MONEY AND

BANKING

NON PERFORMING
ASSETS and their modeling

Submitted By: Submitted To:

Sahil Chadha Animesh Sir
Roll no. 2307
[B.Comm. (Hons.) Sec II, Semester III]
ABSTRACT

Banking sector is the backbone of any economy and plays a pivotal role in the development of the nation.
With the ever increasing need of involvement of banks in the economic growth process, the issue of non-
Performing Assets (NPAs) has assumed mammoth proportions. Subsequently, as government in emerging
countries pushes for financial inclusion, the risk associated with bank assets increases. With this
background, this paper analyses problem of non-Performing Assets (NPAs) in Indian banking system.
The authors have devised a unique way to forecast the NPAs in Indian banking system in 2020. The focus
was to devise a model which would play a pivotal role in forecasting future NPAs in the Indian banking
sector. This was achieved by looking into various methodologies and zeroing in on a model, which could
be implemented to help understand how NPAs could be predicted.

1 INTRODUCTION

In the starting when the financial reforms were undertaken by the Government of India based on the
Narasimham Committee report I and II, Reserve Bank of India introduced some prudential norms to
address the credit monitoring policy, which were being pursued by the banks and other NBFCs. To
strengthen the recovery of loans and dues by the banks and the other financial institutions, Government of
India in the year 1993, promulgated the recovery of debts due to banks and other financial institutions
act and the securitization and reconstruction of financial assets and enforcement of security interest act
in the year 2002.

But statistics shows NPA level is ever increasing day by day, and the said act, which was introduced by
the Government of India, is not serving the purpose, they were actually formed. The reason behind it can
be the banks approach and attitude towards financing and recovery of loans especially from the small and
medium enterprises and also the lack of knowledge about the law and its practice in banking and also
violations of the RBI directives/circulars, which are essential to follow by every bank and financial
institutions. (Non-Performing Assets, n. d.)

In the financial year 2013, the non-performing assets had gone up to Rs. 95825 crores, according to the
CRISIL report, the gross NPA will increase from 3.3% on 03.2013, to 4% by 03.2014. An important
question is to be answered by the banks and other financial institutions about the recovery of the dues,
and banks approach towards focusing on the efficiency and fairness and also become understanding
when dealing genuine difficulties in managing the fraud. A strong banking and financial sector is
important for a developing economy and the failure of which may have adverse effect on all the sectors.
(RBI website, n. d.)

1.1 Non-Performing Asset: Today non-performing assets are the subject of major concerns to the
banking sector and the other non-banking financial institutions. A loan or lease that does not meet the
stated principal amount and the interest amount payments is termed as non-performing assets. NPA
can be classified into commercial loans which are overdue for more than 90 days, and consumer loans
which are due for more than 180 days, and rise in NPA is due to the overdue of the commercial loans,
there are a lot of pending cases which are being handled by the Indian banks and other financial
institutions. (RBI Website, n.d)
Source: http://www.iibf.org.in/documents/IRAC.pdf

1.2 Definitions of NPA by RBI:

a) An asset, including a leased asset, becomes non-performing when it ceases to generate income for
the bank.
b) A non-performing asset (NPA) is a loan or an advance where;
i. Interest and/ or installment of principal remain overdue for a period of more than 90 days in
respect of a term loan,
ii. The account remains out of order as indicated at paragraph 2.2 below, in respect of an
Overdraft /Cash Credit (OD/CC),
iii. The bill remains overdue for a period of more than 90 days in the case of bills purchased and
discounted,
iv. The installment of principal or interest thereon remains overdue for two crop seasons for short
duration crops, the installment of principal or interest thereon remains overdue for one crop
season for long duration crops,
v. The installment of principal or interest thereon remains overdue for one crop season for long
duration crops,
vi. The amount of liquidity facility remains outstanding for more than 90 days, in respect of a
securitization transaction undertaken in terms of guidelines on securitization dated February 1,
2006.
vii. In respect of derivative transactions, the overdue receivables representing positive mark-to-
market value of a derivative contract, if these remain unpaid for a period of 90 days from the
specified due date for payment.
c) Banks should, classify an account as NPA only if the interest due and charged during any quarter is
not serviced fully within 90 days from the end of the quarter.
d) Out of Order statuses: An account should be treated as 'out of order' if the outstanding balance
remains continuously in excess of the sanctioned limit/drawing power. In cases where the outstanding
balance in the principal operating account is less than the sanctioned limit/drawing power, but there
are no credits continuously for 90 days as on the date of Balance Sheet or credits are not enough to
cover the interest debited during the same period, these accounts should be treated as 'out of order'.
e) Overdue: Any amount due to the bank under any credit facility is overdue if it is not paid on
the due date fixed by the bank. (rbi.org.in)

