So, Deepak Shenoy (@deepakshenoy) was in Bangalore and I took this opportunity to meet some fantastic investors like Sunil Arora (@moneybloke), Prashanth (@Prashanth_Krish) along with a host of others in a tweetup at Koramangala. During the tweetup, discussion did turn to the ailing Kingfisher and how Banks would be impacted by it. There was a bit of confusion around how loans are classified under NPA, and I kept saying ‘There is a matrix to decide that, there is a matrix that’ (we had drawn up a matrix in a room to decide NPAs in my Banking days of the yore), but couldn’t offer anything more concrete. This blogpost is to rectify that vague statement and offer a little more insight into the NPA classification as decided by RBI.

Loans are treated as Assets by Banks. These loans can be classified into two types depending on whether the customer has paid up or not.

1) If the customer pays his EMIs regulary, it is called Standard Asset.

2) If the customer does not pay 3 consecutive EMIs, the Banks have to classify it as NPA (Non-Perfoming asset).

Let’s say a Bank issues a car loan to Mr. A. As along as Mr. A pays his EMI (Principal + Instalment) regularly, without missing a payment, the Bank considers Mr. A’s loan as a Standard Asset and will not provision for the loan.

What is a provision and why provision at all? A bank sets aside certain amount (depending on certain criteria and percentages which are set by RBI) to account for future losses on loan defaults. Banks (as strict as their criteria for issuing loans could be) assume that a certain percentage of loans will not pay up at all/not pay regularly. Banks hence provision for these losses earlier rather than when the loss occurs so that the losses if and when they occur still guarantees a bank’s solvency and capitalization.

In the case above, since Mr. A is paying up his loans regularly, the Bank will not provision any amount against the loan granted to Mr. A. Now, assume the same Bank issues a car loan to Mr. B and Mr. B due to various circumstances (lost his job/can’t pay up/will not pay up) does not pay 3 consecutive EMIs. That is, the days past due (Bankers keep harping on ‘DPD’) becomes more than 90 days. In this case, the Bank is a little skeptical on Mr. B paying up the loan. The Bank recognizes this risk (rather, RBI forces the Bank) and provisions for the loan. NPA itelf is sub-classified into 3 categories – Sub-standard, Doubtful and Loss. You can be a NPA for different kinds of loans. For example,

a) If it is a term loan, if the interest and/or principal remains overdue for a period of more than 90 days.

b) In respect of bills purchased/discounted, the bill remains unpaid for a period of more than 90 days.

c) For agricultural loans –

i) If it is a short duration crop, it will be treated as NPA if the EMIs are not being paid for 2 crop seasons

ii) For long duration crops, the loan will be treated as NPA if the EMIs are not being paid for 1 crop season.

d) In case an infrastructure project term loan, if the project does not start commercial operations (and hence can’t pay up EMIs) in 2 years time, then the loan has to be considered as NPA.

I will draw up a matrix now 🙂

e) For power sector, the provisioning norms are slightly different (I think 10% for sub-standard, 20%,30%,50% thereafter)

and so on and so forth. Nowadays, different sectors seem to have different provisionings and its getting difficult to keep track of them.

The table is self-explanatory. Banks in India have to adhere to the matrix depending on the state of loans they have issued in the past.

Customers usually do various gimmicks to avoid the NPA bucket (well, if you get close to NPA bucket, you can be rest assured that you will be barraged with calls/collection agent will sit in front of your home). They pay every alternative month, thus never getting into the NPA bucket (late fees, penalty fees etc. is a secondary issue). Sometimes, they just pay the interest and not the principal, thereby avoiding the NPA bucket. Greening (give another loan to cover the previous loan) happens very often too, to avoid the NPA bucket.

As you realise, the lower down the rung we go, the greater is the provision that is required and more provisioning hurts profits. That’s the reason why the lower down the rung our loans go, more are the number of calls we get from collection agents.

So, what happens after the loan gets classifed as NPA. Well, there are two options –

i) After the Bank follows up, the customer pays all the EMIs (for which he was due) and starts paying his EMIs more regularly. If the customer pays up for 3 months consecutively, he moves back to Standard Asset.

ii) Banks proceed to recovery money from the customer. The SARFAESI act allows Banks to recover their NPAs without the intervention of the court. They can recover this money either through selling it to Asset reconstruction companies (ARCs) for a discount (and hence book a little loss in their P&L) or enforce the Security/collateral provided by the customer at the time of issue of the loan (the treatment of money recovered this way would depend on whether it was higher or lower than the book value).

Also, in case any money is recovered in the case of loans classified as ‘Loss’ in previous years, this money will be booked as revenue in the P&L of banks.

Now, how is the debt of Kingfisher Airlines treated by Banks? Well, RBI already had a rule for restructured loans (we are being told that KFA’s loans are being restructured, aren’t we?). Restructured loans also get to be classified in Standard and NPA depending on how the loan was restructured. So, the rule is –

For restructured/rescheduled assets, provisions are made in accordance with the guidelines issued by RBI, which require that the difference between the fair value of the loan before and after restructuring is provided for, in addition to provision for NPAs. The provision for diminution in fair value and interest sacrifice, arising out of the above, is reduced from advances.

Now, what would be the fair value, interest sacrifice etc. in case of KFA? Your guess is as good as mine (essentially because the term ‘fair value’ has different connotations for different people). However, in cases of restructured accounts classified as standard advances, the loan provisioning would be 2% compared to 1% in the first two years from the date of restructuring. There is a working paper at RBI underway to have a re-look at the restructuring rules. The tentative date for release of this discussion paper is March 2012.

Just in case you are wondering if similar rules apply to NBFCs, they do. Till recently, NBFC has to recognise a loan as NPA only if it crossed a DPD of 180 days. However, a RBI ruling in Sep 2011 changed all that, and now even NBFCs have to adhere to NPA classification of 90+ DPD. Just because of the change in ruling, Gross NPAs will increase by quite a bit, and the effect is increase in provisioning (and hence lower profits) and hence you see some of the NBFCs getting battered since Sep 2011.

P.S: Some general provisions are also made for Standard Assets in case of loan exposure in countries other than the home country.

P.P.S: There is an additional concept of Provisional Coverage Ratio (PCR). RBI has dictated that PCR should be 70% and most banks adhere to it. It’s basically an additional buffer to protect Bank’s solvency

P.P.P.S: There are about 7 deductions that can be made to arrive at the Net NPA figure that Banks bandy about from the Gross NPA figure. Instead of listing the 7 deductions, I will direct you to a RBI document (slightly dated).