Managing Non Performing Advances

Management of Non Performing Advances

Prepared By: P N D Gomes Sri Lanka

Contents Unit No

Page No.

1. Introduction

3

2. Background for the Study

4,5

2.1. The Problem 2.2. Objective of the Study 2.3. Scope 2.4. Hypothesis 2.5. Data 2.6. Sample 3. Technical view on NPAs

6,7

4. Pre Sanction Process

8

5. Macro & Micro Level factors

9 , 10

6. Statistical Information

11

7. Bank Growth Vs NPAs

12

8. NPAs impact on Economy

13

9. Practical Approach to Manage NPAs

14

10. Project Summary

15

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Unit1

Introduction

Banking system is the lifeline of any economy. State of health in the banking sector is very vital since it has a direct impact on the economy. Non performing advances in banks books deteriorate the state of health of the banking sectors.

Unit 2

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Background for the Study

2.1. The Problem Impact of Non Performing Advances for a bank is in several ways. It is not only bank loose interest income on these advances, but it incurs cost to maintain those NPAs in the bank portfolio. Banks have to maintain provisions ,incur legal expenditure other miscellaneous charges on account of NPAs.The impact of NPAs results in lower interest rates for depositors, higher interest rate for borrowers , capital write offs, less return to share holders etc….. NPAs hit the economic conditions of a country in several ways. In proper utilization of borrowed money will not generate any positive results to boost the economic conditions, failure of businesses will create unemployment, high inflationary rate etc…

2.2. Objective of the Study Objective of this study is to identify the importance of managing NPAs and ways of managing in order to have stability in the banking industry.

2.3. Scope In this report on management of Non Performing Advances, activities starting form pre sanction to post sanction, impact on the economy and Bank’s financial position and ways of managing NPAs will be covered

2.4. Hypothesis More effort is required in maintaining advances in performing rather than sanctioning those. In other words more monitoring and supervision is required after sanctioning facilities. 2.5. Data

Page 4 of 15

Secondary Data was taken in compiling this project report. Following are the sources of secondary data, 1. Central Bank releases 2. Banks Financial reports 3. Internet 2.6. Sample Out of all commercial banks a leading private commercial bank with highest number of branch network (among the private sector banks) was taken for the project study.

Unit 3

Page 5 of 15

Technical view on NPAs

Non Performing Advances “An asset becomes Non Performing when it ceases to generate income for the bank” As per the norms of the Central Bank of Sri Lanka, bank maintains five statues for monitoring the performance of asset portfolio which are – Current, Overdue, Substandard, Doubtful and Loss. The above is applicable for all kinds of asset products. (Loans/Overdrafts/Bills) Further Depending on the frequency of the loan recovery number of past due days will differ. Following diagram 1 shows the Non Performing periods of loans with monthly frequency and diagram 2 shows Non performing period for loans other than monthly frequency, overdrafts, bills, etc…. Diagram 1 Asset classification is based on the DPD (days past due) counter for loan products with monthly capital repayment frequency DPD DPD DPD DPD DPD

1 – 60 days 61 – 150 days 151 – 330 days 331 – 510 days > 511days

CURRENT OVERDUE SUBSTANDARD DOUBTFUL LOSS

Diagram 2 Asset classification is based on the DPD (days past due) counter for loan products other than monthly capital repayment frequency and overdrafts DPD DPD DPD DPD DPD

1 – 89 days 90 – 179 days 180 – 359 days 360 – 539 days > 540 days

CURRENT OVERDUE SUBSTANDARD DOUBTFUL LOSS

All the 61/90 days overdue loans fall in the category of non-performing assets and are eligible for provisioning once the loan becomes substandard onwards. Page 6 of 15

Once the loan is outstanding for 61/90 days, it is marked as NPA and interest income is suspended for last 61/90 days and when the loan becomes substandard and thereafter, provisioning for net of the collateral value is being done by the bank. Applicable provisioning % as follows Sub-standard Doubtful Loss -

Provisioning percentage is 20% Provisioning percentage is 50% Provisioning percentage is 100%

Unit 4

Page 7 of 15

Pre Sanction Process

All advances begin with the Credit Appraisal, where banks use different types of appraising tools to ascertain the credit worthiness of the applicant. Appraisal of a credit proposal requires a fluent understanding of credits with wealth of past experience, ability to identifying risks, mitigating the risk and monitoring the risk. Following were identified as ingredients behind quality credit appraisal 1. 2. 3. 4. 5. 6.

Credit staff should be well experienced and trained. Credit staff should be well aware of banks credit policy Risk assessment techniques should be in placed and updated. Accessibility for out side information.(ex:industry,market) Storage of historical data.(ex:Customers past records) Discretionary powers should be given to officers at different levels depending on the credit proposal. 7. Decision making process should be quicker.(Approval or rejection) 8. Adoption of new technology. Even though above factors are in placed for sound lending advances will fall in to Non Performing.

Unit 5

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Macro & Micro Level factors

Macro Level Factors Macro Level factors which leads to NPAs could be broadly categorizes under Political, Economics, Social and Technological Political Political interference in granting some advances deviating from basic credit principles will end up with increasing NPAs. This is a very common factor in state own banks.

