1

ON
MANAGEMENT OF NON PERFORMING ASSETS
IN BANKS
SUBMITTED UNDER PARTIAL FULFILLMENT FOR THE
AWARD OF POST GRADUATE DIPLOMA IN BUSINESS
MANAGEMENT (2006-08)

VARANASI

SUBMITTED TO: SUBMITTED BY:

Miss NUPUR MISHRA PRATEEK SINGH
(LECTURER) PGDBM-IVTHSEM
M/12/121
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CANDIDATE DECLARATION FORM

I hereby declare that the dissertation Report entitled “MANAGEMENT OF NON

PERFORMING ASSETS IN BANKS” submitted by me in partial fulfillment of the

requirements for the PGDM, is my original work and that its has not been
previously formed for the basis for the award of any other Degree, Diploma,
Fellowship or any other similar titles.

Place: - …………... PRATEEK SINGH

Date: - …………... M/12/121

PREFACE
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My topic of Dissertation is “Management of Non Performing Assets in Banks”.

The purpose of this report is explain, how banks manages the Non-
Performing Assets and how these assets are treated in their account books. This
report is considered to research on the Non Performing Assets in Banking System.
It mainly defines the concept of Non Performing Assets, difficulties arising with
NPAs, reasons for turning an asset in NPAs, trend in NPAs, its impact and key
structural changes.
This report is an immense work which has been prepared to
translate the theoretical knowledge of the topic in to the practical field work. This
project is carried out in the domical fulfillment of the PGDBM course of SCHOOL
OF MANAGEMENT SCIENCES, VARANASI.

PRATEEK SINGH
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ACKNOWLEDGEMENT

Project work is a combined effort so one should thank all those people who are
involved in making this report purposeful. It is great opportunity for me to express
my sincere regards to all those without whom this report would have ever came
into existence. I am greatly thankful to Prof. MUKUND LAL Sir, Director
General, School of Management Sciences for providing us every opportunity to
bring up our talent. I am also thankful to Mr. AJAY YADAV coordinator of
PGDM for his immense guidance and help in completion of my Dissertation.
I am highly thankful to Miss NUPUR MISHRA (Lecturer) who is my mentor
for providing me guidance and full support and helping me in selecting the topic
and solving my queries faced by me at the time of survey. I also like to thank my
faculty, library members for their kind support. I would also like to thank all my
friends who helped me in the making of this report a meaningful one.

PRATEEK SINGH
M/12/121

TABLE OF CONTENTS
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S.NO. TOPIC PAGE NO.

1. ABSTRACT 7
2. OBJECTIVE 10
3. RESEARCH METHODOLOGY 12
4. INTRODUCTION
• What is NPA
• Basel norm I 14-20
• Evolution of NPAs

5 LITERATURE REVIEW
• Banking theory –history and banking system
22-47
• Banking composition
• Banking today and tomorrow
6. COCEPTUAL ANALYSIS
• Indian banking system
• The problem of non performing assets 49-68
• Reasons for turning an asset in NPA
• Trend in NPAs
7. FINDINGS AND CONCLUSIONS
• Impact of NPAs 70-77
• Difficulties with NPA
• Key structural changes
• Reporting format of NPA

8. RECOMMENDATION 79-81

9. LIMITAIONS 83

10. BIBLIOGRAPHY 85
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ABSTRACT
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ABSTRACT

This report deals with the problem of having non-performing assets, the reasons for mounting of
non-performing assets and the practices present in country for dealing with non-performing
assets.
“Banks are in the business of managing risk, not avoiding
it……………………..”
Risk is the fundamental element that drives financial behaviour. Without risk, the financial
system would be vastly simplified. However, risk is omnipresent in the real world. Financial
Institutions, therefore, should manage the risk efficiently to survive in this highly uncertain
world. The future of banking will undoubtedly rest on risk management dynamics.
Only those banks that have efficient risk management system will survive in the market in the
long run. The effective management of credit risk is a critical component of comprehensive risk
management essential for long-term success of a banking institution. Credit risk is the oldest and
biggest risk that bank, by virtue of its very nature of business, inherits. This has however,
acquired a greater significance in the recent past for various reasons. Foremost among them is
the wind of economic liberalization that is blowing across the globe. India is no exception to this
swing towards market driven economy. Better credit portfolio diversification enhances the
prospects of the reduced concentration credit risk as empirically evidenced by direct relationship
between concentration credit risk profile and NPAs of banks.

