LITERATURE REVIEW

1. Economic an political weekly, October 16, 2004, CARLTON PEREIRA,pg 4602-4604 INVESTING IN NPAs. 2. THE TREASURY MANAGEMENT,DECEMBER 2004,vinay kumar,PG62-

66securitisation:issues and perspectives

At The Global Level, SECURITISATION is becoming more popular among Fis. It is meant to avoid disparity between assets and liabilities of banks/Fis. In order to promote securitisation in India RBI has constituted a working group on assets securitisation. Though securitisation is in a nascent stage, it holds great promise in areas like infrastructure, power and housing.

3. Chartered Secretary, February 2003, V.S. Datey, Pg. 128-135 SARFAESI ACT

THE

The securities and reconstruction of financial assets and enforcement of security interest act, 2002 made effective on 21.6.2002 is a step to reduce NPAs of Banks. The act also makes provision for asset reconstruction and securitisation.

REASONS BEHIND HUGE LEVEL OF NPAs IN THE INDIAN BANKING SYSTEM (IBS)
The origin of the problem of burgeoning NP As lies in the quality of managing credit risk by the banks concerned. Any lending activity involves the following three stages where discretion needs to be exercised: evaluation and assessment of the proposal; continuing support during the loan period by additional loan or by non-fund based activities; and exit decision and modality. Studies have shown that Indian financial institutions have shown extremes of behavior at each of the above stages. In many instances, loans have been sanctioned because of vested interests. Promoter banker nexus or promoter-politician linkage have been exploited to siphon off-funds from the banking system, Post loan disbursal, bankers are supposed to keep track of the key signals that indicate the health of the loan recipient and monitor project progress. Banks concerned should continuously monitor loans to identify accounts that have potential to become non-performing.

RBI GUIDELINES ON INCOME RECOGNITION (interest income on NPAs)

Banks recognize income including interest income on advances on accrual basis. That is, income is accounted for as and when it is earned. The prima-facie condition for accrual of income is that it should not be unreasonable to expect its ultimate collection. However, NPAs involves significant uncertainty with respect to its ultimate collection. Considering this fact, in accordance with the guidelines for income recognition issued by the Reserve Bank of India (RBI), banks should not recognize interest income on such NPAs until it is actually realized.

ACCOUNTING STANDARD 9 (AS 9) ON REVENUE RECOGNITION

The Accounting Standard 9 (AS 9) on 'Revenue Recognition' issued by the Institute Of Chartered Accountants of India (ICAI) requires that the revenue that arises from the use by others of enterprise resources yielding interest should be recognized only when there is no significant uncertainty as to its measurability or collect ability. Also, interest income should be recognized on a time proportion basis after taking into consideration rate applicable and the total amount outstanding.

Usage of financial statements in assessing the risk of default for lenders

For banks and financial institutions, both the balance sheet and income statement have a key role to play by providing valuable information on a borrower's viability. However, the approach of scrutinizing financial statements is a backward looking approach. This is because; the focus of accounting is on past performance and current positions. The key accounting ratios generally used for the purpose of ascertaining the creditworthiness of a business entity are that of debt-equity ratio and interest coverage ratio. Highly rated companies generally have low leverage. This is because; high leverage is followed by high fixed interest charges, non-payment of which results into a default

High cost of funds due to NPAs

Quite often genuine borrowers face the difficulties ill raising funds from banks due to mounting NPAs. Either the bank is reluctant in providing the requisite funds to the genuine. Borrowers or if the funds are provided, they come at a very high cost to compensate the lender's losses caused due to high level of NPAs. Therefore, quite often corporate prefer to raise funds through commercial papers (CPs) where the interest rate on working capital charged by banks is higher. With the enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, banks can issue notices to the defaulters to pay up the dues and the borrowers will have to clear their dues within 60 days. Once the borrower receives a notice from the concerned bank and the financial institution, the secured assets mentioned in the notice cannot be sold or transferred without the consent of the lenders. The main purpose of this notice is to inform the borrower that either the sum due to the bank or financial institution is paid by the borrower or else the former will take action by way of taking over the possession of assets. Besides assets, banks can also takeover the management of the company. Thus the bankers under the aforementioned Act will have the much-needed authority to either sell the assets of the defaulting companies or change their management.

But the protection under the said Act only provides a partial solution. What banks should ensure is that they should move with speed and charged with momentum in disposing off the assets. This is because as uncertainty increases with the passage of time, there is all possibility that the recoverable value of asset also reduces and it cannot fetch good price. If faced with such a situation than the very purpose of getting protection under the Securitisation Act, 2002 would be defeated and the hope of seeing a must ha\re growing banking sector can easily vanish.

