Non-Performing Asset and Associated Terms

Non-performing asset (NPA)

A loan is categorized as NPA if it is due for a period of more than 90 days. Depending upon the due period, the NPAs are categorized as under:

Sub-Standard Assets: > 90 days and less than 1 year
Doubtful Assets: greater than 1 year
Lost Assets: loss has been identified by the bank or RBI, but the amount has not been written off wholly.
Stressed assets = NPAs + restructured loans + written off assets
Restructured loans: those assets which got an extended repayment period, reduced interest rate, converting a part of the loan into equity, providing additional financing, or some combination of these measures.
Written off assets: When the lender does not count that money, borrower owes to him, then the asset is called written off assets. However, it does not mean that the borrower is pardoned or exempted.
Gross NPA refers to the total NPAs of the banks. Net NPA is calculated as Gross NPA -Provisioning Amount.
Drop in slippage ratio: The slippage ratio is the rate at which good loans are turning bad. It is measured by

Fresh accretion of NPAs during the year ×100/Total standard assets at the beginning of the year

Note: In case of agricultural loans, the loan is classified as NPA if it satisfies the below criteria:

Instalment of principal or interest remains overdue for two crop seasons for short duration crops,
Instalment of principal or interest remains overdue for one crop season for long duration crops.

Note: Long duration crops are the crops with crop season longer than one year and short duration crops are the crops with crop season shorter than one year.

Special Mention Accounts (SMA)

Introduced by the RBI to identify incipient stress in the assets of banks and NBFCs. These are the accounts that have not-yet turned NPAs (default on loan for more than 90 days), but rather these accounts can potentially become NPAs in future if no suitable action is action.

SMA-0: Principal or interest payment not overdue for more than 30 days but account showing signs of incipient stress
SMA-1: Principal or interest payment overdue between 31-60 days
SMA-2: Principal or interest payment overdue between 61-90 days

Note: If the Principal or interest payment is overdue for more than 90 days, then the loan is categorized as NPA.

Provisioning Coverage Ratio

Under the RBI's provisioning norms, the banks are required to set aside certain percentage of their profits to cover risk arising from NPAs. It is referred to as "Provisioning Coverage ratio" (PCR). It is defined in terms of percentage of loan amount and depends upon the asset quality. As the asset quality deteriorates, the PCR increases. The PCR for different categories of assets is as shown below:

Standard Assets (No Default): 0.40%
Sub-standard Assets (> 90 days and less than 1 year): 15%
Doubtful Assets (greater than 1 year): 25%-40%
Loss Assets (Identified by Bank or RBI): 100%

Expected Loss Approach for Provisioning

RBI has published a discussion paper on Expected Loss Approach for provisioning by banks. This paper examines issues and proposes a framework for adoption of an Expected-Loss approach for provisioning by banks in India.

Provisions

A loan loss provision is an expense that is set aside for defaulted loans. Banks set aside a portion of the expected loan repayments from all loans in their portfolio to cover the losses either completely or partially.
In the event of a loss, instead of taking a loss in its cash flows, the bank can use loan loss reserves to cover the loss.
An increase in the balance of reserves is called loan loss provision. The level of loan loss provisions is determined based on the level expected to protect the safety and soundness of the bank.

Current approach to provisioning: Incurred loss approach

Presently, banks are required to make loss provisions based on 'Incurred Loss Approach', where banks need to provide for losses that have occurred/incurred.
Example: Banks in India are required to make provisions of 15% of outstanding in case of secured loans and 25% of outstanding for unsecured loans, when a loan exposure is classified as NPA. This provisioning must be made after the loan has been classified as an NPA.
However, there have been issues of lag in identifying credit risks and procyclical nature of incurred loss approach which led to significant delays and erosion of bank capital during downturns respectively.

Expected Loss Approach for Provisioning

Expected credit losses represent a probability weighted estimate of the present value of all cash shortfalls from an instrument.
Banks to classify financial assets (primarily loans, including irrevocable loan commitments and investments classified as held-to-maturity or available for sale) into following three categories:
- Stage I: Includes financial assets that have not had a significant increase in credit risk since initial recognition or that have low credit risk at reporting date.
- Stage II: Includes financial instruments that have had a significant increase in credit risk since initial recognition (unless they have low credit risk at the reporting date) but that do not have objective evidence of impairment.
- Stage III: Includes financial assets that have objective evidence of impairment at the reporting date. For these assets, lifetime expected credit loss is recognised and interest revenue is calculated on the net carrying amount.

Capital Adequacy Ratio (CAR)

CAR has been laid down by BASEL committee on banking supervision under Bank of International Settlement located in Basel, Switzerland. It has been laid down to ensure financial stability and to prevent failure of banks. So far, 3 BASEL Norms have been laid down: Basel I (1998), Basel II (2004), Basel III (2009).

CAR is the ratio of a bank's capital to its risk. It is also known as the Capital to Risk (Weighted) Assets Ratio (CRAR)

CAR= (Tier-1 Capital + Tier-2 Capital)/ RWAs * 100.

The Banks in India are required to maintain CAR of 9% (Tier-1 capital: 7% + Tier-2 Capital: 2%) along with Capital Conservation buffer (CCB) of 2.5%.