“……………………A bank’s success lies in its ability to assume and aggregate

risk within tolerable and manageable limits”.

Financial sector reform in India has progressed rapidly on aspects like interest rate deregulation,
reduction in reserve requirements, barriers to entry, prudential norms and risk-based supervision.
But progress on the structural-institutional aspects has been much slower and is a cause for
concern. The sheltering of weak institutions while liberalizing operational rules of the game is
making implementation of operational changes difficult and ineffective. Changes required to
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tackle the NPA problem would have to span the entire gamut of judiciary, polity and the
bureaucracy to be truly effective.

The future of Indian Banking represents a unique mixture of unlimited opportunities amidst
insurmountable challenges. On the one hand we see the scenario represented by the rapid process
of globalisation presently taking shape bringing the community of nations in the world together,
transcending geographical boundaries, in the sphere of trade and commerce, and even
employment opportunities of individuals. All these indicate newly emerging opportunities for
Indian Banking. But on the darker side we see the accumulated morass, brought out by three
decades of controlled and regimented management of the banks in the past. It has siphoned
profitability of the Government owned banks, accumulated bloated NPA and threatens Capital
Adequacy of the Banks and their continued stability. Nationalised banks are heavily over-staffed.
The recruitment, training, placement and promotion policies of the banks leave much to be
desired. In the nutshell the problem is how to shed the legacies of the past and adapt to the
demands of the new age.
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OBJECTIVE

OBJECTIVE
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 To explain the meaning of Non Performing Assets in banks.

 To study the Evolution of NPAs.

 To explain the concept of banking theory and banking system.

 To analyze the concepts of:-
 Indian banking system
 The problem of non performing assets
 Reasons for turning an asset in NPA
 Trend in NPAs

 To explain the impact of NPAs

 To point out the difficulties with NPAs & its key structural changes.
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RESEARCH
METHODOLOGY
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RESEARCH METHODOLOGY

RESEARCH PROBLEM: Management of Non Performing

Assets in Banks.

RESEARCH TYPE: Descriptive Research.

DATA COLLECTION
INSTRUMENTS: Books, Articles & Internet.
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INTRODUCTION

INTRODUCTION
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Banking sector reforms in India has progressed promptly on aspects like interest rate
deregulation, reduction in statutory reserve requirements, prudential norms for interest rates,
asset classification, income recognition and provisioning. But it could not match the pace with
which it was expected to do. The accomplishment of these norms at the execution stages without
restructuring the banking sector as such is creating havoc

During pre-nationalization period and after independence, the banking sector remained in private
hands Large industries who had their control in the management of the banks were utilizing
major portion of financial resources of the banking system and as a result low priority was
accorded to priority sectors. Government of India nationalized the banks to make them as an
instrument of economic and social change and the mandate given to the banks was to expand
their networks in rural areas and to give loans to priority sectors such as small scale industries,
self-employed groups, agriculture and schemes involving women.

To a certain extent the banking sector has achieved this mandate. Lead Bank Scheme enabled the
banking system to expand its network in a planned way and make available banking series to the
large number of population and touch every strata of society by extending credit to their
productive endeavours. This is evident from the fact that population per office of commercial
bank has come down from 66,000 in the year 1969 to 11,000 in 2004. Similarly, share of
advances of public sector banks to priority sector increased form 14.6% in 1969 to 44% of the
net bank credit. The number of deposit accounts of the banking system increased from over 3
crores in 1969 to over 30 crores. Borrowed accounts increased from 2.50 lakhs to over 2.68
crores.

Non-performing assets, also called non-performing loans, are loans on which repayments or
interest payments are not being made on time.

A loan is an asset for a bank as the interest payments and the repayment of the principal create a
stream of cash flows. It is from the interest payments than a bank makes its profits.

