Npa in Banks-punit Ganatra Pg-fin

7/31/2019 Npa in Banks-punit Ganatra Pg-fin

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Project Name

NPA IN BANKS

Submitted by:

PUNIT GANATRA

Guided by:

Prof. V.S.DATE

P.G.D.B.M

Yr: 2007-2009

Finance

Institute: N. L. Dalmia Institute of Management Studies & Research

N. L. Dalmia Institute of Management Studies & Research

Shristi, Sector -1, Mira Road (E), Mumbai 401 104.

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N. L. Dalmia Institute of Management Studies & ResearchShristi, Sector -1, Mira Road (E), Mumbai 401 104.

CERTIFICATE

This is to certify that the project titled

NPA IN BANKS

Submitted by: Mr. PUNIT GANATRA

To: N. L. Dalmia Institute of Management Studies and Research,

Mumbai in the fulfillment of the course,

P.G.D.B.M

During academic year2007-2009 this has been carried out by him under our

supervision and guidance.

Prof. V.S.DATE Prof. P. L. ARYA

(Project Guide) (Director)

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ACKNOWLEDGEMENT

First and foremost, I would like to thank Prof. V.S.DATE & Prof.

P. L. Arya for their guidance on the topic. I would also like to thank

all my friends & other classmates who have helped me with their

support and corrected me with their criticisms. I would also like to

thank other faculty & staff members whose teaching & guidance has

helped me in accomplishing this difficult task in such a short time.

My acknowledgements remain incomplete without thanking my

family members. I would like to thank my parents, sister & others for

their wholehearted support in helping me complete this project.

At the end I would like to thank all those who have indirectly

helped me achieving my target & those whom I may not have

mentioned in this acknowledgement.

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EXECUTIVE SUMMARY

The Non-Performing Assets (NPAs) problem is one of the foremost and

the most formidable problems that have shaken the entire banking industry in

India like an earthquake. Like a canker worm, it has been eating the banking

system from within, since long. And like the dreaded disease AIDS, banks have

not been able to find a reliable cure for this malady. It has grown like a cancer

and has infected every limb of the banking system.

At the macro level, NPAs have chocked off the supply line of credit to the

potential borrowers, thereby having a deleterious effect on capital formation and

arresting the economic activity in the country. At the micro level, the

unsustainable level of NPAs has eroded the profitability of banks through

reduced interest income and provisioning requirements, besides restricting the

recycling of funds leading to serious asset-liability mismatches. It has inter alia

lead to reduction in their competitiveness and erosion in their capital base as

well.

The problem of NPAs is not a matter of concern for the lenders alone. It is

a matter of grave concern to the public as well, as bank credit is the catalyst to

the economic growth of the country and any bottleneck in the smooth flow of

credit, one cause for which is mounting NPAs, is bound to create adverse

repercussions in the economy. Mounting menace of NPAs has raised the cost of

credit, made banks more averse to risk and squeezed genuine small and

medium enterprises from accessing competitive credit and has throttled their

enterprising spirits as well.

The spiraling and the devastating affect of NPAs on the economy have

made the problem of NPAs an issue of public debate and of national priority.

Therefore, any measure or reform on this front would be inadequate and

incomprehensive, if it fails to make a dent in NPAs' reduction and stall their

growth in future, as well.

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TABLE OF CONTENTS

Sr.No.

NAMEPAGE

No.1. Introduction to NPAs 01

2. NPA Classification 043. Valuation of NPAs 08

4. Factors responsible for NPAs 135. Statistics 16

6. Implication of NPAs 20

7.Committee on Banking Sector

Reforms22

8. Measures to Recover NPAs 25

9. Securatisation Act 4110. Management of NPAs 50

11. Conclusion 52Bibliography 53


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INTRODUCTION TO NPAs

Granting of credit facilities for economic activities is the main raison detre

of banking. Apart from raising resources through fresh deposits, borrowings, etc.

recycling of funds received back from borrowers constitutes a major part of

funding credit dispensation activities. Non-recovery of installments as also

interest on the loan portfolio negates the effectiveness of this process of the

credit cycle. Non-recovery also affects the profitability of banks besides being

required to maintain more owned funds by way of capital and creation of

reserves and provisions to act as cushion for the loan losses. Avoidance of loan

losses is one of the pre-occupations of management of banks. While complete

elimination of such losses is not possible, bank managements aim to keep the

losses at a low level. In fact, it is the level of non-performing advances, which, to

a great extent, differentiates between a good and a bad bank. Mounting NPAs

may also have more widespread repercussions. To avoid shock waves affecting

the system, the salvaging exercise is done by the Government or by the industry

on the behest of Government/ central bank of the country putting pressure on the

exchequer.

In India, the NPAs, which are considered to be at higher levels than those

in other countries, have, of late, attracted the attention of public as also of

international financial institutions. This has gained further prominence in the

wake of transparency and disclosure measures initiated by the RBI during recent

years. The Committee on Financial System, Capital Account ConvertibilityCommittee on Non-Performing Assets of Public Sector Banks has dealt with the

subject of NPAs of Indian banks.

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What is an NPA?

To begin with, it seems appropriate to define Non-Performing Advance

popularly called NPA. Non-Performing Advance is defined as an advance where

payment of interest or repayment of installment of principal (in case of Term

Loans) or both remains unpaid for a period of two quarters or more. However

with effect from March 2004, default status would be given to a borrower if dues

were not paid for 90 days. If any advance or credit facilities granted by bank to a

borrower becomes non-performing, then the bank will have to treat all the

advances/credit facilities granted to that borrower as non-performing without

having any regard to the fact that there may still exist certain advances / credit

facilities having performing status.

The magnitude

The NPAs in the Indian banking system have assumed astronomical

dimensions. NPAs of scheduled commercial banks totaled Rs.70,904 cr as on

March 31, 2002, which form 10.40% of our gross bank credit, about 15.75% of

our annual budget and 3% of our Gross Domestic Product. It is equivalent to our

annual defense budget. In absolute terms, NPAs have been increasing at the

rate of about 5 to 6% every year. The staggering magnitude of NPAs is costing

the public sector banks alone, more than Rs. 5,000 cr annually, by way of loss of

interest income, apart from servicing and litigation costs. The malady of high

level of NPAs eroding the profitability of banks is not confined to public sector

banks alone, it is equally hammering the bottom lines of old as well as new

generation private sector banks and foreign banks.

Segmentation of NPAs

NPAs cover a cross-section of industries such as iron and steel and

related units like Ferro Alloys; Manmade textiles; Real estate / Civil and Project

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related construction; Pharmaceutical; Leather / goods export; Garment export;

Fertilizers and Chemicals; Cement and Cotton (fibres / textiles); Tea / Coffee;

Jute; Sugar; and Jewellery / Diamonds.

NPA in Indian Banks Vis--Vis other countries

Comparison of the problem loan levels in Indian banking system vis--vis

those in other countries, particularly those in developed economies, is often

made, more so in the context of the opening up of our financial sector. The data

in respect of NPAs level of banking system available for countries USA, Japan,

Hong Kong, Korea, Taiwan and Malaysia reveal that to ranges from 1% to 8.1%

during 1993-94, 0.9% to 5.5% during 1994-95 and 0.85% to 3.9% during 1995-96

as against 23.6% 19.5% and 17.3% respectively for Indian banks during these

years.

Notwithstanding this, some features relating to the NPA

reporting/evaluation practices in other countries vis--vis those in our countries

need, however, to be considered before reaching to any conclusion on the level

of NPAs. In some countries, all or bulk of banks provisions are general

provisions and identified losses are written off at an early stage. Banks in thesecountries carry very little NPAs in their balance sheets. The recovery measures

are also very expeditious in view of stringent bankruptcy and foreclosure laws.

The concept of gross NPA and Net NPA is not in vogue in these countries. In

Indian banking, due to time lag involved in recovery process and the detailed

safeguards/procedures involved before write-offs could be affected, banks even

after making provisions for the advances considered irrecoverable, continue to

hold such advances in their books which is termed as Gross NPA together with

the provisions. The provision adjusted NPAs in Indian banking segment i.e. Net

NPAs, constitute only 8.2% of the net advances of the banks as on 31 st March,

1998 which no doubt are high by international standard but are not so alarming

as Gross NPAs project.