RBI GUIDELINES ON CLASSIFICATION OF BANK ADVANCES

Reserve Bank of India (RBI) has issued guidelines on provisioning requirement with respect to bank advances. In terms of these guidelines, bank advances are mainly classified into: Standard Assets: Such an asset is not a non-performing asset. In other words, it carries not more than normal risk attached to the business. Sub-standard Assets: It is classified as non-performing asset for a period not exceeding 18 months. Doubtful Assets: Asset that has remained NP A for a period exceeding 18 months is a doubtful asset. Loss Assets: Here loss is identified by the banks concerned or by internal auditors or by external auditors or by Reserve Bank India (RBI) inspection. In terms of RBI guidelines, as and when an asset becomes a NPA, such advances, would be first classified as a sub-standard one for a period that should not exceed 18 months and subsequently as doubtful assets. It should be noted that the above classification is only for the purpose of computing the amount of provision that should be made with respect to bank advances and certainly not for the purpose of presentation of advances in the banks balance sheet.

The Third Schedule to the Banking Regulation Act, 1949, solely governs presentation of advances in the balance sheet. Banks have started issuing notices under the Securitisation Act, 2002 directing the defaulter to either pay back the dues to the bank or else give the possession of the secured assets mentioned in the notice. However, there is a potential threat to recovery if there is substantial erosion in the value of security given by the borrower or if borrower has committed fraud. Under such a situation it will be prudent to directly classify the advance as a doubtful or loss asset, as appropriate.

RBI GUIDELINES ON PROVISIONING REQUIREMENT OF BANK ADVANCES

As and when an asset is classified as an NPA, the bank has to further sub-classify it into sub-standard, loss and doubtful assets. Based on this classification, bank makes the necessary provision against these assets. Reserve Bank of India (RBI) has issued guidelines on provisioning requirements of bank advances where the recovery is doubtful. Banks are also required to comply with such guidelines in making adequate provision to the satisfaction of its auditors before declaring any dividends on its shares. In case of loss assets, guidelines specifically require that full provision for the amount outstanding should be made by the concerned bank. This is justified on the grounds that such an asset is considered uncollectible and cannot be classified as bankable asset. Also in case of doubtful assets, guidelines requires the bank concerned to provide entirely the unsecured portion and in case of secured portion an additional provision of 20%-50% of the secured portion should be made depending upon the period for which the advance has been considered as doubtful. For instance, for NPAs which are up to 1-year old, provision should be made of 20% of secured portion, in case of 1-3 year old NPAs up to 30% of the secured portion and finally

in case of more than 3 year old NP As up to 50% of secured portion should be made by the concerned bank. In case of a sub-standard asset, a general provision of 10% of total out standings should be made. Reserve Bank Of India (RBI) has merely laid down the minimum provisioning requirement that should be complied with by the concerned bank on a mandatory basis. However, where there is a substantial uncertainty to recovery, higher provisioning should be made by the bank concerned.

CREDIT RISK AND NPAs

Quite often credit risk management (CRM) is confused with managing non-performing assets (NPAs). However there is an appreciable difference between the two. NPAs are a result of past action whose effects are realized in the present i.e. they represent credit risk that has already materialized and default has already taken place.

On the other hand managing credit risk is a much more forward-looking approach and is mainly concerned with managing the quality of credit portfolio before default takes place. In other words, an attempt is made to avoid possible default by properly managing credit risk. Considering the current global recession and unreliable inforn1ation in finaI1cial statements, there is high credit risk in the banking and lending business. To create a defense against such uncertainty, bankers are expected to develop an effective internal credit risk models for the purpose of credit risk management.

IMPORTANCE OF CREDIT RATING

Fundamentally Credit Rating implies evaluating the creditworthiness of a borrower by an independent rating agency. Here objective is to evaluate the probability of default. As such, credit rating does not predict loss but it predicts the likelihood of payment problems. Credit rating has been explained by Moody's a credit rating agency as forming an opinion of the future ability, legal obligation and willingness of a bond -issuer or obligor to make full and timely payments on principal and interest due to the investors. Banks do rely on credit rating agencies to measure credit risk aIld a.'\sign a probability of default. A credit rating agency generally slot companies into risk buckets that indicate company's credit risk and is also reviewed periodically. Associated with each risk bucket is the probability of default that is derived from historical observations of default behavior in each risk bucket. However, credit rating is not foolproof. In fact, Enron was rated investment grad~ till as late as a month prior to it's filing for Chapter 11 bankruptcy when it was assigned an in default status by the rating agencies. It depends on the information available to the credit rating agency. Besides, there may be conflict of interest, which a credit rating agency may not be able to resolve in the interest of investors and lenders.