Banks usually treat assets as non-performing if they are not serviced for some time. If payments
are late for a short time a loan is classified as past due. Once a payment becomes really late
(usually 90 days) the loan classified as non-performing.
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A high level of non-performing assets compared to similar lenders may be a sign of problems, as
may a sudden increase. However this needs to be looked at in the context of the type of lending
being done. Some banks lend to higher risk customers than others and therefore tend to have a
higher proportion of non-performing debt, but will make up for this by charging borrowers
higher interest rates, increasing spreads. A mortgage lender will almost certainly have lower non
performing assets than a credit card specialist, but the latter will have higher spreads and may
well make a bigger profit on the same assets, even if it eventually has to write off the non-
performing loans.

Non Performing Asset means an asset or account of borrower, which has been classified by a
bank or financial institution as sub-standard, doubtful or loss asset, in accordance with the
directions or guidelines relating to asset classification issued by RBI.

An amount due under any credit facility is treated as "past due" when it has not been paid within
30 days from the due date. Due to the improvement in the payment and settlement systems,
recovery climate, upgradations of technology in the banking system, etc., it was decided to
dispense with 'past due' concept, with effect from March 31, 2001. Accordingly, as from that
date, a Non performing asset (NPA) shell be an advance where

i. interest and /or installment of principal remain overdue for a period of more than 180
days in respect of a Term Loan,

ii. the account remains 'out of order' for a period of more than 180 days, in respect of an
overdraft/ cash Credit(OD/CC),

iii. the bill remains overdue for a period of more than 180 days in the case of bills purchased
and discounted,

iv. interest and/ or installment of principal remains overdue for two harvest seasons but for a
period not exceeding two half years in the case of an advance granted for agricultural
purpose, and

v. Any amount to be received remains overdue for a period of more than 180 days in respect
of other accounts.
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With a view to moving towards international best practices and to ensure greater transparency, it
has been decided to adopt the '90 days overdue' norm for identification of NPAs, form the year
ending March 31, 2004. Accordingly, with effect form March 31, 2004, a non-performing asset
(NPA) shell be a loan or an advance where;

i. interest and /or installment of principal remain overdue for a period of more than 90 days
in respect of a Term Loan,

ii. the account remains 'out of order' for a period of more than 90 days, in respect of an
overdraft/ cash Credit(OD/CC),

iii. the bill remains overdue for a period of more than 90 days in the case of bills purchased
and discounted,

iv. interest and/ or installment of principal remains overdue for two harvest seasons but for a
period not exceeding two half years in the case of an advance granted for agricultural
purpose, and

v. Any amount to be received remains overdue for a period of more than 90 days in respect
of other accounts.

Indian banks (particularly nationalised banks) are struggling to come out of the ‘net’ of non-
performing assets. The rising level of non-performing assets (NPAs) amounting to about Rs 600
bn has plagued the Indian banking system. Thus urgent cleaning up of bank balance sheet has
become a crucial issue.

Banks are in the risk business. In the process of providing financial services, they assume various
kinds of risks viz. credit risk, market risk, operational risk, interest risk, forex risk and country
risk. Among these different types of risks, credit constitutes the most dominant asset in the

balance sheet, accounting for about 60% of total assets. The credit risk is generally made up of
transaction risk (default risk) and portfolio risk. The risk management is a complex function and
requires specialized skills and expertise. As a result managing credit risk efficiently assumes
greater significance.
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WHAT IS CALLED NPA?

It is those assets for which interest is overdue for more than 180 days. In simple words, an asset
(or a credit facility) becomes non-performing when it ceases to yield income. As a result, banks
do not recognize interest income on these assets unless it is actually received. If interest amount
is already credited on an accrual basis in the past years, it should be reversed in the current year’s
account if such interest is still remaining uncollected.

Once an asset falls under the NPA category, banks are required by the Reserve Bank of India
(RBI) to make provision for the uncollected interest on these assets. For the purpose they have to
classify their assets based on the strength and on collateral securities into:

 Standard assets: This is not a non-performing asset. It does not carry more than normal
risk attached to the business.

 Substandard assets: It is an asset, which has been classified as non-performing for a

period of less than two years. In this case the current networth of the borrower or the
current market value of the security is not enough to ensure recovery of the debt due to
the bank. The classification of substandard assets should not be upgraded (to standard
assets) merely as a result of rescheduling of the payments. (Rescheduling indicates
change in payment schedule by the borrower or by the banker) There must be a
satisfactory performance for two years after such rescheduling.

