Pertinent questions

• Are mounting NPA’s a sign of poor credit risk management ?

• What are the costs of an NPA on the books of the bank?
• How is a loan priced?
DEFINITION
“ We should not forget that the basic economic function of these
regulated entities is to take risk. If we minimise risk taking in order to
reduce failure rates to zero, by definition, have eliminated the purpose
of the banking system” – Alan Greenspan, President, Federal Reserve
Board, U.S.A.
INTERPRETATION
• Banks have to take risk but risk has to be managed in a professional
way.
• To manage risk one has to understand different types of risk and how
to mitigate them.
• The risk is same for corporate and retail credit but the degree varies
and is measured differently
• Credit risk denotes defaults
• 1994, the gross NPAs for all scheduled banks were 19.07% and PSBs
24.8%
• Falling interest rates in the early 2000s helped banks book huge
profits in treasury, ( yields dropped and prices increased) which were
used to write off some of the NPAs
• As of March 2020, among 34 listed Indian Banks, the PSBs together held
around 59.38 percent of the loans but were responsible for 71.78 percent
of the gross NPA
• A structure framework for NPA classification and their handling came in
1990
• Prudential norms for classification of NPAs came in April 1992 on account
of Basel norms. Adopted in a phase manner- In 1993 after 4 quarters;
1994 three and 1995, 2 quarters. Till 2001 there was the past due concept
• Before this, there was the health code system- 8 categories from 1
( satisfactory) to 8 ( bad)
Non Performing Accounts
• Standard Accounts
• Substandard Accounts - where the delinquency is 12 months or less
• Doubtful Accounts – where the delinquency exceeds 12 months or value of
security falls below 50%
Secured Category I - doubtful for 1 year
Secured Category 2 – doubtful for 1 to 3 years
Secured Category 3- doubtful for more than 3 years
Unsecured – unsecured portion of a doubtful asset
• Loss Assets - where security value is negligible ( generally less than 10% of
the outstanding loan amount
Provisioning norms

• Substandard – 10% + additional 10% on the unsecured portion

• Doubtful -1 – 20% on secured portion & 100% on unsecured
• Doubtful 2 - 30% on secured portion & 100% on unsecured
• Doubtful 3 – 100%
• Loss asset – 100%
GENUINE DEFAULTS
• When a borrower fails to repay the loan instalments due to personal
set backs like loss of job, personal inability or huge medical expenses,
etc, such borrower is classified as genuine defaulter.
• The borrower has real intention to repay the loan in time.
• Intention to pay is intact but ability to pay is affected.
• The approach of recovery is one of care and concern and customer
oriented.
WILFUL DEFAULTS
• A borrower who deliberately fails to pay the loan instalments even
though he has sufficient cash flows to pay is called a wilful defaulter.
• The intention of the borrower in malafide.
• The reason is to delay and he has no willingness to pay.
• The bank’s approach is firm and prompt.
• Bank should act swiftly the moment the sign of wilful default is
known.
• A wilful default is considered a fraud on the Bank
RECOVERY PROCESS
• In the case of genuine defaulters, recovery process is gentle and
professional so that the genuine borrowers respond favourably.
• In the case of wilful defaulters, banks have to take prompt recovery
steps with out delay as persuasive method is bound to fail.
• Banks have to bring out recovery policy every year to identify thrust
areas and more focus should be given to those portfolios where
defaults are high.
RECOVERY PROCESS
• Meeting defaulters helps banks to find out the reason for default.
• If it is for genuine reasons, banks can take pro active steps like re-
phasing or restructuring the existing loans to prevent them from
becoming NPAs.
• If defaulters are wilful defaulters, banks can take recovery steps like
repossession and securitization of assets charged to the banks.
Restructuring of accounts
• Origin in 1929-39 in USA to handle the aftermath of the great
depression
• After that periodically to handle the aftermath of any major crisis or
natural calamities.
RECOVERY PROCESS
• Recovery is a constant attempt to recover loans on due dates.
• This requires constant monitoring and follow up.
• RBI has put in place concept of special monitoring account to
prevent performing assets slipping in to non performing assets.
• So the early alert system helps banks to take prompt recovery steps
by meeting defaulters.
Special Mention Accounts
• Three categories of accounts-

SMA 0 – repayments due from 1 to 30 days + additional criteria of triggers to EWS