Stock prices are an important (but not the sole) indicator of the credit risk involved. Stock prices are much more forward looking in assessing the creditworthiness of a business enterprise. Historical data proves that stock prices of companies such as Enron and WorldCom had started showing a falling trend many months prior to it being downgraded by credit rating agencies.

REVIEW OF NPAs (Asset-wise):

The operational guidelines for monitoring and follow-up of non-peri~rn1ing assets in respect of various categories of assets are detailed here below: Sub-standard assets: In respect of industrial units showing signs of sickness, prompt steps shall be taken to conduct viability study/nursing progran1me for deciding the future course of action to be taken. ln respect of advances backed by securities like vehicle, machinery , gold. Crops, steps shall be taken to enforce the securities. In case of hypothetical securities like vehicles, machinery, goods, etc., the same shall be sold through public auction and proceeds shall be adjusted towards reduction of dues. In case of pledged securities like goods/shares and debentures/bonds etc., steps hall be taken to sell the same as per the prescribed procedure. In case of jewel loans, the securities shall be disposed off through public auction following the procedure lad down and he loans shall not be allowed to remain in NPA. category. If the dues are not adequately covered by securities. The possibilities of an out of court settlement shall be examined soon so as to avoid incurring of further expenditure and also considering the delay involved in realization of dues. Any slippage from this category will render the account doubtful, thus increasing the provision requirement. This is the most important and crucial area where regular monitoring is required to improve the status of the account.

Doubtful/loss assets: Under these categories, there would be both suit filed and non-suit filed accounts. In case of non-suit filed accounts, the recovery is to be pursued more vigorously and after adjustment of securities, exhausting all the remedies and persuasive methods, steps shall be taken to resort to legal action expeditiously within the validity period of the documents.

NARSIMHAN COMMITTEE'S RECOMMENDATIONS

Committee on financial system (CFS) Narsimhan committee which reported in 1991, meanwhile major changes have taken place in the domestic, economic and institutional science, indicating the movement towards global integration of financial services. Committee has presented second-generation reforms. 1. To strengthen the foundation of financial system 2. Related to this, streamlining procedures, upgrading technology and human resource development. 3. Structural changes in the system It is recommended that an asset can be classified as doubtful if it is in the sub standard category for 18 months in the first instance and eventually for 12 months as loss if it has been so identified but not written off. These norms, which should be regarded as the minimum, may be brought into force in a phased manner. Corporation and FI should avoid the practice of 'ever greening' by making fresh advances to their troubled constituents only with a view to settling interest dues and avoiding classification of the loans in question as NPAs. The committee notes that the regulatory and supervisory' authorities are paying particular attention and such breaches in tile adherence to he spirit of the NPA definition and are taking appropriate connective action.

There is no denying the fact that any effort at financial restructuring in the form of having off NP As portfolio from the books of the corporation or measures to initiate the impact of high level of NPAs must go hand with operational structuring. Cleaning up the balance sheets of banks thus make sense only if simultaneous steps are taken to prevent of limit the re-emergence of new NPAs. Direct credit has a proportionately higher share in NPAs portfolio of corporations and has been one of the factors in erosion in the quality of asset portfolio. There is a continuing need of Financial Corporations to extend Credit to SS 1 sector, which is important segment of national economy but on commercial considerations and on basis of credit worthiness. Government feels reluctant to accept the recommendation for reducing the scope of directed credit under priority sector because tiny sector of industry and small businesses have problem with regard to obtaining credit and some remaining may be necessary for this sector. Poverty alleviation and employment generation schemes. Given the special needs of these sectors, the current practice may continue. As an incentive to bank is to make specific provision, the consideration be given to making such provisions tax deductible. Banks should pay greater attention to asset liability management to avoid such mismatch and to cover, among others, liquidity and interest rate risks.

There is a need for greater use of computerized system. Computerization has to be recognized as an indispensable tool for improvement in customer service. The institution and operation of better control systems, greater efficiency in information technology. The main issue with regard to operations of banks is to ensure operational flexibility and measure of competition and adequate internal autonomy in matters of loan sanctioning and internal administration. The committee believes that the balance sheets of banks and f7Is should be made more transparent and full disclosure made in balance sheet. "This is to be done in phased manner.

NORMS FOR TREATING VARIOUS ADVANCES AS NPAs

An asset which ceases to generate income for the bank is called a non-performing asset (NPA). The basic factor to determine whether an account is NPA or not is the record of recovery and not the availability of security. RBI has advised following norms for identifying the kind of advances as non -performing.