 Doubtful assets: It is an asset, which has remained non-performing for a period

exceeding two years.

 Loss assets: It is an asset identified by the bank, auditors or by the RBI inspection as a
loss asset. It is an asset for which no security is available or there is considerable erosion
in the realizable value of the security. (If the realizable value of the security as assessed
by bank, approved valuers or RBI is less than 10% of the outstanding, it is known as
considerable erosion in the value of asset.) As a result even though there may be some
salvage or recovery value, its continuance as bankable asset is not warranted.
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After classifying assets into above categories, banks are required to make provision against these
assets for the interest not collected by them. In terms of exact prudential regulations, the
provisioning norms are as under:

Asset Classification Provision requirements

Standard assets 0.25%
Substandard assets 10%
Doubtful assets 20% - 50% of the secured portion depending on the
age of NPA, and 100% of the unsecured portion.
Loss assets It may be either written off or fully provided by the bank.

The increasing levels of bad quality loans marred the prospects of nationalised banks in the past
few years. As a result banks shifted their focus from the industrial segment to the corporate
lending. This has curtailed the incremental NPAs to a certain extent.

The norms are tightened even for financial institutions (FIs). They are worst affected by the NPA
wave thanks to lending to the commodity and economy sensitive sectors, not to mention that
loans to steel, chemicals and textile sector played a key role in dragging down performance of
FIs. So far they have been enjoying the privilege of recognizing a loan as NPA only if principal
is overdue for more than 365 days and interest is outstanding for over 180 days. With a view to
bring greater transparency, the RBI has proposed to reduce the time limit to 180 days (for
principal). On the one hand imposition of stricter norms could lead to a difficult time for FIs,
permitting them an option of restructuring their loans could give them some leeway.

Apart from this scheme, the government has designed major policy reforms in order to enhance
the efficiency of the banking system. It has decided to set up 7 more debt recovery tribunals
(DRTs) in addition to the existing 22 and 5 appellate tribunals. It has also proposed to bring in
legislation for facilitating foreclosure and enforcement of securities in case of default.
Repealment of SICA (Sick Industrial Companies Act) was another major step. The RBI has
already asked banks to file criminal cases against borrowers who are willful defaulters. These
initiatives are expected to aid banks to quickly recover their dues from the borrowers.

Basel I Norms
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Basel Committee is a committee of central banks and bank supervisors/ regulators from the
major industrialized countries that meets every three months at the Bank for International
Settlements in Basel.
• The Basel Committee consists of senior supervisory representatives from Belgium,
Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland,
United Kingdom and the United States.
• Basel I was an attempt to standardise the regulation governing the global banking
industry.
• It provides broad policy guidelines for banks that each country's supervisors can use to
determine the supervisory policies they apply.
• The proposed New Basel Capital Accord is to be built on three mutually reinforcing
pillars:
o Minimum capital requirements
o Supervisory review process
o Market discipline

EVOLUTION OF NPAs

In the early Nineties PSBs were suffering from acute capital inadequacy and many of them were
depicting negative profitability. This is because the parameters set for their functioning were
deficient and they did not project the paramount need for these corporate goals.
• Incorrect goal perception and identification led them to wrong destination
• Since the 70s, the SCBs of India functioned totally as captive capsule units cut off from
international banking and unable to participate in the structural transformations, the
sweeping changes, and the new type of lending products emerging in the global banking
Institutions.
• The personnel lacked desired training and knowledge resources required to compete with
international players. Such and other chaotic conditions in parts of the Indian Banking
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industry had resulted in the accumulation of assets, which were termed as non-
productive in an unprecedented level
• "Audit and Inspections" remained as functions under the control of the executive
officers, which were not independent and were thus unable to correct the effect of
serious flaws in policies and directions of the higher ups.
• The quantum of credit extended by the PSBs increased by about 160 times in the three
decades after nationalization (from around Rs. 3000 crore in 1970 to Rs. 475113 Crore
in 2004). The Banks were not developed in terms of skills and expertise to regulate such
stupendous growth in the volume and manage the diverse risks that emerged in the
process.
• The need for organizing an effective mechanism to gather and disseminate credit
information amongst the commercial banks was never felt or implemented. The archaic
laws of secrecy of customers-information that was binding Bankers in India, disabled
banks to publish names of defaulters for common knowledge of the other Banks in the
system.
• Lack of effective corporate management
• Credit management on the part of the lenders to the borrowers to secure their genuine
and bonafide interests was not based on pragmatically calculated anticipated cash flows
of the borrower concern, while recovery of installments of Term Loans was not out of
profits and surplus generated but through recourse to the corpus of working capital of the
borrowing concerns. This eventually led to the failure of the project financed leaving idle
assets.
• Functional inefficiency was also caused due to over-staffing, manual processing of over
expanded operations and failure to computerize Banks in India, when elsewhere
throughout the world the system was to switch over to computerization of operations.
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LITERATURE REVIEW