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NPA CLASSIFICATION

NPA Norms across the world:

The details and classification standards of non-performance vary from

country to country, as the countries put in place norms as per the

peculiarities/requirements of their banking systems.

The practices with regard to these securities also differ. In certain

countries, an advance is considered un-collectible and classified as loss asset

only after it remains as past due or doubtful for a certain length of time, whereas

in India, an advance is considered to be classified as loss the moment it isconsidered un-collectible. In certain other countries, the available securities are

deducted from the doubtful advance to arrive at the net doubtful portion, whereas

in India provision is required to be made even on the secured portion. In India,

the provision required to be made in respect of the portion not covered by the

realizable value of securities in doubtful advance 100% whereas in some

countries, its 75% or even 50%. The concept of collateral also differs in as

much as security of standby nature like guarantee of promoter/third party, net

worth of the promoter/guarantor are not considered as security in India.

Historical Conceptualization of Problem Loans in Indian Banking:

Health Code System:

A critical analysis of a comprehensive and uniform credit monitoring was

introduced in 1985-86 by RBI by way of the Health Code System in banks, which

inter alia, provided information regarding the health of individual advances, the

quality of credit portfolio and extent of advances causing in relation to total

advances. It was considered that such information would be of immense use to

bank managements for control purposes. The RBI advised all commercial banks

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(excluding foreign banks, most of which had similar coding system in their

organizations) on November 7, 1985 to introduce the Health Code classification

indicating the quality (or health) of individual advances in the following eight

categories, with a health code assigned to each borrowal account:

1.Satisfactory Conduct is satisfactory; all terms and conditions are

complied with; all accounts are in order; and safety of

the account is not in doubt.

2.Irregular The safety of the advance is not suspected, though

there may be occasional irregularities which may be

considered to be as a short term phenomenon

3. Sick-viable Advances to unit which are sick but viable under

nursing and units in respect of which nursing/revival

programmes are taken up

4.Sick: non-viable/sticky The irregularities continue to persist and there are no

immediate prospects of regularization; the accounts

could throw up some of the usual signs of incipient

sickness

5.Advances recalled Accounts where the repayment is highly doubtful and

nursing is not considered worthwhile; includes where

decisions have been taken to recall the advance

6.Suit filed accounts Accounts where legal actions or recovery

proceedings have been initiated

7.Decreed debts Where decrees have been obtained

8. Bad and doubtful debts Where the recoverability of the banks dues has

become doubtful on account of short-fall in value of

security; difficulty in enforcing and realizing the

securities; or inability/unwillingness of the borrowers

to repay the banks dues partly or wholly

Under the above Health Code System, the RBI was classifying problem loans of

each bank in three categories, which are as under:

(a) Advances classified as bad and doubtful by the bank

(corresponding to Health Code No. 8)

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(b) Advances where suits were filed/decrees obtained

(corresponding to Health Codes Nos. 6 & 7) and

(c) Those advances with major undesirable features (broadly

corresponding to Health Codes Nos. 4 & 5)

PRUDENTIAL NORMS

In order to ensure greater transparency in the borrowal accounts and to

reflect actual health of banks in their Balance Sheets, RBI introduced prudential

regulations relating to

Asset Classification An Asset is considered Non Performing in case if interest

or installments of principal or both remain unpaid for more than two quarters and

if it has become past due, i.e., 30 days after the due date.

An Advance is to be classified as Sub-standard if it remains NPA upto a period

of two years and will be classified as Doubtful if it remains NPA for more than

eighteen months.

An account will be classified as Loss, without any waiting period, where the

dues are considered uncollectible or only marginally collectible.

BASIS OF NPAs

The basis of treating a credit facility as NPA is as detailed below:

ASSET In respect of which interest has remained past due for six months.

TERM LOAN Inclusive of unpaid interest, when the installment is overdue for

more than six months/on which interest amount remained past due for six

months.

BILL Which remains overdue for six months.

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OTHER CURRENT ASSETS The interest in respect of a debt/income on a

receivable in the nature of short-term loans/ advances, which remained overdue

for a period of six months.

SALE OF ASSETS/SERVICE RENDERED. Any dues on account of

these/reimbursement of expenses rendered which remained overdue for a period

of six months.

LEASE RENTAL/HIRE-PURCHASE INSTALMENT The installment which has

become overdue for a period of more than twelve months.

OTHER CREDIT FACILITIES The balance outstanding including interest

accrued made available to the borrower/beneficiary in the same capacity when

any of the credit facilities become NPA.

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VALUATION OF NPAS: DIFFERING APPROACHES

NPAs are a by-product of most financial systems and the level of NPAs is

an indicator of the health of the financial system of an economy. Valuation

techniques should present the situation, which maximizes the overall interests ofall the concerned parties.

The broad objectives of the valuation Framework are essentially:

To set a sound basis for the selling bank/ institution to finalize the sale of

assets,

To provide a basis for the fair market value of the assets,

To promote transparency of the valuation processes, and, To comply with internationally accepted practices.

The valuation of an asset or the pool of assets is a precursor to any restructuring

exercise. Any valuation exercise shall attempt to address the following issues:

The fair market value of the asset should represent the price at which

market participants would undertake a restructuring.

The transaction value should reflect the potential for income generation

and return of principal, balanced against the applicable risk profile and

market lending margins.

The valuation Framework should allow for valuation of specific assets as

well as a portfolio of assets (i.e. portfolio of loans to be acquired from a

bank). In most cases, a single value will apply to each loan acquired. For

larger loans, however, an element of risk/return sharing with the selling

bank may be considered.

I shall now discuss here the valuation approach in two parts i.e. (i) traditional

approaches and (ii) unconventional approaches.

Traditional Schools of Valuation Processes

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There are various methodologies used to value the companies or their

debt. Typically cash flows, assets or replacement values, or a combination of

these, are considered when determining the value of a company or its debt. The

matrix shows the risk profile of the NPA based on its cash flows and collateral.

As shown, stronger the cash flows and collateral, lower the risk profile of the

asset. Some of the widely used approaches towards valuation of an NPA by the

valuation firms are detailed as under:

Discounted cash flows

Liquidation / sale of assets

Earnings model

Case specific valuation models

Discounted cash flows

One of the commonly used methods for estimating the value of the

companys debt is the anticipated cash flows. The cash flow stream will represent

the interest and principal payments expected to be received by the lender,

primarily arising out of the internal cash flow generation from underlying business

activities. Where the asset is a partly completed project, the cash flow stream will

have to take into account whether the project will be completed and if so how it

will be financed. If certain lenders decide to fund this through extended facility,

this will be taken into account in the asset's cash flow stream. Essentially the

decision on the projects financial viability will be determined by using an

incremental cash flow analysis. Normally, the value of a healthy asset is

computed as the discounted value of the expected future cash flows. However, acompany in distress or an NPA may have negative earnings (profit before

interest, depreciation and tax) and may be likely to incur operating losses for the

next few years. For such companies, the estimation of future cash flows is not so

easy, as there is a strong possibility of bankruptcy (Damodaran, 1994). Under

such a scenario the asset valuation is also based on subjective parameters. A

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company under financial distress has some or all of the following characteristics:

operating loss, inability to meet the debt obligations and high debt equity ratio.

When dealing with such cases, the credit analysts need to evaluate the

possibility and timing of positive financial performance of the company in future

which may be dependent on the industrial scenario, possibility of infusion of

additional funds and the overall macro economic environment. If the company is

expected to improve its financial position in the future, the following discounted

cash flow model may be used for the distress companies / NPAs.

Liquidation value approach

If the loan is in default with no or low expectation of it being serviced, the

cash flow from liquidation of the asset and collateral will be the primary approach

rather than the net present value of the cash flows. In this case, the take-out of

the lender is primarily by way of exercise of their rights on the asset and attached

collateral. The liquidation value of the company is the aggregate of the value of

the assets of the company if sold at the market prices, net of transactions and

legal costs. The estimation of the assets becomes quite complicated when the

assets of the company cannot be easily separated like in a steel, textile or

petrochemical plant. If such assets are sold individually, majority of the assetmay not fetch a price closer to their book value (or when they are sold as a

bundle). Further, when such sale is to take place at a quick pace, the value of the

assets further fall down, as it is more or less equal to forced sale of these assets.

