayment schedule. In other words, these are loans where the borrower has either defaulted on the repayment or has delayed the payment beyond a certain period, typically 90 days in most jurisdictions, including India.
When a loan becomes non-performing, it indicates that the borrower is facing financial difficulties and is unable to service the debt obligations. Non-performing assets pose significant risks to the lending institution as they affect the bank’s profitability, capital adequacy, and overall financial stability.
Types of Non-Performing Assets:
Substandard Assets:
Substandard assets are loans or advances where the borrower has started to default in making repayments, and the loan has remained non-performing for a specific period, typically less than 12 months. These assets have a high risk of default, but there is still a possibility of recovery with additional provisions. Banks need to classify substandard assets as NPAs and make provisions accordingly.
Doubtful Assets:
Doubtful assets are loans or advances where the borrower has significantly defaulted in making repayments, and the loan has remained non-performing for more than 12 months. These assets have a higher risk of default, and full recovery is doubtful. Banks need to make higher provisions against doubtful assets to cover potential losses.
Loss Assets:
Loss assets are loans or advances where the bank or financial institution has identified the loss, either partially or entirely, but has not yet written off the entire outstanding balance. These assets have little chance of recovery, and banks need to make full provisions against such assets to account for the losses.
Non-performing Investment:
Apart from loans and advances, NPAs can also include non-performing investments. These are financial investments made by the bank, such as bonds, equities, or other securities, which have deteriorated in value or have become illiquid, resulting in a loss to the bank.
Impact of Non-Performing Assets:
- Financial Losses: Non-performing assets lead to a decrease in interest income and result in financial losses for the lending institution. It can also impact the bank’s profitability and overall financial health.
- Capital Adequacy: Higher NPAs require the bank to set aside more provisions, reducing its capital base and impacting its capital adequacy ratio.
- Reduced Lending Capacity: Higher NPAs can restrict the bank’s ability to lend as it may be cautious about lending to risky borrowers due to potential further asset quality deterioration.
- Credit Risk: NPAs indicate weak credit risk management and underwriting practices of the bank, which can lead to a loss of investor and depositor confidence.
Measures to Address Non-Performing Assets:
- Loan Restructuring: Banks may consider restructuring the loan terms and conditions to provide relief to borrowers facing temporary financial difficulties.
- Recovery and Enforcement: Banks may take legal actions to recover dues from defaulting borrowers, including invoking collateral, initiating recovery proceedings, and enforcing security interests.
- Asset Quality Review (AQR): Regular AQRs help banks identify potential NPAs and take timely action to manage risks and strengthen their asset quality.
- Provisioning: Banks need to set aside provisions as per regulatory requirements to cover potential losses arising from NPAs.
- Improved Credit Risk Management: Strengthening credit risk assessment, monitoring, and underwriting practices can help reduce the incidence of NPAs.
- Asset Reconstruction Companies (ARCs): Banks may sell NPAs to ARCs to recover some portion of the outstanding dues and focus on core banking activities.
Treatment in Balance Sheet of Bank and Provisioning requirements
The treatment of non-performing assets (NPAs) in the balance sheet of a bank and the provisioning requirements vary based on the regulatory framework and accounting standards of each country.
Treatment in Balance Sheet:
Classification of NPAs:
In the balance sheet, banks classify NPAs into different categories based on the duration of default and the likelihood of recovery. The most common classifications are substandard assets, doubtful assets, and loss assets, as explained in the previous response.
Reduction of Assets:
The amount of NPAs is deducted from the total loan portfolio or advances in the asset section of the balance sheet. The reduction reflects the recognition of potential losses due to defaults.
Impact on Profit and Loss Account:
The interest income that banks were expecting to receive from NPAs is no longer recognized as income in the Profit and Loss Account. Instead, interest income on NPAs is recorded separately and not considered part of the bank’s operating income.
Provisioning Requirements:
Provisioning for Substandard Assets:
Banks are required to set aside provisions for substandard assets to cover potential losses. The amount of provisioning is typically a percentage of the outstanding balance of the substandard assets, depending on the regulatory guidelines.
Provisioning for Doubtful Assets:
For doubtful assets, banks need to set aside higher provisions compared to substandard assets, as the risk of default and potential losses is higher. The amount of provisioning depends on the extent of the doubtfulness and the regulatory requirements.
Provisioning for Loss Assets:
For loss assets, banks need to make full provisions to cover the expected losses, as the likelihood of recovery is very low. This means writing off the entire outstanding balance of the loss assets from the bank’s balance sheet.
Income Recognition Norms:
Regulators may impose strict norms on income recognition for NPAs. Banks may only recognize income from NPAs when it is actually received.
Capital Adequacy:
Provisioning requirements impact the capital adequacy of banks. Banks need to maintain sufficient capital to cover potential losses on NPAs and ensure they meet the minimum capital requirements prescribed by regulators.
Provisions for NPAs are reported as a liability in the balance sheet, representing the bank’s obligation to cover potential losses. Adequate provisioning ensures that banks have a buffer to absorb any losses arising from NPAs, thus safeguarding the interests of depositors and investors and promoting financial stability.
It is important to note that the treatment and provisioning requirements for NPAs may differ based on the specific regulatory framework of each country and may be subject to changes over time based on economic conditions and regulatory policies.