BANKING- THEORY & PRACTICE - HISTORY & EVOLUTION OF

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INDIAN BANKING SYSTEM

"India's banking system has several outstanding achievements to its credit, the most striking of
which is its reach. An extensive banking network has been established in the last thirty years, and
India's banking system is no longer confined to metropolitan cities and large towns: in fact,
Indian banks are now spread out into the remote corners of our country. In terms of the number
of branches, India's banking system is one of the largest, if not the largest in the world today. An
even more significant achievement is the close association of India's banking system with India's
development efforts. The diversification and development of our economy, and the acceleration
of the growth process, are in no small measure due to the active role that banks have played in
financing economic activities in different sectors." [ Dr.Bimal Jalan, Governor RBI in a speech
delivered at the 22nd Bank Economists' Conference, New Delhi,15th February, 2001 ]

WE CAN IDENTIFY THREE DISTINCT PHASES IN THE HISTORY OF INDIAN

BANKING.

1. Early phase from 1786 to 1969

2. Nationalisation of Banks and up to 1991 prior to banking sector Reforms
3. New phase of Indian Banking with the advent of Financial & Banking Sector Reforms
after 1991.

The first phase is from 1786 to 1969, the early phase up to the nationalisation of the fourteen
largest of Indian scheduled banks. It was also the traditional or conservative phase of Indian
Banking. The advent of banking system of India started with the establishment of the first joint
stock bank, The General Bank of India in the year 1786. After this first bank, Bank of Hindustan
and Bengal Bank came to existence. In the mid of 19th century, East India Company established
three banks The Bank of Bengal in 1809, The Bank of Bombay in 1840, and bank of Madras in
1843. These banks were independent units and called Presidency banks. These three banks were
amalgamated in 1920 and a new bank, Imperial Bank of India was established. All these
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Institutions started as private shareholders banks and the shareholders were mostly Europeans.
The Allahabad Bank was established in 1865. The next bank to be set up was the Punjab
National Bank Ltd. which was established with its headquarters at Lahore in 1894 for the first
time exclusively by Indians. Most of the Indian commercial banks, however, owe their origin to
the 20th century. Bank of India, Central Bank of India, Bank of Baroda, the Canara Bank, the
Indian Bank, and the Bank of Mysore were established between 1906 and 1913. The last major
commercial bank to be set up in this phase was the United Commercial Bank in 1943. Earlier the
establishment of Reserve Bank of India in 1935 as the central bank of the country was an
important step in the development of commercial banking in India.

The history of joint stock banking in this first phase was characterised by slow growth and
periodic failures. There were as many as 1100 banks, mostly small banks, failed during the
period from 1913 to 1948. The Government of India concerned by the frequent bank failures in
the country causing miseries to innumerable small depositors and others enacted The Banking
Companies Act, 1949. The title of the Act was changed as "Banking Regulation Act 1949", as
per amending Act of 1965 (Act No.23 of 1965). The Act is the first regulatory step undertaken
by the Government to streamline the functioning and activities of commercial banks in India.
Reserve Bank of India as the Central Banking Authority of the country was vested with
extensive powers for banking supervision. Salient features of the Act are discussed in a separate
page/article

At the time of Independence of the country in 1947, the banking secor in India was relatively
small and extremely weak. The banks were largely confined to urban areas, extending loans
primarily to trading sector dealing with agricultural produce. There were a large number of
commercial banks, but banking services were not available at rural and semi-urban areas. Such
services were not extended to different sectors of the economy like agriculture, small industries,
professionals and self-employed entrepreneurs, artisans, retail traders etc.
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DEFICIENCIES OF INDIAN BANKING SYSTEM BEFORE NATIONALISATION