As a result of this forced sale, the seller has to accept a discount on the fair

market value of such assets. In most cases, such a realization is not able to

cover even the secured debt fully and hence the valuation of the debt would be

limited by this realizable value. This approach has been widely used in countries

like Thailand where a significant number of loans were secured by real estate

and other marketable securities of various kinds.

Earning model

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In performing companies, the P/E ratio of the industry or other similar

companies may be used as a tool for determining the market value of the assets

of company. If the debt of the company is more than its assets, then a

proportionate discount may be applied to the debt. The above approach,

however, cannot be used for most of the NPAs, as they would have negative

EPS. In such cases, the cash earning per share of the company and cash P/E

ratio of the similar companies may be used to arrive at a market value of the

assets. This shall enable the analyst to arrive at a reasonable valuation of the

NPA debt.

Case specific valuation models

Depending on case to case, various models have been evolved and used

for specific requirements. I shall discuss here one of such models to provide an

idea as to how varied the models can be from the conventional approaches.

Segmentation into buckets

For a huge portfolio of small loans, different kind of approach may be used

for arriving at the realistic valuation. One of them is categorizing the loans invarious buckets and then analyzing a sample picked from various buckets. Post

currency crisis of late 1990s in Thailand, the price of real estate had declined to

abysmally low levels and majority of the property-linked loans had become NPAs

in the books of the local banks. One of the leading financial companies in the

world was contemplating to purchase these loans totaling over 20,000 small

loans. For arriving at the appropriate valuation, they had followed the following

methodology:

Segmentation of the assets in various buckets

Selection of a sample out of each bucket

Detailed analysis of each sample

Statistical extrapolation of the sample to the entire bucket

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Arriving at the final range of the valuation of the portfolio

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FACTORS RESPONSIBLE FOR NPAs

The dues of the Banking sector are generally related to the performance

of the unit / industrial segment. In a few cases, the cause of NPA has been due

to internal factors (to the banks) such as weak appraisal or follow-up of loans but

more often than not, it is due to factors such as management inefficiency of

borrowal units, obsolescence, lack of demand, non-availability of inputs,

environmental factors, etc.

The main reasons for sickness and the factors leading to NPA are as under

INTERNAL FACTORS:

Diversion of Funds for expansion, modernization, setting up of new

projects, helping or promoting sister concerns.

Time / Cost overruns while implementing the project.

Business failure like product failing to capture market, inefficient

management, strike / strained labour relations, wrong technology,

technical problems, product obsolescence, etc.

EXTERNAL FACTORS:

Failure, non-payment / overdues in other countries, recession in other

countries, externalization problems, adverse exchange rates, etc.

Government policies like excise, import duty changes, deregulation,

pollution control orders, etc.

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Willful default, siphoning of funds, Fraud, misappropriation, promoters /

management disputes, etc.

Deficiencies on the part of the Banks, viz., in credit appraisal, monitoring

and follow-up, delay in release of limits, delay in settlement payments /subsidies by Government bodies, etc.

External factors like raw material shortage, raw material / input

price escalation, power shortage, industrial recession, excess capacity,

natural calamities like floods, accidents, etc.

Contribution to NPAs by factors like siphoning off funds thorough

Fraud/misappropriation was less significant in comparison with other factors.

Incidence of NPAs on account of deficiencies on the part of banks such as

delay in sanction and disbursement of funds whereby borrowing units are starved

of funds when in need, and delay in settlement of payments/subsidies by the

Government bodies was on the low side in proportion to other factors.

Lack of effective co-ordination between banks and financial institutions in

respect of large value projects does contribute to the emergence of NPAs even

at the implementation stage. RBI had, in February 2000,drawn up certain ground

rules in this regard in consultation with banks, financial institutions and IBA and

circulated the same among banks and financial institutions for implementation.

Susceptibility of the sanctioning authorities to external pressure, failings of

the CEOs and the ineffectiveness of the Board to check his ways also

contributed in no small measure to the unusual build up of NPAs in some of the

banks.

One of the most prominent causes for NPAs, as often observed by RBI

Inspectors, is the slackness on the part of the credit management staff in their

follow up to detect and prevent diversion of funds in the post-disbursement stage.

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Impact of Priority Sector Advances on NPAs

There is a common perception that the prescription of 40% of the net bank

credit to priority sectors have led to higher level of NPAs, because credit to these

sectors become sticky. However, it has been observed that the proportion of

NPAs in these sectors is lesser than the proportion of NPAs in the Non-Priority

sector, although, the incidence of NPAs in the priority sectors is much higher.

The gradual increase in the proportion of the NPAs in the Non-priority

sectors indicates that NPAs are increasingly occurring on borrowal accounts of

Industrial sector during the recent years.

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STATISTICS PERTAINING TO NPAs

NPA OF INDIAN BANKS

The Non Performing Assets (NPA) of 27 public sector banks shot up toRs.56,608 crore in September 2001. NPA not only reduces the yield on

advances but also reduces the profitability of banks. The huge NPA's of the bank

is due to the debtor friendly foreclosure and bankrupt laws which allows

customers to default with

(Rs. In crores)

Year Gross NPAGross NPA as % of

Gross advanceNet NPA

Net NPA as

% of net

advances

1993 39,253 23.2% NA NA

1994 41,041 24.8% NA NA

1995 38,385 19.5% 17,567 10.7%

.1996 41,661 18% 18,297 8.9%

1997 47,300 15.7% 22,340 8.1%

1998 50,815 14.4% 23,761 7.3%

1999 58,722 14.7% 28,020 7.6%

2000 53,066 13% 26,596 7%2001 56,608 13% 27,856 7%

It will be also interesting to have a look at the movement of NPAs (gross

and net), as a percentage of advances, group-wise over the last four years. This

will give an idea of where banks, as different groups, stand in regard to their

NPAs.

Percentage of gross / net NPAs to total advances as at end March

Bank Groups 1998 1999 2000 2001

Public sector banks 16.0

(8.2)

15.9

(8.1)

14.0

(7.4)

12.4

(6.7)

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All private sector banks 8.7

(5.3)

10.8

(7.4)

8.2

(5.4)

8.5

(5.4)

Old private sector banks 10.9

(6.5)

13.1

(9.0)

10.8

(7.1)

11.1

(7.3)

New private sector banks 3.5

(2.6)

6.2

(4.5)

4.1

(2.9)

5.1

(3.1)

Foreign banks 6.4

(2.2)

7.6

(2.9)

7.0

(2.4)

6.8

(1.9)

All commercial banks 14.4

(7.3)

14.7

(7.6)

12.7

(6.8)

11.4

(6.2)

Note: Figures in parenthesis denote percentage of net NPAs to net advances

It may be observed that the malady of high level of NPAs eroding the

profitability of banks is not confined to public sector banks alone, but it is equally

present in the private sector banks too. While some of the foreign banks loan

portfolio had been affected by a few large accounts turning NPA, it is a matter of

concern that some of the new private sector banks, which started off, on a clean

slate had acquired so quickly such a large level of NPAs.

Share of NPAs in Net Advances

Bank Group Number of

Banks

Number of Banks

with Higher Share

Number of Banks with

Lower Share in Assets

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in Assets

Public Sector

Banks

27 4 3 4 16

Old Private Sector

Banks

24 11 4 8 1

New Private

Sector Banks

8 8 -- -- --

Foreign Banks 36 15 2 11 1

Total 95 38 9 23 18

In all forums of interactions the global multilateral institutions and rating

agencies had with RBI and the Government, directed lending concept gets

quoted as an important attribute and a contributory factor for the build up of

NPAs in banks in India. It is a different matter that RBI and the Government areaccused of soft attitude towards banks which do not fulfill the prescribed targets

for priority sector lending, particularly agriculture and small scale sector. The

figures in the following table as on March 31, 2001 reveals information regarding

the contribution by various segments of borrowers to the NPA stock of public

sector banks: -

Gross NPAs as on March 31, 2001

Borrowing segment-

wise distribution of

Amount

(Rs.

