EARLY WARNING SIGNALS OF NON PERFORMING

ASSETS

INTRODUCTION

Non- performing assets is one of the biggest challenge facing the banking system
today. The extent of the challenge for nationalized banks is such that non action is
no longer an option. This issue is likely to get worse due to an overall economic
slowdown and is now impacting almost all customer segments MSME (micro,
small and medium enterprises), large corporate, agriculture etc.

MEANING - A non performing asset (NPA) refers to a classification for loans

on the books of financial institutions that are in default or are in arrears on
scheduled payments of principal or interest. In most cases, debt is classified as
nonperforming when loan payments have not been made for a period of 90 days.
While 90 days of nonpayment is the standard period of time for debt to be
categorized as nonperforming, the amount of elapsed time may be shorter or
longer depending on the terms and conditions set forth in each loan.

No loans turn NPA overnight. It is generally a prolonged affair. The

failure of the banks to notice the warning signals lead to repayment problems or
potential cases of NPA. It can be deteriorating cash position on continuous basis
or poor cash management and the resultant liquidity problems or poor risk
management, declining profitability and deteriorating asset position or adverse
current asset / sales ratio.
The early warning signals are those which clearly indicates or
show some signs of credit deterioration in the loan account. They indicate the
potential problems involved in the accounts so that remedial action can be
initiated immediately.

CLASSIFICATION OF EARLY WARNING SIGNALS

The early warning signals can be broadly classified into six broad categories :

EARLY WARNING
SIGNALS

FINANCIAL OPERATIONAL BANKING MANAGERIAL EXTERNAL OTHERS

(1) FINANCIAL WARNING SIGNALS

Some of the financial warning signals are :
a) Default in repayment.
b) Continuous irregularity in the account.
c) Devolvement of LC or invocation of guarantees.
d) Deterioration in working capital position or in liquidity.
e) Declining sales compared to previous period
f) Substantial increase in long term debts.
g) Raising sales but falling profits.
h) Incurring operating losses or net losses.
i) Raising level of bad debt losses.
(2) OPERATIONAL WARNING SIGNALS
Some of the operational warning signals are :

a) Underutilisation of plant capacity

b) Non payments of electricity, wages etc
c) Frequent labour problems
d) Poor diversification and frequent changes in plan for expansion or
diversification or modernization.
e) Delayed or missed employee payrolls.
f) Evidence of overstocking and aged inventory.
g) Loss of important customers

(3) MANAGERIAL WARNING SIGNALS

Some of the Managerial warning signals are :

a) Diversion of funds and poor financial controls.

b) Lack of cooperation from key personnel.
c) Change in ,management or ownership pattern or key personnel.
d) Undertaking of undue risks.
e) Fudging of financial statements.

(4) BANKING WARNING SIGNALS

Banking related warning signals are :
a) Frequent request for further loans
b) Delays in servicing of interest
c) Reduction of operations in the account or reduction in bank balances.
 d) Breaching the limit of operating loans; for example, a sudden
overdraft without any business logic.
e) Opening of accounts with other banks.
f) Dishonour of cheques or return of bills sent for collection
g) Not routing sales transactions through the account.
h) Delays in submitting stock statements and other data or non
submission of periodical statement.
i) Frequent excesses in the account.

(5) EXTERNAL WARNING SIGNALS

Signals relating to external factors are :
a) Economic recession.
b) Introduction of new technology
c) Changes in govt policies
d) Emergence of new competition.
e) Natural calamities.
f) Weakening of industry characterstics.

(6) OTHER INDICATORS

Some other indicators are :
 OTHERS

BEHAVIOUR GEOGRAPHIC INDUSTRY

PERCEPTION

I. BEHAVIOURAL INDICATORS
a) Any attempt at deception / misrepresentation of facts.
b) Regular and consistent attempts at delaying financial reporting
requirements;unwillingness to respond to various
communications.
c) Avoiding direct and complete responses to specific questions;
bluffing by answering a question with a question.
d) Evading requests or providing irrelevant information to a
request; excessive delays in responding to a request for no valid
reason.
e) Creating fake or shell entities for the purpose of
misappropriating goods and services.
f) Transferring assets without any concrete business reason to
back up the decision; disposing of the asset at less than the fair
value.
II. GEOGRAPHIC INDICATORS
a) Exchange rate devaluation.
 b) Continuous decline in economic growth in the region
c) Steady growth in money laundering. Country risks due to
unfavorable political environment.
III. INDUSTRY INDICATORS
a) Increase in adverse industry regulations, such as a ban on
exports.
b) Inability to control increasing costs and rising input prices.
c) Changing customer behavior with respect to the business
segment.

IV. PERCEPTION INDICATORS

a) A decrease in awareness of the client’s brand and/or logo.
b) Less positive media exposure.
c) Deteriorating relationships.
d) Negative price perception in the eyes of end customers.