Commercial banks, as they were privately owned, on regional or sectarian basis resulted in
development of banking on ethnic and provincial basis with parochial outlook. These Institutions
did not play their due role in the planned development of the country. Deposit mobilisation was
slow. Public had less confidence in the banks on account of frequent bank failures. The savings
bank facility provided by the Postal department was viewed a comparatively safer field of
investment of savings by the public. Even the deficient savings thus mobilised by commercial
banks were not channeled for the development of the economy of the country. Funds were
largely given to traders, who hoarded agricultural produce after harvest, creating an artificial
scarcity, to make a good fortune in selling them at a later period, when prices were soaring. The
Reserve Bank of India had to step in at these occasions to introduce selective credit controls on
several commodities to remedy this situation. Such controls were imposed on advances against
Rice, Paddy, Wheat, Other foodgrains (like jowar, millets, ragi etc.) pulses, oilseeds etc.

INITIAL PHASE OF NATIONALISATION

When the country attained independence Indian Banking was exclusively in the private sector. In
addition to the Imperial Bank, there were five big banks each holding public deposits
aggregating Rs.100 Crores and more, viz. the Central Bank of India Ltd., the Punjab National
Bank Ltd., the Bank of India Ltd., the Bank of Baroda Ltd. and the United Commercial Bank
Ltd. Rest of the banks were exclusively regional in character holding deposits of less than Rs.50
Crores.

Government first implemented the exercise of nationalisation of a significant part of the Indian
Banking system in the year 1955, when Imperial Bank of India was Nationalised in that year for
the stated objective of "extension of banking facilities on a large scale, more particularly in the
rural and semi-urban areas, and for diverse other public purposes" to form State Bank of India.
SBI was to act as the principal agent of the RBI and handle banking transactions of the Union &
State Governments throughout India. The step was in fact in furtherance of the objectives of
supporting a powerful rural credit cooperative movement in India and as recommended by the
"The All-India Rural Credit Survey Committee Report, 1954". State Bank of India was obliged
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to open an accepted number of branches within 5 years in unbanked centres. Government
subsidised the bank for opening unremunerative branches in non-urban centres. The seven banks
now forming subsidiaries of SBI were nationalised in the year 1960. This brought one-third of
the banking segment under the direct control of the Government of India.

But the major process of nationalisation was carried out on 19th July 1969, when the then Prime
Minister of India, Mrs.Indira Gandhi announced the nationalisation of 14 major commercial
banks in the country. One more phase of nationalisation was carried out in the year 1980, when
seven more banks were nationalised. This brought 80% of the banking segment in India under
Government ownership. The country entered the second phase, i.e. the phase of Nationalised
Banking with emphasis on Social Banking in 1969/70.

CHRONOLOGY OF SALIENT STEPS BY THE GOVERNMENT AFTER

INDEPENDENCE TO REGULATE BANKING INSTITUTIONS IN THE COUNTRY

1. 1949: Enactment of Banking Regulation Act.

2. 1955(Phase I) : Nationalisation of State Bank of India
3. 1959(Phase II) : Nationalisation of SBI subsidiaries
4. 1961 : Insurance cover extended to deposits
5. 1969(Phase III) : Nationalisation of 14 major banks
6. 1971 : Creation of credit guarantee corporation
7. 1975 : Creation of regional rural banks
8. 1980(Phase IV) : Nationalisation of seven banks with deposits over 200 crores.
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ASSESSMENT OF POSITIVE RESULTS OF THE STEPS TAKEN BY GOVERNMENT
AFTER INDEPENDENCE

The government's banking policy has paid rich dividends over the last three decades in terms of
the objectives set up, after 1969 when 14 major private banks were nationalised.