Hence, unlike the BASEL III norms, which stipulate capital adequacy of 10.5% (8%-CAR + 2.5% CCB), the RBI has mandated to maintain capital adequacy of 11.5% (9%-CAR + 2.5%-CCB)

Liquidity Coverage Ratio (LCR)

It is the minimum required high-quality liquid assets (HQLA) that the banks must hold to allow them to survive a liquidity stress for 30 days. It was introduced under Basel III to improve a bank’s short-term resilience to liquidity shocks.

HQLA are assets that can be converted into cash quickly with no significant loss of value. Thus, HQLAs include

Cash outside the Cash Reserve Ratio requirement
Gold
G-sec outside SLR requirement
Assets under SLR.
High-rated corporate bonds
FACILITY TO AVAIL LIQUIDITY COVERAGE RATIO (FALLCR)

Facility to Avail Liquidity for LCR. The RBI has declared that the entire SLR-eligible assets held by the Banks can be considered as HQLAs for meeting LCR requirements.

Leverage Ratio (LR)

The Basel Committee on Banking Supervision (BCBS) introduced Leverage ratio (LR) in the 2010 Basel III package of reforms. The Formula for the Leverage Ratio is (Tier 1 Capital/ Total Consolidated Assets) ×100 where Tier 1 capital represents a bank's equity.
It is to be noted that the Tier 1 capital adequacy ratio (CAR) is the ratio of a bank’s core tier 1 capital to its total risk-weighted assets. On the other hand, leverage ratio is a measure of the bank's core capital to its total assets.
Thus, the Leverage ratio uses tier 1 capital to judge how leveraged a bank is in relation to its consolidated assets whereas the tier 1 capital adequacy ratio measures the bank's core capital against its risk-weighted assets.
BANKING STABILITY INDEX (BSI)
A measure of the level of interdependence of financial institutions mainly banks. It is “the expected number of banks that could become distressed given that at least one bank has become distressed.”
If more banks are expected to become distressed if one bank in the system is distressed, then the BSI is higher
Parameters: Efficiency of the Banks, Profitability, Soundness, Liquidity, Asset Quality.

Domestic-Systemically Important Banks (D-SIBS)

Systemically Important Banks (SIBs)

The SIBs are perceived as banks that are ‘Too Big to Fail (TBTF)’. There is a need for stronger regulatory environment for the SIBs. In this regard, the Basel Committee on Banking Supervision (BCBS) came out with a framework in 2011 for identifying the Global Systemically Important Banks (G-SIBs). Similarly, the RBI has been mandated to identify the Domestic Systemically Important banks (D-SIBs) and lay down suitable regulatory requirements to prevent their failure.

Difference between G-SIBs and D-SIBs
Criteria	Globally Systemic Important Banks (G-SIBs)	Domestic- Systemic Important Banks (D-SIBs)
Methodology proposed by?	Basel Committee on Banking Supervision (BCBS)	Basel Committee on Banking Supervision (BCBS)
Declared by?	Financial Stability Board	Reserve Bank of India
Qualifying Criteria	Only 75 largest Global Banks considered	Only those Banks whose size is equal to or more than 2% of GDP considered.
Criteria used for Identification	Size, Interconnectedness, Substitutability and Complexity	Size, Interconnectedness, Substitutability and Complexity
Obligation	Higher Capital Requirement	Higher Capital Requirement
Number of Banks	30	3
Examples	JP Morgan Chase, BNP Paribas, Citigroup, HSBC, Bank of America etc.	SBI, HDFC and ICICI

How are domestic-systemically important banks (D-SIBs) identified?

Qualifying Criteria: To identify the D-SIBs, the RBI considers only those banks whose size is equal to or more than 2% of GDP.

Criteria used for Identification of D-SIBs

Size: Failure of Bank with higher Balance sheet can cause greater damage to Economy.
Interconnectedness: Extent of linkages with other Banks and financial institutions. Failure of Bank with higher interconnectedness can cause greater damage to Economy.
Substitutability: Lack of readily available substitutes. Failure of a large bank would inflict greater damage if certain critical services provided by the bank cannot be easily substituted by other banks.
Complexity: The more complex a bank is, the greater are the costs and time needed to resolve its problems.

Computation of Score: The systemic importance of a bank is computed as weighted average scores of all 4 indicators. Thus, the systemic importance score of a bank would represent its relative importance with respect to the other banks. Banks that have scores above a threshold score are classified as D-SIBs.

Note: Presently, the SBI, ICICI Bank, and HDFC Bank have been identified as Domestic Systemically Important Banks (D-SIBs).

Higher capital requirement for D-SIBs

The D-SIBs are placed under different buckets (categories) depending upon their importance. According to the bucket in which they are placed, the bank would be required to maintain higher Tier-I capital under the BASEL Norms as shown below:

Bucket	Banks	Additional Common Equity Tier 1 requirement as a percentage of Risk Weighted Assets (RWAs)
5	-	1%
4	-	0.80%
3	State Bank of India	0.60%
2	-	0.40%
1	ICICI Bank, HDFC Bank	0.20%

Ease Reforms Index

Enhance Access & Service Excellence (EASE) reforms index. It measures the performance of Public Sector Banks on 140 objective metrics across 6 themes. It is published by Indian Banks’ Association.