Understanding What Is NPA In Banking Sectors: One of the easiest ways to learn how a business works are to look at the simple enterprises around your community. Your local mechanic, grocery store, or laundromat. Their business operation is simple. They provide you and all the residents of your community with a product or service and charge a fee.
In the case of a grocery store, they sell tangible products to the customers, which they buy at a wholesale price and sell at their retail price. A service provider like a mechanic sells his services to you, i.e., his expertise in repairs and maintenance, which is an intangible asset.
Now turn your attention to banks. A general understanding of how they earn money is by taking deposits at a lower cost of borrowing and lending it to customers and clients at a higher interest rate. Sounds simple and easy. But it isn’t as simple or easy as it’s taught in college textbooks.
In fact, banks have a substantial risk when it comes to lending money, a concept we will cover in this article called Non-Performing Assets (NPAs) In the banking Sector.
By the end of this article, you will learn:
- What Are NPAs?
- What Is NPA In Banking?
- How NPAs Work
- Types Of NPAs
- Important NPA Ratios
- Provision For NPAs
What Is NPA In Banking?
The main service that banks provide is lending and borrowing. The interest they earn from the funds they lend is their main source of revenue, also known as interest income. These loans issued to their customers and clients are their assets. The loans that have stopped generating interest income for the banks are called NPAs (Non-Performing Assets).
According to the Reserve Bank Of India, an NPA is an asset that has been overdue for more than 90 days or three months. Overdue means it has stopped receiving any income for the loans it issued. Based on how long NPAs have been defaulting on payments, there are different types of NPAs. We’ll get to that section after understanding how NPAs function.
Also Read: Privatisation Of Banks Pros And Cons – Stay Public Or Go Private?
How Non-Performing Assets (NPAs) Work
Imagine you’re the branch manager at your national bank, IBS. You’ve lent a sizable amount of money to a business enterprise, at an interest of 15 percent. For a few months, the business hasn’t been paying its dues, and it has officially entered into the NPA section in the bank’s records.
The few months in which it hasn’t received payments will lead the bank to consider the loan overdue. It’s only after the stipulated 90-day period that it will classify the loan as an NPA.
Banks give the business and every customer or client a grace period (90 days, as per RBI), before which they send notices of foreclosure and their customers before eventually auctioning the asset provided as collateral. The banks have to do this to collect the outstanding debt on the loan they issued, or else it will be an immense loss, and the asset would otherwise be irrecoverable.
Types Of NPAs
The different types of NPAs are differentiated solely based on how long they stay NPAs.
1. Standard Assets: Standard Assets are all the NPAs that have been due for more than 90 days, but less than 12 months, with a normal level of risk.
2. Sub-Standard Assets: The next type is the NPAs overdue for over 12 months or 1 year. Sub-standard Assets have a higher level of risk because the credit rating of the borrower who is one year overdue is usually sub-standard. The banks reduce the market value of these assets, as the chances of default are higher.
3. Doubtful Assets: The NPAs that have been overdue for 18 months or more are classified under the doubtful assets category. The assets in this category are at serious risk of default, and the banks highly doubt any chance of repayment.
4. Loss Assets: Among all the types of NPAs, this is the worst category for banks. After an extended period, the banks are forced to accept that the borrower will never repay the loan. This means they will have to realize the losses in their books and write off the entire loan amount. Such assets are categorized as “uncollectible”.
Important Non-Performing Assets (NPA) Ratios
Since NPAs in banking sectors play such an important role in banking, analysts use certain ratios to quickly understand the NPA situation of banks. The two main ratios used are:
- Gross NPA ratio, which shows the total GNPA of the total advances and,
- Net NPA is a ratio used to determine the ratio of total advances.
Provision For NPAs
Now, we’ve established that NPAs are bad for banks, and can leave a sizable impact on the bank’s balance sheets. At the same time, borrowers defaulting on their loans is expected, as every borrower will not be in the same financial position. To better prepare themselves for loss-making assets, the banks have to keep certain provisions in place for NPAs.
Imagine a situation where banks cannot pay depositors their interest or their principal, because of borrowers who have defaulted on their loans. The entire financial system would collapse every time a big client defaults on their loan. To better prepare and avoid such circumstances, banks should keep aside a portion of their revenues every year towards NPAs.
NPAs are an important part of banking. It’s necessary to know what is NPA in banking sector & how NPAs have an effect on the bank’s balance sheets and the most important risk that the banking industry faces. While it is unrealistic to expect banks to have no NPAs, banks must keep track of their NPAs, to analyze the direction of the banks’ assets.
Short-term liabilities are common with banks, but bad debts carried over time can have a direct impact on its growth and profitability. In the worst-case scenario, the banks will have to write off the NPA as a bad debt and realize it as a loss.
1. What is the reason for NPA?
NPA happens when people don’t repay loans, the things they pledged as collateral are not enough to cover the loan amount, or banks don’t properly track and recover the loans. Economic problems can also cause NPA.
2. How is NPA calculated?
NPA is calculated by dividing the total outstanding loan amount that has not been repaid by the borrower by the total loan amount disbursed and multiplying it by 100 to get a percentage value.
The formula is NPA Ratio = (Total NPA / Total Advances) x 100.
3. What happens when personal loan becomes NPA?
When a personal loan becomes an NPA, the borrower fails to repay the loan as per the agreed terms. The bank initiates recovery actions, such as contacting the borrower, imposing penalties, and in severe cases, taking legal measures to recover the outstanding amount.
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