Finitiative Blog
Layman’s Explanation of Non-Performing Assets (NPA’s)
by Sharon Anusha Andrew on December 02, 2021
Imagine the following scenario. You have lent your friend Rs. 100,000 to be paid in a month. He has even given you as security a gold ring worth Rs. 40,000. The month ends and your friend seems to have conveniently forgotten his debt. Do you simply write it off? Of course not! You wait. He is your friend after all. He will pay you back.
Consider the following situations.
Situation 1: Month 3 arrives and ends with you giving him a gentle reminder. Same situation at the end of Month 4. Now the seed of doubt is planted. Will he or won’t he pay you back?
Situation 2: It has been just a little over a year! What is he doing? The conversation is stilted. He gives you excuses, and you accept it with a sliver of doubt.
Situation 3: It has now been 2 years. You are getting frustrated and angry. You bombard him with calls and texts asking him to pay you back. You ask for at least part of the money due to you. He begs for more time. You give it to him.
Situation 4: Over 3 years have passed. He no longer picks up your calls and many people haven’t seen him for months.
Situation 5: Your friend is now absconding. You lose all hope and consider your Rs. 1,00,000 permanently lost.
What has all this got to do with the NPA? Let me slide right in.
What is an NPA?
A non-performing asset (NPA) refers to a classification for loans/advances – in a Bank’s balance sheet (which from the bank’s perspective, are assets) - that are in default or in arrears, for over 90 days.
When is a loan/advance considered to be in arrears? When the principal or interest payments are late or missed.
NPAs place a financial burden on the bank (i.e.) the lender; a significant number of NPAs over a period of time may indicate that the financial fitness of the bank is in jeopardy. Banks are required to classify non-performing assets into one of three categories according to how long the asset has been nonperforming: sub-standard assets, doubtful assets, and loss assets.
Provisioning Norms
Following the principle of prudence, banks will make a provision estimating that there is a potential that a certain percentage of the debt may not be recoverable. The amount of provision depends on the probability of loan recovery with the minimum provision to be provided below. A bank may however voluntarily make higher provisions.
The provision will be made on both ‘secured’ and the ‘unsecured’ portion of the loan. In our Situations given above, the unsecured portion of the loan is Rs. 60,000 as there is a security of Rs. 40,000 from the gold ring.
The provisions on standard assets should not be reckoned for arriving at net NPAs.
Broadly speaking, classification of assets into the above categories should be done while considering the degree of well-defined credit weaknesses and the extent of dependence on collateral security for the realization of dues.
The effect of NPAs
Interest earned on loans is a major source of income for the bank or lender. As a result, non-performing assets will have a negative impact on their ability to generate sufficient income and on their overall profitability. It is critical for banks to keep track of their non-performing assets (NPAs), as having too many NPAs can have a negative impact on their liquidity and ability to grow. It is necessary for banks to lessen NPAs in order to improve the health of the banking sector as a whole.
References: https://taxguru.in/rbi/performing-assets-npa-management.html
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