FRAMEWORK FOR DEALING WITH LOAN FRAUDS

1.0 Objective of the framework

In the context of increasing incidence of frauds in general and in loan portfolios in

particular, objective of this framework is to direct the focus of banks on the aspects
relating to prevention, early detection, prompt reporting to the RBI (for system
level aggregation, monitoring & dissemination) and the investigative agencies (for
instituting criminal proceedings against the fraudulent borrowers) and timely
initiation of the staff accountability proceedings (for determining negligence or
connivance, if any) while ensuring that the normal conduct of business of the
 banks and their risk taking ability is not adversely impacted and no new and
onerous responsibilities are placed on the banks.

2.0 Early Warning Signals (EWS) and Red Flagged Accounts (RFA)

2.1 The concept of a Red Flagged Account (RFA) is being introduced in the
current framework as an important step in fraud risk control. A RFA is one where a
suspicion of fraudulent activity is thrown up by the presence of one or more Early
Warning Signals (EWS). These signals in a loan account should immediately put
the bank on alert regarding a weakness or wrong doing which may ultimately turn
out to be fraudulent. A bank cannot afford to ignore such EWS but must instead
use them as a trigger to launch a detailed investigation into a RFA.

2.2 An illustrative list of some EWS is given for the guidance of banks
in Appendix I to this circular. Banks may choose to adopt or adapt the relevant
signals from this list and also include other alerts/signals based on their experience,
client profile and business models. The EWS so compiled by a bank would form
the basis for classifying an account as a RFA.

Appendix I

Some Early Warning signals which should alert the bank officials about some
wrongdoings in the loan accounts which may turn out to be fraudulent

1. Default in payment to the banks/ sundry debtors and other statutory bodies, etc.,
bouncing of the high value cheques
2. Raid by Income tax /sales tax/ central excise duty officials
3. Frequent change in the scope of the project to be undertaken by the borrower
4. Under insured or over insured inventory
5. Invoices devoid of TAN and other details
6. Dispute on title of the collateral securities
7. Costing of the project which is in wide variance with standard cost of installation
of the project
8. Funds coming from other banks to liquidate the outstanding loan amount
9. Foreign bills remaining outstanding for a long time and tendency for bills to
remain overdue
10.Onerous clause in issue of BG/LC/standby letters of credit
11.In merchanting trade, import leg not revealed to the bank
12.Request received from the borrower to postpone the inspection of the godown for
flimsy reasons
13.Delay observed in payment of outstanding dues
14.Financing the unit far away from the branch
15.Claims not acknowledged as debt high
16.Frequent invocation of BGs and devolvement of LCs
17.Funding of the interest by sanctioning additional facilities
18.Same collateral charged to a number of lenders
19.Concealment of certain vital documents like master agreement, insurance coverage
20.Floating front / associate companies by investing borrowed money
21.Reduction in the stake of promoter / director
22.Resignation of the key personnel and frequent changes in the management
23.Substantial increase in unbilled revenue year after year.
24.Large number of transactions with inter-connected companies and large
outstanding from such companies.
25.Significant movements in inventory, disproportionately higher than the growth in
turnover.
26.Significant movements in receivables, disproportionately higher than the growth in
turnover and/or increase in ageing of the receivables.
27.Disproportionate increase in other current assets.
28.Significant increase in working capital borrowing as percentage of turnover.
29.Critical issues highlighted in the stock audit report.
30.Increase in Fixed Assets, without corresponding increase in turnover (when project
is implemented).
31.Increase in borrowings, despite huge cash and cash equivalents in the borrower’s
balance sheet.
32.Liabilities appearing in ROC search report, not reported by the borrower in its
annual report.
33.Substantial related party transactions.
34.Material discrepancies in the annual report.
35.Significant inconsistencies within the annual report (between various sections).
36.Poor disclosure of materially adverse information and no qualification by the
statutory auditors.
37.Frequent change in accounting period and/or accounting policies.
38.Frequent request for general purpose loans.
39.Movement of an account from one bank to another.
40.Frequent ad hoc sanctions.
41.Not routing of sales proceeds through bank
42.LCs issued for local trade / related party transactions

2.3 All accounts beyond Rs.500 million classified as RFA or ‘Frauds’ must also
be reported on the CRILC data platform together with the dates on which the
accounts were classified as such. The CRILC data platform is being enhanced to
provide this capability by June 1, 2015. As of now, this requirement is in addition
to the extant requirements of reporting to RBI.

2.4 The modalities for monitoring of loan frauds below Rs.500 million threshold is
left to the discretion of banks. However, banks may continue to report all identified
accounts to CFMC, RBI as per the existing cut-offs.