1.3 Classification of Assets: Non-performing assets are further classified into three categories based on
the span for which the asset has remained non-performing and the recovery of the dues:
 i. Substandard Assets
With effect from March 31, 2005, a substandard asset would be the one, which has remained
as a nonperforming asset for a period of less than or equal to 12 months. Substandard assets
have credit weaknesses that jeopardize the liquidation of the debt and there are also
possibility of incurring and sustaining some losses if the deficiencies are not corrected.
ii. Doubtful Assets
With effect from March 31, 2005, an asset is classified as doubtful if it has remained as a
sub-standard asset for a period of 12 months. A loan classified under the doubtful category
has all the weakness characteristics as defined for the sub-standard assets; also it has added
characteristics that the weakness makes full liquidation or collection, on the basis of the
currently known conditions, facts, and values that are highly doubtful and questionable.
iii. Loss Assets
A loss asset is one where loss has been identified by the banks internal auditors and RBIs
external auditors, but the amount has not been written off fully. These kinds of assets are also
considered as uncollectible, and of little value that its continuance or maintenance as a
bankable asset is not warranted or acceptable though there may be some salvage or recovery
value. (RBI Website, n.d.)

Source: http://www.iibf.org.in/documents/IRAC.pdf

2 CAUSES FOR NON PERFORMING ASSETS

A strong banking sector is important for a flourishing economy. The failure of the banking sector may
have an adverse impact on other sectors. The Indian banking system, which was operating in a closed
economy, now faces the challenges of an open economy.

On one hand a protected environment ensured that banks never needed to develop sophisticated
treasury operations and Asset Liability Management skills.
 On the other hand a combination of directed lending and social banking relegated profitability and
competitiveness to the background. The net result was unsustainable NPAs and consequently a higher
effective cost of banking services.

One of the main causes of NPAs into banking sector is the directed loans system under which
commercial banks are required a prescribed percentage of their credit (40%) to priority sectors. As of
today nearly 7 percent of Gross NPAs are locked up in 'hard-core' doubtful and loss assets,
accumulated over the years.

The problem India Faces is not lack of strict prudential norms but

i. The legal impediments and time consuming nature of asset disposal proposal.
ii. Postponement of problem in order to show higher earnings.
iii. Manipulation of debtors using political influence.

2.1 Macro Perspective Behind NPAs

A lot of practical problems have been found in Indian banks, especially in public sector banks. For
Example, the government of India had given a massive wavier of Rs. 15,000 Crs. under the Prime
Minister ship of Mr. V.P. Singh, for rural debt during 1989-90. This was not a unique incident in
India and left a negative impression on the payer of the loan.

Poverty elevation programs like IRDP, RREP, SUME, SEPUP, JRY, PMRY etc., failed on various
grounds in meeting their objectives. The huge amounts of loan granted under these schemes were
totally unrecoverable by banks due to political manipulation, misuse of funds and non-reliability of
target audience of these sections. Loans given by banks are their assets and as the repayment of
several of the loans was poor, the quality of these assets was steadily deteriorating. Credit allocation
became 'Lon Melas', loan proposal evaluations were slack and as a result repayment was very poor.

There are several reasons for an account becoming NPA.

* Internal factors
* External factors

2.1.1 Internal factors:

1. Funds borrowed for a particular purpose but not use for the said purpose.
2. Project not completed in time.
3. Poor recovery of receivables.
4. Excess capacities created on non-economic costs.
5. In-ability of the corporate to raise capital through the issue of equity or other debt instrument
from capital markets.
6. Business failures.
7. Diversion of funds for expansion\modernization\setting up new projects\ helping or promoting
sister concerns.
8. Willful defaults, siphoning of funds, fraud, disputes, management disputes, mis-appropriation
etc.,
9. Deficiencies on the part of the banks viz. in credit appraisal, monitoring and follow-ups, delay
in settlement of payments\ subsidiaries by government bodies etc.,
2.1.2 External factors:

1. Sluggish legal system -

o Long legal tangles

o Changes that had taken place in labor laws
o Lack of sincere effort.

2. Scarcity of raw material, power and other resources.

3. Industrial recession.
4. Shortage of raw material, raw material\input price escalation, power shortage, industrial
recession, excess capacity, natural calamities like floods, accidents.
5. Failures, nonpayment/ over dues in other countries, recession in other countries, externalization
problems, adverse exchange rates etc.
6. Government policies like excise duty changes, Import duty changes etc.