SMA 1 - repayments due from 31 to 60 days
SMA 2 - repayments due from 61 to 90 days

The SMAs are recognised inorder to

• Arrest further slippage
• Initiate prompt corrective actions
Further SMA classification is required as per RBI guidelines
Steps to be taken
When accounts are classified as SMA the bank should take the
following steps

Discuss the problem with the Promoter

Obtain the latest financial statements
Conduct verification of all collaterals ( ensure that the securities are
intact)
The bank can also discuss rescheduling of the account, handholding in
genuine cases
RESCHEDULEMENT
• Banks are permitted to re-phase or reschedule loans before they
become NPA.
• This rephasement or rescheduling can be done for genuine defaulters.
• Bank has to find out from the borrowers the reason for reduced cash
flow to confirm whether such reduced cash flow is temporary or
permanent.
• At times banks are permitted to reschedule substandard assets and in
specific cases retain them in the same category
RESCHEDULEMENT
• Increase in floating interest or reset in fixed interest rates may
change the equated monthly instalments. This is also one of the
reasons for default on loan instalments by retail borrowers.
• Under these circumstances banks can re-phase the loan instalments
by lengthening the period of repayment by keeping the existing EMI
intact.
• Banks also resort to stepping up the EMI to match the increase in
future cash flows like annual increase in salary.
Early warning signals
These are generally signals that warrant close monitoring of the
accounts by the bank.
The EWS can be identified in these areas
Financial
Operational
Physical
Attitudinal changes
The list is not exhaustive

Current ratio dropping to 80 % of benchmark

Leverage ratio increasing significantly
No operations in account for more than 30 days
Borrower reporting stress in the unit
Delay in submission of statements
Deteriorating financial statements and operating losses for more than 2
quarters
RECOVERY PROCESS
• There are many recovery tools available to bankers. Through recovery
agents, recovery through Lok Adalats, action under SARFAESI ACT
2002 or DRT to name a few. Banks can also take legal steps like filing
suits in the civil courts for relief if they are not able to take action
under SARFAESI.
• Repossession of security is aimed at recovery of dues.
• Repossession is possible for movable assets charged to banks and this
is possible only after issuing notice to defaulters on repossession.
• Due process of law should be followed.
RECOVERY PROCESS
• Once the securities are repossessed with the help of authorized
recovery agents, banks have to take prompt action in selling them in
public auction.
• Even after repossession but before auction sale, defaulter can take
back the movable security after clearing the dues and charges
incurred on repossession.
• SARFAESI Act
• DRT
• Lok Adalat
• Securitisation