Percentage to total

NPAs

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gross NPAs crores)

Public sector units 1334.05 2.44

Large Industries 11498.10 20.99

Medium industries 8658.69 15.81

Other non priority sectors 9516.62 17.37

Agriculture 7311.40 13.35

Small scale industries 10284.97 18.78

Other priority sectors 6169.33 11.26

Total 54773.16 100.00

It can be understood that recovery of NPAs under priority sector advances

particularly to agriculture and small-scale industries is sometimes hampered by

externalities. Further, such NPAs are also spread over a large number of

accounts and for small amounts. However, one fails to understand the reluctance

of large borrowers to honour their repayment obligations. In many cases, failure

of banks to take effective action against some of the defaulting large corporate

borrowers was also noticed.

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IMPLICATIONS OF NPA s

Supervisory action that may arise on account of high level of NPAs

One of the trigger points in the proposed Prompt Corrective Action (PCA)

mechanism [which was widely circulated by RBI through the public domain] is the

level of net NPAs. When the trigger point under the mechanism is activated by

the performance of a bank, the mandatory actions would follow by way of

restriction on expansion of risk-weighted assets, submission and implementation

of capital restoration plan, prior approval of RBI for opening of new branches and

new lines of business, paying off costly deposits and special drive to reduce the

stock of NPAs, review of loan policy, etc.

Provisioning for NPAs Based on the Asset classification, Banks are required

to make provision against the NPAs at 100% for Loss Assets;

100% of the unsecured portion plus 20% to 50% of the secured portion,

depending on the period for which the account has remained in doubtful

category; and 10% general provision on the outstanding balance in respect of

Sub-standard assets. Banks have been asked to make provision @ 0.25% on

their standard advances.

Other implications

The most important business implication of the NPAs is that it leads to the

credit risk management assuming priority over other aspects of bank's

functioning. The banks whole machinery would thus be pre-occupied with

recovery procedures rather than concentrating on expanding business.

As already mentioned earlier, a bank with high level of NPAs would be

forced to incur carrying costs on a non-income yielding assets. Other

consequences would be reduction in interest income, high level of provisioning,

stress on profitability and capital adequacy, gradual decline in ability to meet

steady increase in cost, increased pressure on net interest margin (NIM) thereby

reducing competitiveness, steady erosion of capital resources and increased

difficulty in augmenting capital resources.

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The lesser appreciated implications are reputational risks arising out of

greater disclosures on quantum and movement of NPAs, provisions etc. The

non-quantifiable implications can be psychological like play safe attitude and

risk aversion, lower morale and disinclination to take decisions at all levels of

staff in the bank.

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COMMITTEE ON BANKING SECTOR REFORMS:

The Committee on Banking Sector Reforms (CBSR) report suggests

remedies to recover the NPAs as well their subsequent transfer as assets

through fund management. Some of the critical points are discussed here under:

- Where guarantees have been given by the central or state government

and a demand thereunder has been raised by the banks, these demands

should be honoured.

- Banks must put greater reliance upon the recommendations of the

Settlement Advisory Committee (SAC) in order to make better use ofcompromises for reduction of NPAs in their books.

- The most effective way of removing NPAs from the books of the weak

banks would be to move these out to a separate agency which will buy the

loans and make its own efforts for their recovery.

- The proper financial vehicle through which non-performing loans can be

transferred would be that of the FRA-owned (government) asset

reconstruction (ARF) managed by the independent private sector Asset

Management Company.

- The ownership of the assets will lie with the government and the

management thereof with a separate private sector entity having the

necessary expertise and organization.

- The ARFs operations will be profit oriented and its aim will be to recover

from the acquired assets (NPA) more than the price paid for it.

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- The FRA and the ARF owned by it may be set up under a special act of

the parliament which while protecting it against obstructive litigation from

the borrowers could also provide for quick and effective enforcement of its

rights against them.

- The government will provide the fund needed for the ARF. The size of the

fund needed will depend upon the size of business it handle. Presently it is

proposed that the ARF may restrict its activities to the NPAs of the three

identified weak banks.

- The ARF should focus on comparatively larger NPAs. It would be

desirable not to acquire assets value below Rs.50 lakh.

- The payment in respect of the assets purchased from the weak banks

may be made by the ARF by issuing special bonds guaranteed by the

government and bearing a suitable rate of interest.

- The bonds issued by the ARF in payment of the assets acquired as also

those which it will issue for raising funds against the security of the assets

it has purchased and which are in the course of collection may have amaturity of five years.

- The ARF should purchase from the banks loans, which are NPAs as on a

certain date say, 31.3.2000. In view of the foregoing it will be adequate for

the ARF to have a life of not more than seven years form the date of its

commencing business, say beginning 1.4.2000.

- To begin with, the ARF may buy NPAs of only the three identified weak

banks. However buying NPAs from other banks need not be totally

excluded.

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- If need arises, more funds could be set up later. Participation in these

funds may be open to both public and private sector. These funds can

facilitate growth of secondary market for loans in the country.

- Price at which NPAs will be transferred should be arrived by mutual

agreement and in a transparent manner.

- In the ownership of the AMC while the government may have a share of

upto 49 percent, majority shareholding should be non-government.

Institutions like SBI, LIC, GIC, UTI and IFCI and parties form the private

sector could be the other shareholders. The possibility of attracting

participating of multilateral agencies like IFC or ADB should also be

explored. The initial capital requirement of the AMC is not likely to be more

than Rs. 15 crore.

- Professionals such as bankers, chartered accountants, engineers, lawyers

and valuers should man the AMC, which must have a lean structure, so

that it has the desired expertise and is cost efficient.

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MEASURES TO RECOVER NPAs

Life Line of Banking: New RBI Formula for NPA Recovery

Over the last few years Indian banking in its attempt to integrate itself withthe global banking has been facing lots of hurdles in its way due to its inherent

weaknesses, despite its high sounding claims and lofty achievements. One of the

major hurdles, the Indian banking is facing today, is its ever-growing size of non-

performing assets over which the top management of almost each bank is

baffled. On account of the intricacies involved in handling the NPAs the ticklish

task of asset management of the bank has become a tight rope walk affair for the

controlling heads, because a little wavering this or that side may land the

concern bank in trouble. The growing NPAs is a potent source of worry for the

finance minister as well, because in a developing country like ours, banking is

seen as an important instrument of development, while with the backbreaking

NPAs, banks have become helpless burden on the economy.

RBI has announced the modified guidelines under the settlement advisory

committee (sac) scheme vide its letter no bp.bc.11.21.01 040/99-00 dated 27 th

July 2000. A specific time frame was also stipulated in the scheme, but due to

various reasons the scheme could not make any sizeable dent into the problem.

Therefore, realizing the obstacles in handling the NPAs and solving the issue in a

meaningful, and realistic manner, RBI now have come out with a fresh set of

guidelines under the modified sac schemes discussed hereunder.

Laying stress on the timeframe, the scheme looks more definitive and

decisive, as cut off dates have been fixed for the implementation of the scheme.Under the scheme, detailed guidelines have been issued by RBI to cover NPA

with outstanding amount upto Rs.5 crore. However for outstanding amount above

Rs. 5 crore, policy formulation for the settlement of the account is left with the

concerned bank it is observed that majority of the NPA constitute accounts with

outstanding amount below rupees five crores. Thus by following the provisions of

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the revised schemes, the size of the NPAs can be reduced to a level acceptable

as per the international norms. As per the guidelines, the scheme covers NPAs,

which have become doubtful or loss assets as on 31.3.1997. Further the scheme

also covers NPA classified as sub-standard as on 31.3.1997, but later on

becoming doubtful or loss assets.

