What are Non-Performing Assets (NPAs)?

Kolkata: Nowadays one regularly confronts the term NPA, which is an abbreviation of non-performing asset. Though used in different contexts, NPA is originally linked to the banking system. Non-performing assets are loans and advances where the borrower has defaulted on payments to the lending institution. Technically speaking, NPAs are those where repayments have not taken place for 90 days, raising doubts whether these would be payable at all.

Though apparently a simple concept, NPAs are of immense significance to the banking system of any country, and in turn, for the entire economy. If high NPAs accumulate in any economy, it can negatively impact the ability of banks to lend, can lead to an overall credit squeeze, raise interest rates and even decelerate economic growth. One of the most spectacular examples of how high NPAs can harm an economy was the global financial crisis of 2008. It was marked by a surge in NPAs in the banking system, leading to widespread mortgage defaults and significant losses for financial institutions in the US. Numerous banks around the world and those in India suffered a NPA crisis.

An NPA is an asset that is not performing for a bank. Loans are the assets in the books of a bank since they earn interest for the lender. A loan that generates income -- for which the borrower regularly pays installments -- is a performing asset. The converse is a non-performing asset -- a loan for which the borrower has failed to pay installments. A loan is categorised as an NPA when the borrower fails to make interest payments and/or principal repayments for a continuous period of 90 days. The signal is clear -- the loan has run into the risk of default. In short, the bank might not be able to recover its money, which is the nightmare of any bank.

A low NPA is one of the primary indicators of the health of a bank or NBFC. Conversely, a high NPA indicates poor or deteriorating health of a lending institution. While an NPA stops earning income for a bank, rules stipulate that the bank is also required to keep aside additional funds to cover potential losses from these loans, which is known as provisioning.

The first alarm for the bank is that of loss. NPAs, therefore, directly affect profit margins of the lending institution. NPAs in the books of accounts of a bank need earmarking additional capital for covering such losses. This act, referred to as provisioning, directly reduces the amount of money available to the bank for lending to other parties/projects and hampers the institution's ability to generate new business. The bank will be able to expand business more slowly than it could have otherwise managed to do. A high degree of NPA also erodes the confidence of investors and depositors in a bank. In short, high NPAs can ruin the reputation of a bank or NBFC. Therefore, managing NPAs is one of the core functions of any pending institution.

Interestingly, non-performing assets are classified into different categories by banks, depending on the potential/expectation of recovery of the amount of money loaned out. The following are the types:

Substandard assets: If a loan becomes due for a period between 90 days and 12 months, it is called substandard assets. These assets (or loan) are labelled risky since the borrower has started defaulting, but there is still some hope that payment could be eventually done.

Doubtful assets: If the default status continues beyond 12 months, the substandard asset is treated as a doubtful asset. According to banking experts, the chances of recovery of a doubtful asset literally becomes very doubtful. At this stage the bank could proceed towards provisioning.

Loss assets: These are really hopeless loans and the management including auditors decide that recovery of the asset is almost impossible and it is an admission that the lender has exhausted all possible avenues of recovery. Banks are now required to write off the loan.

NPAs are usually measured in two ways -- both as a proportion to the loan issued by the bank or NBFC. Gross NPA ratio measures the total quantum of NPA against the total loans given by a bank. Net NPA is a measure that is arrived at by deducting the provisions for possible losses from the gross NPA figure. Net NPA is often a more realistic assessment of the impact of NPAs on a bank finances.