• CDR mechanism
RECOVERY AGENTS
• RBI has given detail guide lines on appointment and role of recovery
agents in commercial banks as an aftermath of supreme court
judgement.
• As per RBI guidelines on appointment of recovery agents, they should
be properly trained to handle with care and sensitivity of the issue,
their responsibilities and the legal procedures of recovery.
• Banks should have adopt due diligence process for hiring recovery
agents.
RECOVERY AGENTS
• IBA is directed by the RBI to train recovery agents for period of minimum 100
hours on nuances of recovery process.
• Banks are directed to shortlist trained recovery agents.
• There is uniformity in training of recovery agents and certificates are given to
the trained recovery agents issued by Indian Institute of Banking and Finance
(IIBF).
• Banks should inform the defaulters the names and other details of the
recovery agents hired for recovery of repossession of charged securities.
• Recovery agents are directed to video graph the recovery action taken by
them to prevent borrowers prefer false criminal complaints of using force or
adopting third degree methods of recovery.
SARFAESI ACT
• SARFAESI Act, passed in the year 2002 came as boon to banks as the
act has given quasi judicial powers to authorized officers of banks to
seize secured movable and immovable assets charged to the banks.
• This act has helped banks to recover their dues without seeking legal
remedy in the civil courts which took very long time for recovery of
bank dues.
• Besides the recovery is cumbersome through legal process.
SARFAESI ACT
• Under the provisions of this act, recovery is possible within 120 days as
the defaulters are given 60 day notice to repay the entire loan
outstanding plus interest and cost. If they fail to repay, the banks are
empowered to take physical or symbolic possession of securitized
assets. Thereafter sale notice is issued to the defaulters and finally sale
by auction is done.
• 45 days time limit is given between taking symbolic or physical
possession of securitized assets and auction sale of the asset. This time
limit is given for borrowers to arrange funds to pay loan arrears and get
the sale proceeding dropped or take legal course by moving debt
recovery tribunals to stay auction sale on the grounds of merit.
SARFAESI ACT
• Once the securitized asset is sold in public auction and sale proceeds
are to be used to clear the existing loan in full and cost incurred on
recovery process.
• Balance if any should be credited to the account of the borrowers
with intimation to them.
• SARFAESI Act has helped banks to recover major chunk of defaulted
secured loans thereby increase the comfort level of banks to further
lend for retail asset products.
RECOVERY THROUGH LOK ADALATS
• Under the directions of supreme court of India, RBI has directed
banks to utilize the services offered by district court judges for
recovery of bank dues through conciliation process.
• This is possible only when suits are pending in civil courts and there is
willingness on both the parties to the litigation for conciliation and
settlement.
RECOVERY THROUGH LOK ADALATS
• The district judge or any serving judge will be the presiding officer of
Lok Adalat.
• He hears both sides and gives his award based on the merit of the
case.
• Once his award is acceptable to both the parties, the suits filed in civil
courts are withdrawn.
• The defaulters have to pay as committed before the Lok Adalat and
clear his/her loan liabilities.
DEBT RECOVERY TRIBUNALS
• DRTs are created for speedy recovery of bank loans of Rs 20 lakhs and
above.
• Since SARFAESI Act is not applicable to agriculture loans and
exempted category of loans, DRTs are utilized by banks to recover
their dues. DRTs are expected to deliver judgements within 6 months
from the date of filing the suit by banks.
DEBT RECOVERY TRIBUNALS
• DRTs have to hear the issues from both litigants and decide on the
issue.
• The judgement given by DRTs is in the form of recovery certificate.
• Subsequently on getting recovery certificate, banks have to file it
before recovery officer who is attached to DRTs for attachment and
sale of assets charged to banks.
• The procedure for recovery is not only cumbersome but also time
consuming.
• In August 2001, the CDR mechanism was put in place.
• Any debt of over 20 crores could be restructured outside the purview
of the BIFR, DRT or other legal channels.
• The CDR concept evolved through revisions in 2003, 2005 and 2008
• The scope widened, but the regulations became more stringent.
• The requirement was to restructure the account within a time frame
for the benefit of all.
SECURITISATION
• Securitisation is the process of converting and breaking definable
asset classes into tradable units and selling to others through a
mechanism called as special purpose vehicle (SPV).
• Through the securitisation process, the assets are removed from the
balance sheet and funds generated through securitisation can be used
for asset expansion.
• Securitisation is the process of pooling of individual long term loans
which are packaged and sold to various investors in the form of pass
through certificates.
• The advantage of securitisation is that the receivables are removed
from the books as they have sold and the transaction does not create
a liability in the balance sheet.
SPV CONCEPT
• The SPV converts assets into securities called “pass through
certificates” and sell them to the buyers who may buy it for
investment purpose.
• Since these certificates are backed by assets, they are called asset
backed securities (ABS).
• If assets which have underlying mortgages are securitised , they are
called as “mortgage based securitisation”.
PROCESS
• Securitisation helps in asset liability management
SECURITISATION PROCESS:
• The lender first selects the assets they want to securitize.
• The issuer (SPV) makes payment to the lender for the loans
securitised.
• The assets are converted into pool of securities by the issuer for the
purpose of issuing pass through certificates.
PROCESS
• The pass through certificates are sold to the investors who are willing
to invest.
• The lender continues to receive recoveries from the original
borrowers and passed on to the SPV.
• The SPV in turn passes the recoveries to the investors.
PROCESS
COLLATERAL DEBT OBLIGATION:
• In the retail product , another concept called Collateral Debt
Obligation (CDO) is also in vogue.
• In CDO, asset classes/ receivables like car loans, credit card
receivables and mortgage loans like home loan are grouped and
securitised.
• Multi layers of PTC with varying rates and coupons are issued based
on the quality of assets and risk perceptions of the underlying assets.
SECURITISATION OF RETAIL BANKING
• The asset based securitisation which is backed by retail loans other
than housing loans formed a major chunk of total asset based
securitisation.
• The mortgage based securitisation is applicable for all types of
housing loans and mortgage based retail loans.
• In the present scenario, banks resort to securitisation of retail assets
to take advantage of increase in the interest rates on retail asset
portfolio