NPAs with outstanding upto Rs. 5 crore

In case of doubtful and loss assets as of 31.3.1997, through the modified

schemes, the banks have been directed to follow up a settlement formula under

which the minimum amount to be recovered, amounts to be entire outstanding

running ledger balance as on the date the account was identified as NPA i.e. the

date from which the interest was not charged to the running ledger, an analysis

of the given formula shows that RBI has been very much generous in granting

huge relaxation to the borrowers who were not coming forward for setting their

overdue loans due to one or other reason. The scheme is of high practical value

as it protects the borrowers who were having genuine problems in clearing their

dues because the interest component constituted a multiplied amount of principal

outstanding. On the other hand, the concerned banks were also finding in difficult

to sacrifice the entire interest component, but outstanding in the dummy ledger.Now as per the provision to he scheme, they will be ready to grant such

relaxation in favour of the borrowers. These guidelines have come as a windfall

for borrowers who after a lot of negotiations, were almost ready to repay back

their principal as well as a part of the interest component to settle their accounts,

as under the modified scheme, they would be able to save the interest

component. To that extent the concerned bank stands to lose.

In the case of sub-standard asset as of 31.3.1997, the settlement formula

as given in the modified scheme states that the minimum sum to be recovered

must contain the entire running ledger outstanding balance as on the date of the

account was identified as NPA. i.e. the date from which interest was not charged

to the running ledger + interest at the existing prime lending rate of the bank from

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1.4.1997 till the date of final payment. As per the modified sac scheme, the terms

suggested for the payment of settlement amount of NPA are simple and

pragmatic. As per the terms of the scheme, the settlement amount should be

paid in lump Sum by the borrower. However in case of the borrower is unable to

repay back in a lump Sum, the scheme allows sufficient breathing period to

enable him to arrange the funds and clear at least 25 percent of the settlement

amount to be paid upfront and the remaining amount to be recovered in

installments spread over a period of one year along with interest at the existing

PLR from the date of settlement upto the date of final payment

It is observed that each bank is having a system of delegation of authority

for the clearance of NPAs, so there should not be any operational problem in the

implementing of the scheme as per the modified guidelines.

NPAs with outstanding over Rs. Five crore

For recovery of NPAs over Rs.5 crore, RBI has left the matter to the

concerned banks and advised that the concerned banks may formulate policy

guidelines regarding their settlement and recovery. The freedom, in such cases,is given to the banks, because the attending circumstances in each case may

vary from the other. Therefore it was in the right direction that adopting a

generalized approach was not thought appropriate.

In cases, where the amount involved is above Rs.5 crore, RBI expects

CMD of each bank to supervise the NPA personally. The CMDs of the concerned

banks are advised to review all such cases within a given timeframe and decide

the course of action in terms of rehabilitation/restructuring. OTS or filing of suits

by 31st August 2000.It is also expected that in all such cases, the matter be

placed before the boards of the concerned banks for finalising the course of

action by 31.9.2000. Further it is also clarified that in cases where a legal suit is

required to be filed, the same should be filed in all such cases by 31.10.2000 and

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prospective, but it is successful implementation depends upon a number of

factors as enumerated below:

- The success of the scheme would be limited to the level of seriousness

evinced by the concerned banks. If it is taken as a routine guideline from

the RBI and disposed of without attaching the importance it deserves, it

may end up as any other routine matter.

- Looking to the gravity of the issue, the rate of success of the scheme

depends upon the publicity given to the golden opportunity available

among the defaulting borrowers. It is felt that the scheme must reach

every nook and corner of the country as the disease reflected in the form

of NPA is not restricted to a particular area or pockets in the country.

- It is also required that the progress of the implementation of the scheme

be assessed periodically by evolving an alert monitoring system by each

bank. As the implementation of the scheme is going to decide the destiny

of the concerned bank, it is absolutely necessary that an effective

monitoring system is there to ensure successful implementation of the

scheme.

- It is also essential that while settling the NPA as a dispassionate and

unprejudiced approach is adopted without any discrimination failing which

the banks will not be able to weed out NPAs.- A multifrontal approach to the problem involving all the concerned staff

members in the field as well as in the controlling points is another

condition for proper implementation of the scheme. In the absence of

teamwork involving a top management as well as everybody upto the

grassroot level, the banks would not be able to root out the problem.

Measures initiated by Reserve Bank and Government of India for reduction

of NPAs

Compromise settlement schemes

The RBI / Government of India have been constantly goading the banks to take

steps for arresting the incidence of fresh NPAs and have also been creating legal

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and regulatory environment to facilitate the recovery of existing NPAs of banks.

More significant of them, I would like to recapitulate at this stage.

The broad Framework for compromise or negotiated settlement of NPAs

advised by RBI in July 1995 continues to be in place. Banks are free to

design and implement their own policies for recovery and write-off

incorporating compromise and negotiated settlements with the approval of

their Boards, particularly for old and unresolved cases falling under the

NPA category. The policy Framework suggested by RBI provides for

setting up of an independent Settlement Advisory Committees headed by

a retired Judge of the High Court to scrutinise and recommend

compromise proposals.

Specific guidelines were issued in May 1999 to public sector banks for one

time non-discretionary and non-discriminatory settlement of NPAs of small

sector. The scheme was operative upto September 30, 2000. [Public

sector banks recovered Rs. 668 crore through compromise settlement

under this scheme.]

Guidelines were modified in July 2000 for recovery of the stock of NPAs of

Rs. 5 crore and less as on 31 March 1997. [The above guidelines which

were valid upto June 30, 2001 helped the public sector banks to recover

Rs. 2600 crore by September 2001]

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An OTS Scheme covering advances of Rs.25000 and below continues to

be in operation and guidelines in pursuance to the budget announcement

of the Honble Finance Minister providing for OTS for advances up to

Rs.50, 000 in respect of NPAs of small/marginal farmers are being drawn

up.

Measures for faster legal process

Lok Adalats

Lok Adalat institutions help banks to settle disputes involving accounts in

"doubtful" and "loss" category, with outstanding balance of Rs.5 lakh for

compromise settlement under Lok Adalats. Debt Recovery Tribunals have now

been empowered to organize Lok Adalats to decide on cases of NPAs of Rs.10

lakhs and above. The public sector banks had recovered Rs.40.38 crore as on

September 30, 2001, through the forum of Lok Adalat. The progress through this

channel is expected to pick up in the coming years particularly looking at the

recent initiatives taken by some of the public sector banks and DRTs in Mumbai.

Debt Recovery Tribunals

The Recovery of Debts due to Banks and Financial Institutions

(amendment) Act, passed in March 2000 has helped in strengthening the

functioning of DRTs. Provisions for placement of more than one Recovery

Officer, power to attach defendants property/assets before judgment, penal

provisions for disobedience of Tribunals order or for breach of any terms of the

order and appointment of receiver with powers of realization, management,

protection and preservation of property are expected to provide necessary teeth

to the DRTs and speed up the recovery of NPAs in the times to come.

Though there are 22 DRTs set up at major centers in the country with

Appellate Tribunals located in five centers viz. Allahabad, Mumbai, Delhi,

Calcutta and Chennai, they have not been able to deliver as expected as they

got swamped under the huge volume of cases (41,243) filed with them, since

inception, out of which 35,871 cases were still pending as on 31.3.2002. Banks

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could recover Rs. 2,947 cr only, which is less than 1% of the amount claimed

through the DRT mechanism up to 31.3.2002.

The banks should institute appropriate documentation system and render

all possible assistance to the DRTs for speeding up decisions and recovery of

some of the well-collateralized NPAs involving large amounts. I may add that

familiarization programmes have been offered in NIBM at periodical intervals to

the presiding officers of DRTs in understanding the complexities of

documentation and operational features and other legalities applicable of Indian

banking system. RBI on its part has suggested to the Government to consider

enactment of appropriate penal provisions against obstruction by borrowers in

possession of attached properties by DRT receivers, and notify borrowers who

default to honour the decrees passed against them.

Circulation of information on defaulters

The RBI has put in place a system for periodical circulation of details of

willful defaults of borrowers of banks and financial institutions. This serves as a

caution list while considering requests for new or additional credit limits from

defaulting borrowing units and also from the directors /proprietors / partners of

these entities. RBI also publishes a list of borrowers (with outstanding

aggregating Rs. 1 crore and above) against whom suits have been filed by banks

and FIs for recovery of their funds, as on 31st March every year. It is our

experience that these measures had not contributed to any perceptible

recoveries from the defaulting entities. However, they serve as negative basket

of steps shutting off fresh loans to these defaulters. A real breakthrough can

come only if there is a change in the repayment psyche of the Indian borrowers.

