Small businesses need funds as capital for investment, or to handle expenditures or for further expansion of the business. Most often banks are the primary source for procuring funds and also for handling accounts. However when a business defaults on the loan repayments, the banks bear the brunt too.
Functioning Of Banks
As a primary function, banks accept deposits for the purpose of lending and investment. Banks offer loans for various purposes and interest income on these loans is their main source of income. All loans are ‘Assets’ of the bank. The source of funds for a bank include the deposits accepted of the loans granted previously as well as those funds which are available out of recovery of loans granted earlier.
In spite of best efforts, some loans pose problems in recovery or become irrecoverable. Such loans are termed as ‘’bad debts.’’ Banks have to make provision (keeping aside portion of profit) for bad debts out of profits generated by the bank out of business. The Reserve Bank of India has issued guidelines to banks as to how to identify a loan account as a bad debt and how much provision should be made against it. These guidelines are called prudential norms for IRAC i.e.,’ Income Recognition and Asset Classification’ norms.
What Are Non Performing Assets?
When any loan (credit facility) is sanctioned by the bank, it gives a repayment schedule to the borrower and recovery of loan is expected as per this repayment schedule. Any amount which is due for payment to the bank, but not paid, is termed as ‘’Overdue”. Bank has to classify its loan accounts under two categories, viz. Performing assets (PA) and Non Performing Assets (NPA). When overdue period exceeds 90 days, such asset/loan account showing overdues is treated as NPA. As defined by RBI, once the loan account ceases to generate income for the bank, it is termed as NPA. When the account becomes NPA, the bank cannot apply/book interest on such account unless and until it is actually recovered or received. In addition to this, the bank is required to make provision against these bad debts out of the profit otherwise earned from other business. Thus, NPA acts as a double-edged weapon in affecting the profitability of the bank. That is why, recovery and management of NPAs has become a very vital function for banks.
Even before the implementation of IRAC/NPA norms, banks have been handling bad debts and have been making provisions there against out of the profits. But in those times, provisioning was subjective, which means it was decided based on the discussion between banks and its Auditors. There was no set formula or uniform applicability for deciding the amount of provision. However, with the application of IRAC norms, the process has become transparent, uniform and objective, meaning thereby that it has become an arithmetical exercise leaving no room for discussions.
Impact Of NPAs On Banks And Businesses
It is in the interest of both the banks and borrowers to maintain performing status of accounts. For banks, it improves their profitability as well as allows them to concentrate on business development instead of concentrating on recovery. More NPAs also result in reputational loss for the bank which may have to work under restrictions put by RBI under Prompt Corrective Action. For borrowers also, NPA status harms reputation and their credit rating and credit score gets affected which may result in non-availability of further finance for development or for any other purpose. One has to keep in mind that high level of NPAs ultimately affects the economy of the country as a whole.
Mr. Shirish Potdar
Mr. Shirish Potdar is a hard core banker and has a three decade combined experience with both Nationalised and Cooperative bank. Currently he is a mentor at deAsra Foundation with 37+ years of experience in banking.