Management of Non-Performing Assets (NPAs)in the Urban Cooperative Banks (UCBs 1. Introduction 1.

1 RBI introduced, in 1992-93, the prudential norms for income recognition, asset classification & provisioning IRAC norms in short in respect of the loan portfolio of the UCBs. The objective, inter-alia, was to bring out the true picture of a banks loan portfolio. The fallout of this momentous regulatory measure for the management of the UCBs was to divert its focus to profitability, which till then used to be a low priority area for it. Asset quality assumed greater importance for the UCBs when RBI introduced the Basel norms for Capita Adequacy from year-ended March 31, 2002 in the aftermath of serious financial problems in the sector. Maintenance of high quality credit portfolio continues to be a major challenge for the UCBs, especially with RBI gradually moving towards convergence with more stringent global norms for impaired assets. 1.2 The quality of a banks loan portfolio can impact its profitability, capital and liquidity. Asset quality problems are at the root of other financial problems for banks, leading to reduced net interest income and higher provisioning costs. If loan losses exceed the Bad and Doubtful Debt Reserve, capital strength is reduced. Reduced income means less cash, which can potentially strain liquidity. Market knowledge that the bank is having asset quality problems and associated financial conditions may cause outflow of deposits. Thus, the performance of a bank is inextricably linked with its asset quality. Managing the loan portfolio to minimise bad loans is, therefore, fundamentally important for a financial institution in todays extremely competitive and market driven business environment. This is all the more important for the UCBs, which are at a disadvantage vis--vis the commercial banks in terms of professionalised management, skill levels, technology adoption and effective risk management systems and procedures. 1.3 Management of NPAs begins with the consciousness of a good portfolio, which warrants a better understanding of risks in lending. The Board has to decide a strategy keeping in view the regulatory norms, the business environment, its market share, the risk profile, the available resources etc. The strategy should be reflected in Board approved policies and procedures to monitor implementation. The essential components of sound NPA management are i) quick identification of NPAs, ii) their containment at a minimum level and iii) ensuring minimum impact of NPAs on the financials. A two-pronged strategy of preventing slippage of standard assets in to NPA category and reducing NPAs through cash recovery, up gradation, compromise, legal means etc., is called for. 2. Preventing NPAs 2.1 At the pre-disbursement stage, appraisal techniques of bank need to be sharpened. All technical, economic, commercial, organizational and financial aspects of the project need to be assessed realistically. Bankers should satisfy themselves that the project is technically feasible with reference to technical know how, scale of production etc. The project should be commercially feasible in that all background linkages by way of availability of raw materials at competitive rates and that all forward linkages by way of assured market are available. It should be ensured assumptions on which the project report is based are realistic. Some projects are born sick because of unrealistic planning, inadequate appraisal and faulty implementation. As the initiative to sanction or reject the project proposal lies with the banker, he can exercise his judgment judiciously. The banker should at the pre-sanction stage not only appraise the project but also the promoter his character and his capacity. It is said that it is more prudent to sanction a 'B' class project with an 'A' class entrepreneur than viceversa. He has to ensure that the borrower complies with all the terms of sanction before disbursement. 2.2 A major cause for NPA is fixation of unrealistic repayment schedule. Repayment schedule may be fixed taking into account gestation or moratorium period, harvesting season, income generation, surplus available etc. If the repayment schedule is defective both with reference to quantum of instalment and period of recovery, assets have a tendency to become NPA. 2.3 At the post-disbursement stage, bankers should ensure that the advance does not become and NPA by proper follow-up and supervision to ensure both assets creation and asset utilisation. Bankers can do either off-site surveillance or on site inspection to detect whether the unit / project is likely to become NPA. Instead of waiting for the mandatory period before classifying an asset as NPA, the banker should look for early warning signals of NPA. 2.4 The following are the sources from which the banker can detect signals, which need quick remedial action: 1. a) Scrutiny of accounts and ledger cards During a scrutiny of these, banker can be on alert if there is persistent regularity in the account, or if there is any default in payment of interest and instalment or when there is a downward trend in credit summations and frequent return of cheques or bills, b) Scrutiny of statements If the scrutiny of the statements submitted by the borrower reveal a sharp decline in production and sales, rising level of inventories, diversion of funds, the banker should realise that all is not well with the unit.