Recovery action against large NPAs

After a review of tendency in regard to NPAs by the Honble Finance

Minister, RBI had advised the public sector banks to examine all cases of willful

default of Rs 1 crore and above and file suits in such cases, and file criminal

cases in regard to willful defaults. Board of Directors are required to review NPA

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accounts of Rs.1 crore and above with special reference to fixing of staff

accountability.

On their part RBI and the Government are contemplating several

supporting measures including legal reforms, some of them I would like to

highlight.

Asset Reconstruction Company:

An Asset Reconstruction Company with an authorised capital of Rs.2000

crore and initial paid up capital Rs.1400 crore is to be set up as a trust for

undertaking activities relating to asset reconstruction. It would negotiate with

banks and financial institutions for acquiring distressed assets and develop

markets for such assets. Government of India proposes to go in for legal reforms

to facilitate the functioning of ARC mechanism

Corporate Debt Restructuring (CDR)

Corporate Debt Restructuring mechanism has been institutionalised in

2001 to provide a timely and transparent system for restructuring of the corporate

debts of Rs.20 crore and above with the banks and financial institutions. The

CDR process would also enable viable corporate entities to restructure their dues

outside the existing legal Framework and reduce the incidence of fresh NPAs.

The CDR structure has been headquartered in IDBI, Mumbai and a Standing

Forum and Core Group for administering the mechanism had already been put in

place. The experiment however has not taken off at the desired pace though

more than six months have lapsed since introduction. As announced by the

Hon'ble Finance Minister in the Union Budget 2002-03, RBI has set up a high

level Group under the Chairmanship of Shri. Vepa Kamesam, Deputy Governor,

RBI to review the implementation procedures of CDR mechanism and to make itmore effective. The Group will review the operation of the CDR Scheme, identify

the operational difficulties, if any, in the smooth implementation of the scheme

and suggest measures to make the operation of the scheme more efficient.

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Credit Information Bureau

Institutionalisation of information sharing arrangements through the newly

formed Credit Information Bureau of India Ltd. (CIBIL) is under way. RBI is

considering the recommendations of the S.R.Iyer Group (Chairman of CIBIL) to

operationalise the scheme of information dissemination on defaults to the

financial system. The main recommendations of the Group include dissemination

of information relating to suit-filed accounts regardless of the amount claimed in

the suit or amount of credit granted by a credit institution as also such irregular

accounts where the borrower has given consent for disclosure. This, I hope,

would prevent those who take advantage of lack of system of information sharing

amongst lending institutions to borrow large amounts against same assets and

property, which had in no small measure contributed to the incremental NPAs of

banks.

Proposed guidelines on willful defaults/diversion of funds

RBI is examining the recommendation of Kohli Group on willful defaulters.

It is working out a proper definition covering such classes of defaulters so that

credit denials to this group of borrowers can be made effective and criminal

prosecution can be made demonstrative against willful defaulters.

Corporate Governance

A Consultative Group under the chairmanship of Dr.A.Ganguly was set up

by the Reserve Bank to review the supervisory role of Boards of banks and

financial institutions and to obtain feedback on the functioning of the Boards vis-

-vis compliance, transparency, disclosures, audit committees etc. and make

recommendations for making the role of Board of Directors more effective with a

view to minimising risks and over-exposure. The Group is finalising itsrecommendations shortly and may come out with guidelines for effective control

and supervision by bank boards over credit management and NPA prevention

measures.

OTHER MEASURES TO CURB NPA:

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Banks need to have better credit appraisal so as to prevent NPAs from

occurring. However once NPAs do come into existence, the problem can be

solved only if there is enabling legal structure, since recovery of NPAs often

requires litigation and court orders to recover stuck loans. With long-winded

litigation in India, debt recovery takes a very long time. But according to the new

union budget of 2001-02 this problem will soon cease to exist

Banks will get the teeth to salvage their stucky loans. Bad loans, which

have dropped from 14 percent of total assets to 7.4 in the past decade, may now

come down to the internationally accepted 5 percent level if the proposed

foreclosure laws are enacted. Besides bankers said the decision to form seven

more debt recovery tribunals will improve loan recovery. The proposed repeal of

the sick industrial companies act will also prevent defaulting companies form

taking refuge in the board for industrial and financial reconstruction.

The setting up of additional tribunals, repealing of SICA and amendment

of foreclosure norms will go a long way in helping banks recover non performing

assets said Janki Ballabh, chairman SBI. Under the current system, banks have

to file a suit and obtain a court decree to attach the property that is mortgagedwith them. The new foreclosure norms will allow lenders to directly take

possession of property by giving a notice; said P S Shenoy, chairman Bank of

Baroda.

According to bankers, bad loans are one of the reasons why banks have

not been in a position to bring down lending rates further. With an average of

over 7 percent of total amount lent not coming back, banks have to build in the

cost of such delinquencies into their lending rates.

Although the Finance Minister has not announced any specific measures

for the three weak banks, the new foreclosure norms if implemented will go a

long way in getting the weak banks back on track.

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The BIFR was constituted with the intention of providing an opportunity to

sick companies to get back on the rails by keeping lenders at the bay until they

restructured their operations. Corporate have, however been misusing these

provisions by making an application to the BIFR as soon as banks sent them

notices to recover the loans.

Banks are now working on developing debt recovery tribunals to solve this

problem. The government has also mooted the suggestion of an asset

reconstruction company, which will be a specialized agency set up for

rehabilitating revival NPAs and recovering funds out of unrevivable NPAs

Experts have also suggested the concept of narrow banking, where only

strong and efficient banks will be allowed to give commercial loans, while the

weak banks will take positions in less risky assets such as government securities

and inter bank lending. One way of curbing NPA is a massive one-time write off

bad loans in its balance sheet. This could be aimed at bringing down the net non

performing assets closer to the targeted 5 percent from the present level of

around 7 percent of net advances.

A classic example could be that of ICICI which have written off its bad loan

in its balance sheet for the year 2000-01

ICICI net NPAs outstanding as on 31.12.2000 were Rs.4215 crore. The

ratio of net NPA to net advances declined to 7.2 percent as on 31.12.2000 from

7.6 as on 31.3.2000. Bringing down the NPA below 5 percent will help the

institution obtain a clearance from the reserve bank of India for setting up a non-

life insurance subsidiary.

Bringing the NPAs down to 5 percent in one stroke will require

provisioning of over Rs.1000 crore, going by the last figure. Last year (99-00)

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ICICI had made enhanced provisions and write offs of Rs.690 crore (Rs.478

crore in 98-99) and had earned a profit after tax of Rs. 1206 crore.

RBI had earlier said that non-banking finance companies would need to

contain their NPAs at below 5 percent to be eligible to promote insurance

companies.

Resolution of NPAs in the Asian Context

To understand better the way that can be used to resolve the issue of

NPAs, case study of KOREA have been described below which show as to how

this nation have tackled the issue through the setting up of Asset Management

Companies.

Korea

In resolving NPA problems, the Korean government relied on a centralized

AMC approach. The government had in 1997, assigned the role of purchase of

bad loans to the Korea Asset Management Corporation (KAMCO). Also bank-based AMCs were created for the sale of bad loans of two major banks. KAMCO

was established in 1996 for the foreclosure and sale of assets attached to for tax

arrears, the liquidation of corporations and the NPA Fund, KAMCOs role was

expanded to include the purchase of NPAs to assist in the rehabilitation of the

financial sector. KAMCO became a bad bank and a non-performing asset fund

was created to finance the purchase of NPAs. The government of Korea, Korea

Development Bank and 24 banks are joint shareholders of KAMCO. Most of its

funds come from bonds, which are issued for a period of 3 years and yield a

quarterly interest applicable to the Korean Development Bank. The balance

comes from the central bank, financial institutions and Korea Development Bank.

