NPA is crucial for banks. NPAs are not just non-performing assets they are beyond that as it impacts the future prospects of banks.
What are NPA
A non performing asset (NPA) is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days. There are three categories of NPA
1. Substandard assets: Assets which has remained NPA for a period less than or equal to 12 months.
2. Doubtful assets: An asset would be called as doubtful if it has remained in the sub-standard category for a period of 12 months. These are the assets whose probability of recovery is very less.
3. Loss assets: As per RBI, “Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted, although there may be some salvage or recovery value.” This is the asset which has gone and there is no chance of recovery.
- After 90 days from the due date i.e. March 31, 2014, the loan amount will be considered as a sub-standard asset (NPA) for next twelve months i.e. till March 30, 2015.
- • If the bank does not receive the amount for next 12 months then it will consider it as a doubtful asset for next 12 months i.e. from March 31, 2015, to March 30, 2016.
- • If auditors identify it as a loss, then it will be considered as loss asset. A loan can be categorized as a doubtful asset for 3 years, starting from being as NPA.
Economic definitions apart. Let us try to understand NPAs practically with some example.
Let’s start a small bank and call it State Bank of Abhishek. Some people have deposited their money in this bank, say they have deposited 1500 ₹ I have to pay some interest on this deposit to the depositors. Let’s assume that interest rate is 4% per annum, which translate to 60 ₹ per year.
This 1500 Rs which people have deposited in my bank is liability on my bank, which I have to return at some point of time with interest.
There are also some expenses in managing the bank, the salary of employees, office bills etc. Lets assume it is 1% of the liability. Which comes out to be 15 ₹
My bank can earn money by lending this money of depositors to the borrowers. I will be charging some interest on it, lets assume that interest rate is 10%. The difference of the interest my bank is going to pay and receive will determine the profitability.
The profit of my bank will be this interest income. I have to deduct the interest which I have to pay to the depositors and the expenses of managing the bank. What left will be the profit. Which is going to be 10% – (4%+1%) = 5%
The rules of the government doesn’t allows to lend all the money of the depositors to the borrowers. I have to keep some part with the RBI and some part in reserve for withdrawals of customers. In the language of banking its called as statutory deposit and cash reserve. The SLR CRR thing.
Lets assume my bank can lend 1000 ₹ loan at the interest rate of 10% this should fetch 100 ₹ of profit. 15 ₹( 1% of 1500) are expenses of managing the bank. 60 ₹ (4% of 1500) has to be paid to depositors
So my bank can make a profit of 100-(60+15) = 25 ₹ in the ideal situation.
Before we get into the details of worst situations. Let’s summarize the things in the financial terms
Liabilities : 1500 ₹
Assets: 1000 ₹
Expenses: 15 ₹
Interest payable: 60 ₹
Interest receivable: 100 ₹
Assuming my banks gives the loan of 100 ₹ to 10 people at the interest rate of 10% per annum. All borrowers will pay 10 ₹ interest at the end of the year.
If one of the borrower defaults from paying back the interest and principle. It will result in 10% NPA as that one borrower was holding the 10% asset. 10 ₹ of possible interest income gone and also the 10% of asset gone.
If other pays the regular interest, the banks earn 90 ₹
The profitability of my bank will now be
Interest received – interest paid – bank expenses
90 – 60 – 15 = 15 ₹
So you can see how with 10% NPA the profit of my bank has reduced from 25 ₹ to 15 ₹. The reduction of 40%
Also my banks assets are down by 100 ₹. Making profit of only 15 ₹ and losing 100 ₹ of assets is ultimately the loss for my bank even though my bank did made a profit of 15 ₹. Before I can lend 100 Rs to 10 people now I can lend 100 ₹ to 9 people only. This means my earnings in future will also be impacted.
So, now you can understand even if the bank makes the profit, if its NPA rises it is ultimately a loss only.
Government banks have very high NPAs and theirs stocks are doing poor. Private banks have low NPA and their stocks are doing better. Banks like HDFC, Kotak are managing their NPAs very well and their stocks are doing well even in severe market falls.