2.5 The tracking of EWS in loan accounts should not be seen as an additional task
but must be integrated with the credit monitoring process in the bank so that it
becomes a continuous activity and also acts as a trigger for any possible credit
impairment in the loan accounts, given the interplay between credit risks and fraud
risks

2.6 The FMG should report the details of loan accounts of Rs.500 million and
above in which EWS are observed, together with the decision to classify them as
RFAs or otherwise to the CMD/CEO every month.

3. Filing Complaints with Law Enforcement Agencies

Banks are required to lodge the complaint with the law enforcement agencies
immediately on detection of fraud. There should ideally not be any delay in filing
of the complaints with the law enforcement agencies since delays may result in the
loss of relevant ‘relied upon’ documents, non-availability of witnesses, absconding
of borrowers and also the money trail getting cold in addition to asset stripping by
the fraudulent borrower..

4. Penal measures for fraudulent borrowers

 In particular, borrowers who have defaulted and have also committed a

fraud in the account would be debarred from availing bank finance from
 Scheduled Commercial Banks, Development Financial Institutions,
Government owned NBFCs, Investment Institutions, etc., for a period of
five years from the date of full payment of the defrauded amount. After this
period, it is for individual institutions to take a call on whether to lend to
such a borrower.
 No restructuring or grant of additional facilities may be made in the case of
RFA or fraud accounts.
 No compromise settlement involving a fraudulent borrower is allowed
unless the conditions stipulate that the criminal complaint will be continued.

5. Central Fraud Registry

Presently there is no single database which the lenders can access to get all the
important details of previous frauds reported by banks. The creation of such
database at RBI will make available more information to banks at the time of start
of a banking relationship, extension of credit facilities or at any time during the
operation of an account. The Reserve Bank is in the process of designing a Central
Fraud Registry, a centralised searchable database, which can be accessed by banks.
The CBI and the Central Economic Intelligence Bureau (CEIB) have also
expressed interest in sharing their own databases with the banks.

WHAT IS SPECIAL MENTION ACCOUNTS (SMA)?

 The classification of Special Mention Accounts (SMA) was introduced by

the RBI in 2014, to identify those accounts that has the potential to become
an NPA/Stressed Asset.
 Logic of such a classification is because some accounts may turn NPA
soon.
  Here, an early identification will help to tackle the problem better.
 Special Mention Accounts are those assets/accounts that shows symptoms
of bad asset quality in the first 90 days itself.

WHAT IS THE DIFFERENCE BETWEEN NPA AND SMA?

Remember that NPA has a duration of 90 days. On the other hand, the worst type
of special mention account (SMA – 2) has less than 90 days’ duration.

The Special Mention Account identification is an effort for early stress

discovery of bank loans. It was introduced as a corrective action plan to contain
stress. As per the SMA regulations, banks should identify potential stress in the
account by creating a new sub-asset category viz. ‘Special Mention Accounts’
(SMA).

CLASSIFICATION OF SPECIAL MENTION ACCOUNTS

The Special Mention Accounts are usually categorized in terms of duration. For
example, in the case of SMA -1, the overdue period is between 31 to 60 days. On
the other hand, an overdue between 61 to 90 days will make an asset SMA -2. In
the case of SMA -NF, non-financial indications about stress of an asset is
considered.

SMA Sub Classification basis

Category

SMA – NF Non-financial (NF) signals of stress

SMA-0 Principal or interest payment not overdue for

 more than 30 days but account showing signs
of incipient stress, Delay of 90 days or more in
(a) submission of stock statement / other
stipulated operating control statements or (b)
credit monitoring or financial statements or (c)
non-renewal of facilities based on audited
financials.

SMA- 1 Principal or interest payment overdue between

31-60days.

SMA – 2 Principal or interest payment overdue between

61-90 days.

 ‘Special Mention’ category of assets is not only on the basis of non-

repayment or overdue position but also due to other factors that reflect
sickness/irregularities in the account (SMA -NF).
 There will not be any particular provisioning for SMA assets.
 The Reserve Bank of India (RBI) has sent commercial banks a second list of
at least 26 defaulters with which it wants creditors to start the process of
debt resolution before initiating bankruptcy proceedings.
 These are accounts where 60% of the outstanding amount was classified as
non-performing on the books of banks as of 30 June. Videocon Industries
 Ltd and Jai prakash Associates Ltd (JAL) are the two large companies
among the list of 26 defaulters, accounting for over Rs1 trillion of debt.
 The Reserve Bank of India (RBI) sought to address potentially about one
fourth of the Rs 10 lakh-crore non-performing assets (NPAs) on the books
of local lenders, mandating that a dozen such accounts be taken to the
bankruptcy courts. Although the RBI didn't name any defaulter, bankers
say borrowers such as Bhushan Steel, Essar Steel, Lanco, and Alok
Textiles may be the first set of companies facing proceedings under
stringent recovery laws.