Economic Changes in macro economic environment like inflation, high interest rates, depreciation of currency, taxes, Industry barriers, Government policy changes etc….will result in turning some lending of banks to Non Performing. Rise in inflation, high interest rates will create new burden in meeting monthly commitment. Depreciation of currency will impact on imports with upward movement on prices. Other than that impose of taxes, change in fiscal policies to achieving political objectives will also turn performing advances to bad. Social Factors Integrity of borrowers, ethics, values, education levels also influence the NPAs Technological Factors Adoption of latest technology also plays an important role in credit evaluation process. Today in the banking sector sophisticated models are used in assessing and rating borrowers. Non adoption of technology results in high cost of funds, delay in approval process, missing of risk mitigating tools etc…. will influence the Non Performing Advances.

Micro Factors (Within the Bank)

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Biased Lending When advances are granted with influence of officers in the approval process or at management level not following basic credit principles, may result in Non Performing in future. Achievement of Targets Branch managers are set targets for lending and towards the year end if targets are not met loans are sometime granted without through analysis. Achievement of Profits Branch managers grant facilities taking risks to meet profits targets compromising basics of credits. Example: Temporary overdrafts are high risks but managers take the risk and grant due to high interest income Inadequate Credit Information Complete information is required to do a proper credit evaluation (5C’s). It is a common factor that even without available information loans are sanctioned. Some cases staff carrying out the appraisal, when customer is unable to provide basic information gives alternative suggestions in order to process the appraisal. Integrity Lack of integrity in bankers also influenced the Non Performing portfolio. Ex: Making decisions for financial rewards

Unit 6

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Statistical Information Following diagrams show Gross NPA and Net NPA Ratio of Licensed Commercial Banks for the period between 1998 and Up to March 2009

I T A P N S O R G

LICENSED COMMERCAIL BANKS GROSS NPA RATIO 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0

Series1

YEARS

9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0

Series1

19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 0 20 7 08 M ar ** 09 **

NET NPA RATIO

LICENSED COMMERCIAL BANKS NET NPA RATIO

YEARS

***Gross Non-Performing Advances Ratio, % (Net of Interest in Suspense) ***Net Non-Performing Advances Ratio, % (Net of Interest in Suspense and provisions) Unit 7

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Bank Growth Vs NPAs Following were identified as major impacts of NPAs on Banks Growth/Stability 1. Deterioration of Profits When an advance become NPA Interest due for last 3 month and future accruals are required to transfer in to interest in suspense. 2. Increase in Provisions When a loan or overdraft falls in to substandard category it is required to provide capital provisioning. 3. Drop in Reserves When a facility is not recoverable capital will be write off at last. This will have an impact on Profits 4. Impact on Capital Adequacy Banks will have an issue in meeting specified Tear 1 & Tier 11 requirements. 5. Increasing Overhead Costs It is costly to maintain non performing advances, since it doesn’t generate an income. (Ex: follow up costs, staff costs, legal costs) 6. Increasing Market Borrowings When advances are not recoverable there fill be a liquidity issue in meeting payments and granting further credit.Inorder to finance banks tend to borrow from the market at high rate. 7. Drop in Share Value When it is known a bank is having a high Gross NPA ratio and Net NPA ratio share value will be dropped. 8. Negative Image In the long run bank will have a negative image due to NPAs.

Unit 8

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NPAs impact on Economy 1. High Interest rates In order to compensate the loss of interest in NPAs banks have to charged high interest rate from other borrowers.this will have an indirect impact on inflation. 2. Negative Impact on development When funds to lend become scare due to NPAs country’s development will get effected 3. Unemployment Businesses ceased to exist due to inability to meet its repayment obligations. This will create unemployment. 4. Instability in the banking system Due to high NPA position if liquidity crisis arises and bail out is required, this has huge impact on whole banking sector

Unit 9

Practical Approach to Manage NPAs Page 13 of 15

At the later part of the Project study question was asked from selected branch mangers and credit officers of the bank to establish suggestions to Managing NPAs. Following are the summarized suggestions, 1. Improving the Appraisal system Emphasis should be given to appraisal process to ensure proper evaluation done to establish the credit worthiness of the customer. It should be noted at the appraisal level all required information to submit in order for the approving authorities to take a credit decision. 2. Continuous Monitoring supervision and follow up. Monitoring supervision and Follow-up should not be a task to be implemented when an advance turn in to loss category. Early warning signals should be identified and preventive measures should be implemented 3. Availability of historical data Availability of historical data is paramount of important in preparation of a credit proposal. So banks should have historical data base to extract past records as and when required. 4. Market Intelligence system MIS information should be available for various reasons when taking credit decisions. Ex: To rate a customer, to extract performance ratios 5. Speedy legal actions When all possible attempts for recovery is failed only option is to proceed with legal action and this should be speedy otherwise this will be costly. 6. Integrity Staff integrity is also vital factors. No member in the approval cycle should take a decision based on financial rewards. 7. Rewarding staff Introducing a staff rewarding/incentive scheme will also support in reducing NPAs. It should be noted rewarding staff will be less costly rather than spending. Unit 10

Page 14 of 15

Project Summary

It is the duty of the Senior management, Middle management and down the line all staff involved in credit to ensure a quality advance portfolio. When processing appraisals all must adhere to basic credit principles without deviating. Proper training should be given to staff either internally or externally and bank should ensure it has experienced staff to handle credit.Ethics and Values should be observed by all staff handling credits. Timely monitory follow-up and supervision is required and customer should be contacted promptly when any early warning signal is identified. Further message should be clear to borrowers that they can’t default and be free since they are accountable for the money borrowed. Finally NPAs should treated as most critical factor for banks survival. It is not possible to get away from NPAs. But should be Managed Properly.

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