Apart from the nationalisation process, the other features of the policy include enactment of the
Banking Regulation Act in 1949, and the creation of the first state-owned State Bank of India in
1955. The policy has resulted in the creation of the massive network of the banking structure in
the country. The major chunk of the structure was contributed by the nationalised banks, which
number 27 at present. According to bank economists, during the last 28 years of nationalisation,
the branches of the public sector banks rose 800 per cent from 7,219 to 57,000, with deposits and
advances taking a huge jump by 11,000 per cent and 9,000 per cent to Rs 5,035.96 billion and Rs
2,765.3 billion respectively.(statistics as at 1993)

Contrary to the popular belief, employee productivity has been rising in the nationalised banks
over the period, as per studies conducted by economists. Productivity per employee in respect of
business volume (both deposits and advances) has gone up from Rs 250,000 in 1969 to Rs
4,780,000 in 1993. Accordingly, profits of these banks went up to Rs 30 billion in 1993 as
against Rs 90 million at the time of the nationalisation. These banks also contributed to the
generation of employment. Their staff strength increased by 300 per cent over the period to
900,000. The growth of the banking sector after the nationalisation was unprecedented anywhere
in the world. It is particularly true of branch expansion to every nook and corner of the country.
While there were hardly any branches in the rural areas in 1969, 35,000 bank branches are
operating there at present (1993).

SHORTCOMINGS IN THE FUNCTIONING OF NATIONALISED BANKING

INSTITUTIONS

However Nationalised banks in their enthusiasm for development banking, looking exclusively
to branch opening, deposit accretion and social banking, neglected prudential norms, profitability
criteria, risk-management and building adequate capital as a buffer to counter-balance the ever
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expanding risk-inherent assets held by them. They failed to recognise the emerging non-
performing assets and to build adequate provisions to neutralise the adverse effects of such
assets. Basking in the sunshine of Government ownership that gave to the public implicit faith
and confidence about the sustainability of Government-owned institutions, they failed to collect
before hand whatever is needed for the rainy day. And surfeit blindly indulged is sure to bring
the sick hour. In the early Nineties after two decades of lop-sided policies, these banks paid
heavily for their misdirected performance in place of pragmatic and balanced policies. The
RBI/Government of India has to step in at the crisis-hour to implement remedial steps. Reforms
in the financial and banking sectors and liberal recapitalisation of the ailing and weakened public
sector banks followed. The emphasis shifted to efficient, and prudential banking linked to better
customer care and customer service. The old ideology of social banking was not abandoned, but
the responsibility for development banking is blended with the paramount need for complying
with norms of prudency and efficiency.

COMPOSITION OF INDIAN BANKING SYSTEM

INDIAN BANKING SYSTEM

The banking system has three tiers. These are the scheduled commercial banks; the regional rural
banks which operate in rural areas not covered by the scheduled banks; and the cooperative and
special purpose rural banks.

• SCHEDULED AND NON SCHEDULED BANKS

There are approximately 80 scheduled commercial banks, Indian and foreign; almost 200
regional rural banks; more than 350 central cooperative banks, 20 land development banks; and a
number of primary agricultural credit societies. In terms of business, the public sector banks,
namely the State Bank of India and the nationalized banks, dominate the banking sector.
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India had a fairly well developed commercial banking system in existence at the time of
independence in 1947. The Reserve Bank of India (RBI) was established in 1935. While the RBI
became a state owned institution from January 1, 1949, the Banking Regulation Act was enacted
in 1949 providing a framework for regulation and supervision of commercial banking activity.

The first step towards the nationalisation of commercial banks was the result of a report (under
the aegis of RBI) by the Committee of Direction of All India Rural Credit Survey (1951) which
till today is the locus classic us on the subject. The Committee recommended one strong
integrated state partnered commercial banking institution to stimulate banking development in
general and rural credit in particular. Thus, the Imperial Bank was taken over by the Government
and renamed as the State Bank of India (SBI) on July 1, 1955 with the RBI acquiring overriding
substantial holding of shares. A number of erstwhile banks owned by princely states were made
subsidiaries of SBI in 1959. Thus, the beginning of the Plan era also saw the emergence of public
ownership of one of the most prominent of the commercial banks.