The main goal of the KAMCO was to speedily dispose off NPAs to better the

liquidity and soundness of the financial institutions, and this is to be

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accomplished by 2003. To begin with, KAMCO paid for the bad loans partly in

cash and partly in bonds but from 1998 onwards it was done through KAMCO

bonds (Cooke & Foley, 2000). In the past, KAMCO had purchased NPAs from

financial institutions in batches at fixed amounts up front, based on the expected

recovery value of the portfolio. KAMCO had then engaged in due diligence

process on each NPA, adjusted the initial price and then resettled depending on

the nature of each loan and asset. In September 1998, there was a change in the

acquisition method to a fixed purchase rate. KAMCO purchases were exempt

from acquisition and registration fees but this did not carry forward for

subsequent purchasers of the assets from the investor.

KAMCO had planned recoveries though asset-backed securitization

schemes or outright sales or workout schemes. In a December 1998 auction,

Texas based Lone Star Fund purchased W 565 bn for W201 bn (a 64% discount)

from KAMCO. KAMCO had acquired the debts collateralized by 1500 houses,

buildings and factories from financial institutions for W204 bn. This was

KAMCOs first sale of assets using an international securitization vehicle under

Koreas asset backed securities law. KAMCOs strategies for recovery were debt

restructuring (partial debt forgiveness, amended terms and debt-equity swaps),

outright sales (loans sold individually or packaged in portfolios and offered toinvestors), asset-backed and equity partnerships securities. These assets were

transferred to a SPV trust, which in turn issued debentures and bonds to be sold

to institutional investors. KAMCO also went in for foreclosure auctions where

they could dispose off the assets through court auctions and asset restructuring.

KAMCO had issued CLOs and MBSs using the assets bought from banks and

properties obtained through exercising collateral rights. These CLOs were

guaranteed by KAMCO and carried a put option to sell the loan assets back to

the banks in case the loan fell into default.

The use of securitization to resolve NPAs

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In recent times, securitization has been used by banks and AMCs to

dispose off their NPAs. The securitization market has hence, assumed a role of

specific importance in the context of NPAs (Kendall, 1996). Asset securitization is

the conversion of assets or cash flows into securities, which are typically rated

and called Asset-Backed securities (ABS). This has become popular for the

disposal of NPAs as it brings with it benefits to both the issuer and investor. For

issuers, it offers cheaper and more efficient funding for operations combined with

greater balance sheet flexibility. For investors, securitization provides a broad

selection of fixed income investment alternatives, most with higher credit ratings,

higher yields, less downgrade risk than corporate bonds and more stable and

predictable cash flows than other fixed income securities. Variants that have

been introduced include Mortgage backed securities (MBS) and Collateralized

bond and loan obligations (CBOs and CLOs). A CBO is an asset-backed security

supported by an underlying portfolio of high yield bonds (Albulescu). They are set

up to capture the arbitrage sometimes available from the yield differential

between the high yield and investment grade debt markets. They are created by

issuing multiple debt tranches to investors to finance the purchase of the

underlying portfolio. The most senior tranche receives investment grade status

by virtue of priority call on the cash flows from the high yield debt portfolio. The

other tranches have junior priority rights to this cash flow. The most juniortranche is considered equity, which receives income after all the income spread

after commitments to the senior tranches and expenses are met. This process

can be used in the disposition of NPAs where the asset can be sold in this

manner such that the claims on the cash flows would follow a pre-determined

pattern.

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SECURITISATION ACT

All the measures mentioned before have been able to help banks recover

a small fraction of their NPAs. But slippages of advances from the performing to

the non-performing category has outstripped the recoveries of NPAs, as such,

the problem kept on aggravating year after year and reached such a level that

government was left with no option except to take drastic measures and

promulgate the Securitization and Reconstruction of Financial Assets and

Enforcement of Security Interest Ordinance in June 2002 and repromulgation

thereof again in August 2002. This Ordinance was later replaced by the

Securitization Act in December 2002.

Securitization Act is a fine, comprehensive and an extraordinary piece of

legislation. It is a giant leap forward in the realm of financial sector reforms. It is a

most reassuring sign of government's commitment to reforms. It fully addresses

all concerns with regard to lenders' interests and all attendant legal aspects. This

Act is revolutionary in the Indian context, as it gives sweeping powers to banks

and financial institutions to seize the assets charged to them without intervention

of courts and sells them off to realize their loans, which have become NPAs. The

Act provides a framework for securitization of stressed assets. It provides a

window to banks and financial institutions to deal with illiquid assets andstrengthens their right of foreclosure and enforcement of securities.

Salient features of Securitization act

The secured creditor has been vested with two options under the Act. It

can either transfer the Security Interest to a Securitization or a Reconstruction

Company or enforce the provisions of the Act on its own, without the intervention

of the court. As per Section 35, the provisions of this Act override all other laws

for the time being in force notwithstanding anything inconsistent therewith

contained therein. Further as per Section 37, the provisions of this Act or the

rules made thereunder are in addition to and not in derogation of the Companies

Act, 1956, Securities Contract (Regulation) Act, 1956, the SEBI Act, 1992 (15 of

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1992) and Recovery of Debts due to Banks and Financial Institutions, Act, 1993

(51 of 1993) or any other law for the time being in force.

i.) The Secured Creditor, may require the borrower (whose debt has been

classified as NPA by the Secured Creditor), by notice in writing to discharge his

liabilities in full within 60 days from the date of the notice, failing which the

Secured Creditor can exercise all or any of the following rights under sub-section

13(4) to recover his Secured Debt.

a. Take possession of Secured Assets of the borrower including right to transfer

by way of lease, assignment or sale for realizing the Secured Assets.

b. Takeover the management of the Secured Assets of the Borrower including

right to transfer by way of lease, assignment or sale for realizing the Secured

Assets.

c. Appoint any person as Manager to manage the Secured Assets, the

possession of which has been taken over by the Secured Creditor.

d. Require any person, who has acquired any of the Secured Asset from the

Borrower from whom any money is due and payable to Borrower, to pay the

same to the Secured Creditor, as is sufficient to repay the secured debt.

ii.) In case a Financial Asset has been jointly financed by more than one secured

Creditors, under Consortium or Multiple Banking Arrangement, no Secured

Creditor will be entitled to any or all of the above-said rights conferred on him u/s

13(4) of the Act, unless it is agreed upon by the Secured Creditors representing

not less than 3/4th in value of the amount outstanding as on record date and such

actions will be binding on all Secured Creditors.

iii.) Where dues of the Secured Creditor, are not fully satisfied, with the saleproceeds of the Secured Assets, the Secured Creditor can file an application with

the Debt Recovery Tribunal having jurisdiction or a competent Court of Law for

recovery of the balance amount from the Borrower.

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iv.) Secured Creditor(s) can proceed against the guarantor(s) or sell the pledged

Assets without first taking any of the measures specified in clause (a) to (d) of

sub-section 13(4) in relation to the Secured Assets, under the Act.

v.) Secured Creditors can take over the management of the business of the

defaulting Borrowers and appoint Directors where the Borrower(s) is a company

or Administrator of the business in any other case, by publishing a Notice in

newspaper in English and any other Indian language of the area, in which

principal office of the borrower is situated.

vi.) Once a Notice preparatory to repossession is received, the borrower cannot

alienate the Secured Asset(s) in question.

vii.) Banks can package and sell Loans via Securitization. Loans can be traded

among Banks, like Bonds or Shares.

viii.) Transactions to which the Act is not applicable.

The provision of the Act shall not, inter alia, apply to

a. Any Security Interest created in the Agricultural Land.

b. Any Debt where the amount due is less than 20% of the Principal amount and

Interest thereon.

c. Any Security Interest for securing repayment of any financial asset not

exceeding Rs. 1 lakh.

d. Pledge of Movable assets within the meaning of section 172 of Indian Contract

Act 1872.

e. Any conditional sale, hire purchase or lease or any other contract in which no

Security Interest has been created.

ix.) Right of Appeal though flat powers have been conferred on the Secured

Creditors (Banks and Financial Institutions) for taking possession of assets, right

to appeal is also given to the borrowers against the steps like possession of

assets taken by the banks. The aggrieved borrower can file appeal u/s 17 before

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the DRT within 45 days from the date of initiation of steps, though 75% of the

amount stated in Notice or such lower amount as DRT may direct, is required to

be deposited with the DRT concerned. Similar right of appeal before DRAT within

30 days is given u/s 18 to any person aggrieved by the order of the DRT. Thus

the Act restricts frivolous or dilatory appeals. The Act ousts the jurisdiction of the

Civil Courts and mandates that no Injunction shall be granted in respect of any

exercise of rights conferred by or under this Act.