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c) External sources The banker may know the state of the unit through external sources. Recession in the industry, unsatisfactory market reports, unfavourable changes in government policy and complaints from suppliers of raw material, may indicate that the unit is not working as per schedule. d) Computerisation of loan monitoring In computerised branches, it is possible to computerise the loan monitoring system so that accounts, which show signs of sickness or weakness can be monitored more closely than other accounts.

2.5 Personal visit and face-to-face discussion By inspecting the unit the banker is able to see for himself where the problem lies - either production bottlenecks or income leakage or whether it is a case of willful default. During discussion with the borrower, the banker may come to know details relating to breakdown in plant and machinery, labour strike, change in management, death of a key person, reconstitution of the firm, dispute among the partners etc. All these factors have a bearing on the functioning of the unit and on its financial status. 2.6 Special Mention category of accounts Based on warning signals obtained through both off-site and on-site monitoring, banks may classify accounts with irregularities persisting for more than 30 days under Special Mention or Potential NPA category. This will help the bank to initiate proactive remedial measures for early regularisation. The measures include timely release of additional funds to borrowers with temporary liquidity problems and restructuring of accounts of sincere and honest borrowers after considering cases on merit. 2.7 On going classification Although classification of assets is a yearly exercise, banks would do well to have a system of on going classification of assets and quarterly provisioning. This helps in assessing provisioning requirements well in advance. All doubts regarding classification should be settled internally and a system of fixing accountability for failure to comply with the regulatory guidelines should be introduced. 2.8 Strategy for reducing provision The extent of provision for doubtful asset is with reference to secured and unsecured portion. Cent percent provision needs to be made for the unsecured portion. If banks can ensure that the loan outstanding is fully secured by realisable security, the quantum of provision to be made would be less. It takes one year for a sub standard asset to slip into doubtful category. Therefore, as soon as an account is classified as substandard, the banker must keep strict vigil over the security during the next one year because in the event of the account being classified as doubtful, the lack of security would be too costly for the bank. 3. Reducing NPAs 3.1 Cash recovery Banks, instead of organising a recovery drive based on overdues, must short list those accounts, the recovery of which would provide impetus to the system in reducing the pressure on profitability by reduced provisioning burden. Vigorous efforts need to be made for recovery of critical amount (overdue interest and instalment) that can save an account from NPA classification: 1. 2. 3. a) In case of a term loan, the banker gets 90 days after the date of default to take appropriate action and to persuade the borrower to pay interest or instalment whichever is due. b) In case of a cash credit account, the banker gets 90 days for ensuring that the irregularity in the account is rectified. c) In case of direct agricultural loans, the account is classified NPA only after two crop seasons (from sowing to harvesting) from the due date in case of short duration loans and one crop season from the due date in case of long duration loans.

3.2 Up gradation of assets Once accounts become NPA, then bankers should take steps to up grade them by recovering the entire overdues. Close follow-up will generally ensure success. 3.3 Compromise settlements Wherever feasible, in case of chronic NPAs, banks can consider entering into compromise settlements with the borrowers. 3.4 Recovery through legal recourse Since provision amount progressively increases with increase in time, it is necessary to take steps to recover dues either through persuasion or by legal recourse. A strategy of fixing a dead line for recovery may force the bank to either recover or shed the asset off the balance sheet. Banks may file suits promptly against wilful defaulters. Banks can take recourse under either a civil suit or the Special Recovery Acts passed by various states or the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002. The bank should vigorously follow up the legal cases.

6. Conclusion 6.1 Management of NPA is need of the hour. To be effective, NPA management has to be an exercise pervading the entire bank from the Board down the last level. Time is of prime essence in NPA management. The course open to the banker is to ensure that an asset does not become NPA. If it does, he should take steps for early recovery failing which the profitability of the bank will be eroded. That can trigger other problems to undermine the banks financial condition. Revised by Shri R. R. Borbora, Member of Faculty, CAB