Source: http://www.indianmba.com/Faculty_Column/FC56/fc56.html

2.2 Moral Hazard and NPAs

2.2.1 What is 'Moral Hazard'

Moral hazard is the risk that a party to a transaction has not entered into the contract in good faith, has
provided misleading information about its assets, liabilities or credit capacity, or has an incentive to
take unusual risks in a desperate attempt to earn a profit before the contract settles. Moral hazards can
be present any time two parties come into agreement with one another. Each party in a contract may
have the opportunity to gain from acting contrary to the principles laid out by the agreement.

2.2.2 BREAKING DOWN 'Moral Hazard'

A moral hazard occurs when one party in a transaction has the opportunity to assume additional risks
that negatively affect the other party. The decision is based not on what is considered right, but what
provides the highest level of benefit, hence the reference to morality. This can apply to activities
within the financial industry, such as with the contract between a borrower or lender, as well as the
insurance industry.

2.2.3 Moral Hazard and the Banking Industry

When a borrower obtains loan on collateral, the contract is based on the idea that the borrower will
avoid situations that may cause inability to repay loan i.e. he will try to protect the value of collateral.
The moral hazard exists that the borrower, because of the availability of the loans, may be less
inclined to protect the interest of lender, since the payment from a banking company lessens the
burden on the borrower to protect such asset in the case of a disaster.

Source: http://www.investopedia.com/terms/m/moralhazard.asp#ixzz4x6R8UGGp

3 VARIABLES USED IN FORECASTING TECHNIQUE

 To use MLR we had to determine the factors on which NPAs in India depend on. Qualitative factors
cannot be modeled in the forecasting equations and hence they were neglected for the purpose of this
study.
After much deliberation and thought process we came up with the following 4 quantitative variables
which were used to predict NPAs in 2020 of banking sector.
1) Repo rate
Repo rate is the rate at which the central bank of a country (RBI in case of India) lends money to
commercial banks in the event of any shortfall of funds. Repo Rate is generally related to the
Bank Prime lending rate as well as reverse repo and MLR. It is an indicator of the prevailing
interest rate in the country. Interest rate and inflation has a cumulative effect on the economy and
ability of the borrower to pay back. Hence, repo rate is a crucial factor impacting NPAs.
2) Gross domestic product
A countrys GDP is the total market value of all final goods and services produced in a country in
a given year which is equal to the total consumer, investment and government spending. GDP is a
growth indicator of an economy. As GDP grows, loans and advances also grow and hence it
directly impacts NPAs. Moreover, when the economy is in shambles, corporate will not be able to
pay the debts which will thereby lead to an increase in NPAs.
3) Loans and advances
Loans and advances are considered the most important factor while forecasting NPAs. As the size
of loans and advances increases, the proportion of NPAs increase due to increase in risk in that
case.
4) Inflation rate
The index is a measure of the average price which consumers spend on a market-based basket
of goods and services. Inflation based upon the consumer price index (CPI) is the main inflation
indicator in most of the countries. Inflation rate in India is based upon the Indian Consumer Price
Index. As inflation rises it becomes cheap for borrowers to borrow money, because of inflation
purchasing power of consumers fall resulting in a drop in profits for the companies. Combination
of both these factors results in rise in NPAs [9].

4 DATA COLLECTED

Source: Gross Advances and Gross NPAs data: Annual Publication, RBI (04- 15); GDP & CPI
data: tradingeconomics.com.

5 RESULTS

5.1 MLR Analysis (Linear, Stepwise and Logarithmic) and Results for Overall Banking Sector
 In Multiple Linear Regression we have used a combination of independent variables (CPI, GDP,
Repo Rate, Loans and Advances) for finding out their relationship with the NPAs. It can be used to
predict the NPA of a given bank on the basis of the independent variables [10] [11]. The MLR model
is:

Where,
Yi = Gross NPA for the quarter i (dependent/response variable),
Xki = independent/explanatory variable taken for regression such as GDP,
0 = Y intercept,
k = slope of Y with respect to Xki, holding other variables constant,
i = random error in Y for observation i.
MLR models were developed using combination of all variables.
5.2 MLR Equation:

There can be a case of multicollinearity in this kind of situation. For example, we can fairly guess
here that with GDP growth, loans and advances will grow. Hence rather than directly doing MLR
analysis we do a stepwise regression which gives us the model with only the significant independent
variable and also it keeps in check any issue which arises due to multicollinearity. As expected with
stepwise regression we got only three significant variables CPI%, GDP and Loans & Advances.
MLR Equation:

For MLR we will choose the equation given by stepwise regression for the reasons mentioned above.
While performing Stepwise MLR all other assumptions (homoscedasticity etc.) were also checked.
We also explored the possibility of a nonlinear relationship between NPA and the variables identified
from stepwise regression. A logarithmic regression model was run between Ln (NPA) as dependent
variable and Ln (CPI), Ln (GDP) & Ln (Loan & Advances) to check if there exists a polynomial
relationship between NPA and the mentioned independent variables. The table below shows results
from the logarithmic regression model.
MLR Equation:

It can be clearly seen from above results that MAPE of logarithmic regression is very high and hence
it cannot be used. We would use stepwise regression equation as our final model [11].
The final forecasting model to be used will be linear stepwise regression model as discussed above.
The forecasting equation is:

We will calculate NPA in 2020 based on the above equation.

In 2020 assumptions regarding the independent variables are:
CPI (X1) in 2020 = 6% (assuming stable inflation),
Loans and Advances in 2020 = INR 158,127 billion (Taking loans and advances growth rate of 20%
year on year as we expand the banking services),
GDP in 2020 = 4189 billion USD (Taking growth rate of 7% year on year).
With this the Forecasted NPA = INR 7808 billion which is 4.94% of the Average Loans and
Advances of all scheduled commercial banks.

6 REMEDIES
The model proposed by us predicts 7.07% of the Average Loans and Advances of SBI will fall under
the NPA bracket. The sheer value of the figure, INR 147,921 crore, is enough to point towards a
 major situation in the making. It is imperative to implement remedial measures so as to deflect the
major repercussions of the same. Some of them have been discussed in detail below:
1) Strengthening the pre-sanction and after disbursement monitoring process by using
technology
Banks need to monitor their internal and external processes and constantly look for avenues to
fortify the same. This is where technology can stake is claim. Data analytics is the new buzzword
and has the potential to provide keen insights in the NPA problem. Our PSUs can avail the
services of data analytics to create state of the art processes for cash flow generation capacity of a
particular company, past records of the borrowers, track a particular sectors growth projections,
track the loan payment schedule etc. Creation of a Central Data repository for all corporate
borrowers of all banks would go a long way in establishing coordination and provide a way to
track defaulters, thus restricting their entry into the system. Detailed analysis of the fixed assets
claimed by the borrowers needs to be done. Proper processes should be in place to check the fixed
assets as claimed by the borrowers. Innovative techniques like surprise visits to the factories will
keep the borrowers on their toes. Mid-term audits will also ensure a status check of the borrowers,
thus allowing banks to take preventive measures [13].
2) Sector wise planning
Certain sectors need to be monitored more closely than other. RBI financial stability report states
that sectors like infra, aviation, iron and steel, mining; textiles make up 24.8% of total advances
of commercial banks whereas they hold a staggering 51.1% in total stressed advances. The
concerned sectors should be dealt with extreme caution and extensive due diligence should be
carried out before sanctioning anything. Moving forward, banks can think on the lines of creating
a credit appraisal team which would cater to specific industries and monitor new applications and
their status quo, subsequently raising a red flag if any anomalies are found [14] [15] .
3) Standardization of 3rd party Vendors
3rd party agencies like financial analysts, engineers, verification agencies play a pivotal role in
concurring the veracity of the claims of borrowers. It is easy to obtain the required documents,
provided the 3rd parties are also on the same page. It is important for the government to intervene
and create a mechanism which would be conducive to both the borrower and the lender.
Monitoring of 3rd party vendors, standardization via government authorization can pave the way
for reducing forgery and initiating a step towards creating a transparent system [13].

7 CONCLUSION
The linear stepwise regression model was used to forecast NPAs for Indian Banking Sector and it was
also used to predict the same for SBI, as a special case. The model predicted that if the current path
was treaded, the issue of NPAs would snowball into a major problem with serious repercussions. As
far as the Indian Banking Sector is concerned, it was seen that bad loans would amount to INR 7808
billion which is 4.94% of the Average Loans and Advances of all scheduled commercial banks. The
results point that the need of the hour is NPA control so as to avoid the serious consequences that the
future holds for us. We also covered various causes for NPAs and their possible solution which could
prevent a loan from converting it into an NPA.

SOURCE: http://file.scirp.org/Html/21-1500949_70231.htm

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