Action taken by banks

Banks and financial institutions have already started taking action under

this Act swiftly. Notices have since been flashed to thousands of borrowers

involving several thousand crores of NPAs. Borrowers, who never responded to

the calls of the banks earlier and have been playing hide and seek game with

them, have now seen the writing on the wall and have started responding

positively. They are coming forward to settle their dues with banks. Settlements

are being reached as per RBI norms and banks' own recovery management

policies. Cash recoveries have started pouring in. Where the borrowers have not

responded to the 60-day notices, the banks have tightened the noose and have

started procuring Seizure Orders from District Magistrates (DMs) or Chief

Metropolitan Magistrates (CMMs). Secured Assets have since been seized inseveral cases, which has compelled even hard-core defaulters to pay their dues.

Never before the banks have received such an overwhelming response to any

recovery measure taken by them earlier. Print media too is playing its part in

building up the euphoria by giving wide publicity to the steps taken/being taken

by banks. Despite initial hiccups, recovery of NPAs is gathering momentum.

A dream act for banks and financial institutions

In my view, it is a dream Act for banks and financial institutions. It can

bring cataclysmic change in the financial sector. Borrowers will no longer be able

to take banks lightly and simply walk away with precious funds of the public. The

threat of taking over of the collateral assets and enforcement of loan covenants

has already begun to show positive results. So far NPA recoveries are estimated

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to be in the region of 20%. During next 3-4 years, the banks hope to recover 50

to 60% of NPAs through such tough measures. Recovery of NPAs will

substantially bring down weighted average cost of working funds. It will pave the

way for lower lending rates and better bottom lines.

This Act is an essential prerequisite for smooth operations. Banks have

got a shot in the arm with this Act. This Act has created the much needed

recovery climate. This has given major fillip to the banks to deal with defaulters

and reduce their NPAs. It has instilled a sense of urgency in borrowers to settle

their dues. This Act will not only help in improving the financial health of the

country, but also our moral fiber as a society by enforcing the sanctity of the

contracts. Indian economy has suffered immensely from the lack of legal

machinery for contract enforcement and strong lenders' rights. Successful

implementation of the Act will free massive misallocated resources, bring back

into circulation the same funds that have been locked up in sick assets. They will

simultaneously relieve the pressure for fresh investments and create an overall

multiplier effect that would boost employment, industrial activity and asset build

up, apart from more efficient use of new capital and loss of rent seeking. Banks

got to declare total war on the NPAs as it warrants action, on a war-footing basis.

Reality bites

The scope of the Act is limited. The provisions of the Act do not cover small loans

up to Rs. 1,00,000 and the unsecured loans. Security interest of the banks in

agricultural lands is also not covered. The secured loans are estimated to be just

30-35% of total NPAs of the banking industry.

There are several limitations, weaknesses and shortcomings in the Act. Thefollowing issues need to be addressed at the earliest:

1. Issues with regard to Stamp Duty chargeable for transfer of assets from

the originators to Asset Reconstruction Company (ARC), has not been

addressed in the Act. The Stamp Duty is a state subject; it would require

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initiatives from the respective state governments. As a matter of fact,

these banking assets should be exempted from the levy of Stamp Duty.

2. The issue of pricing or fixing a realizable value on the assets is another

question not addressed in the Act so far.

3. Who will pay statutory dues like overdue sales tax, excise duty, income

tax, electricity charges and other local tax arrears after the management

takeover option is exercised by the Secured Creditor. Legal position in this

regard need to be defined very clearly.

4. The appointment of a manager for the management of the acquired

assets, in consultation with the borrowers, whose assets have been

seized by the banks, seems to be an utopian idea.

5. The Act provides for appeal and for appeal over appeal, again a lengthy

judicial process that may delay execution proceedings.

6. In case of gone concerns i.e., concerns which have been closed down, the

banks will have to go through the same rigmarole for disposal of security

in possession of an official liquidator.

7. The Act provides for concurrence of Secured Creditors representing three-

fourths in value of the amount outstanding where there are more than one

Secured Creditors. This concurrence especially in cases of going

concerns may not come through.

8. It is not clear whether the banks can use powers conferred under the Act

to enforce the Security Interest simultaneously in cases pending with BIFR

and or DRT or the Doctrine of Election will come to play.

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9. Section 13(4) provides for management of Secured Assets only. Where a

company has hundreds of assets, the management of isolated assets is

how far feasible is difficult to decide and the Act is silent on this point.

10.In law, one cannot do indirectly what is prohibited directly. In case of saleof seized assets, the seller and the beneficiary will be the same. The sale

of Secured Assets by banks at value enough to cover their dues would be

adequately self-serving, but may appear to be unfair to the stakeholders.

11.In case of management control over the business of the defaulter(s), the

Secured Creditor will have effective control over unsecured assets of the

borrower as well, which contravenes the stipulated intent of the Act.

12.It will be difficult for banks to sell distressed assets, as there will be few

takers for such assets. The corporate(s) may gang up to prevent sale of

assets by banks. Auctions may turn out to be farce.

13.The Act empowers the banks to takeover the management of defaulting

companies. Banks are not business tycoons, or jacks of all trades who can

run any business activity with guaranteed success. Banks are not even

custodians or merchants of commodities.

14.The Act does not address the problem of lack of infrastructure and

practical problems involved in sale of distressed assets.

15.In case of certain specific industries where an industrial license, specific

government approval or permission or special rights like mining lease etc.,

is issued in the name of the borrowing company, will such

license/approval/permission be automatically transferred to the name of

buyer/bank/concerned or not?

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16.Will intangible assets like patents, brands, goodwill be deemed to be

automatically transferred to the banks/buyers and defaulter won't have any

right, title, or interest in such assets, once he has been divested of the

secured assets charged to the bank.

17.The reason(s) behind exempting borrowers u/s 31 of the Act from the

application of the Act, when amount due is less than 20% of principal and

interest due thereon, is not understandable.

18.Valuation of assets and bidding process can trigger legal cases. There

can be lack of unanimity among lenders also, as all lenders holding at

least 75% stake in outstanding dues are required to agree to sell the

assets of defaulters.

19.Borrowers might prefer objection on several issues before magistrates

authorized to issue Seizer Orders and can transform into a potential

enquiry into nature of Secured Assets, proper status, nature of liability and

so on and so forth.

20.Lenders are vulnerable to prosecution by compliance authorities on many

issues, despite the indemnity given under the Act to persons exercising

the rights of Secured Creditors.

21.The Act provides for creating a Central Registry to record the particulars of

transactions related to Securitization and Reconstruction of Financial

Assets and Creation of Security Interest including electronic record of the

same. It has not been clarified whether this registration would exempt

ARCs and securitization companies from filing particulars with the State

Registry simultaneously.

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22.Last, but not the least, the extent to which a Secured Creditor can proceed

against a third party acquirer of Secured Assets from the borrower has not

been adequately addressed in the Act. It may open a Pandora's box of

Legal proceedings with third parties for the Secured Creditors.

With the enactment of this landmark Act, though a giant leap forward has

been taken, yet there is a long way to go. NPAs are not a one-time phenomena.

It is a continuous process. Until the root cause of NPAs is eliminated, they will

continue to generate with a vengeance. It is important to know the extent of

malady and the question of how large a hole has been created in our Indian

financial system by the NPAs? With the euphoria and the media hype that has

been created, it may appear that banks are having a party time, as they have got

the so called sweeping powers to rein in the recalcitrant borrowers. The Act is not

a financial TADA. It is a tool and not a weapon in the hands of the banks to shoot

the defaulters. It is an enabling provision, an extra right, which will be used by

banks very sparingly, as a last resort to nail the hardcore defaulters only.

Bankers have never been and they will never be capricious. They have always

been considerate and will remain so in future as well. Much of the initial delight

expressed by banks on the positives of the Ordinance is nothing, but a good old

br

Documents

Npa in Banks-punit Ganatra Pg-fin