The All-India Rural Credit Survey Committee Report, 1954 recommended an integrated
approach to cooperative credit and emphasised the need for viable credit cooperative societies by
expanding their area of operation, encouraging rural savings and diversifying business. The
Committee also recommended for Government participation in the share capital of the
cooperatives. The report subsequently paved the way for the present structure and composition of
the Cooperative Banks in the country

There was a feeling that though the Indian banking system had made considerable progress in the
'50s and '60s, it established close links between commercial and industry houses, resulting in
cornering of bank credit by these segments to the exclusion of agriculture and small industries.
To meet these concerns, in 1967, the Government introduced the concept of social control in the
banking industry. The scheme of social control was aimed at bringing some changes in the
management and distribution of credit by the commercial banks. The close link between big
business houses and big banks was intended to be snapped or at least made ineffective by the
reconstitution of the Board of Directors to the effect that 51 per cent of the directors were to have
special knowledge or practical experience. Appointment of whole-time Chairman with special
knowledge and practical experience of working of commercial banks or financial or economic or
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business administration was intended to professionalize the top management. Imposition of
restrictions on loans to be granted to the directors' concerns was another step towards avoiding
undesirable flow of credit to the units in which the directors were interested. The scheme also
provided for the take-over of banks under certain circumstances.

Political compulsion then partially attributed to inadequacies of the social control, led to the
Government of India nationalising, in 1969, 14 major scheduled commercial banks which had
deposits above a cut-off size. The objective was to serve better the needs of development of the
economy in conformity with national priorities and objectives. In a somewhat repeat of the same
experience, eleven years after nationalisation, the Government announced the nationalisation of
seven more scheduled commercial banks above the cut-off size. The second round of
nationalisation gave an impression that if a private sector bank grew to the cut-off size it would
be under the threat of nationalisation.

From the fifties a number of exclusively state-owned development financial institutions (DFIs)
were also set up both at the national and state level, with a lone exception of Industrial Credit
and Investment Corporation (ICICI) which had a minority private share holding. The mutual
fund activity was also a virtual monopoly of Government owned institution, viz., the Unit Trust
of India. Refinance institutions in agriculture and industry sectors were also developed, similar in
nature to the DFIs. Insurance, both Life and General, also became state monopolies.

Reform Measures

The major challenge of the reform has been to introduce elements of market incentive as a
dominant factor gradually replacing the administratively coordinated planned actions for
development. Such a paradigm shift has several dimensions, the corporate governance being one
of the important elements. The evolution of corporate governance in banks, particularly, in PSBs,
thus reflects changes in monetary policy, regulatory environment, and structural transformations
and to some extent, on the character of the self-regulatory organizations functioning in the
financial sector. Policy Environment

During the reform period, the policy environment enhanced competition and provided greater
opportunity for exercise of what may be called genuine corporate element in each bank to
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replace the elements of coordinated actions of all entities as a "joint family" to fulfill
predetermined Plan priorities.

Greater competition has been infused in the banking system by permitting entry of private sector
banks (9 licenses since 1993), and liberal licensing of more branches by foreign banks and the
entry of new foreign banks. With the development of a multi-institutional structure in the
financial sector, emphasis is on efficiency through competition irrespective of ownership. Since
non-bank intermediation has increased, banks have had to improve efficiency to ensure survival.

Regulatory Environment

Prudential regulation and supervision have formed a critical component of the financial sector
reform programme since its inception, and India has endeavored to international prudential
norms and practices. These norms have been progressively tightened over the years, particularly
against the backdrop of the Asian crisis. Bank exposures to sensitive sectors such as equity and
real estate have been curtailed. The Banking Regulation Act 1949 prevents connected lending
(i.e. lending by banks to directors or companies in which Directors are interested).

Periodical inspection of banks has been the main instrument of supervision, though recently there
has been a move toward supplementary 'on-site inspections' with 'off-site surveillance'. The
system of 'Annual Financial Inspection' was introduced in 1992, in place of the earlier system of
Annual Financial Review/Financial Inspections. The inspection objectives and procedures, have
been redefined to evaluate the bank's safety and soundness; to appraise the quality of the Board
and management; to ensure compliance with banking laws & regulation; to provide an appraisal
of soundness of the bank's assets; to analyse the financial factors which determine bank's
solvency and to identify areas where corrective action is needed to strengthen the institution and
improve its performance. Inspections based upon the new guidelines have started since 1997.
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Self Regulatory Organizations

India has had the distinction of experimenting with Self Regulatory Organisations (SROs) in the
financial system since the pre-independence days. At present, there are four SROs in the
financial system -

1. Indian Banks Association (IBA),

2. Foreign Exchange Dealers Association of India (FEDAI),
3. Primary Dealers Association of India (PDAI) and
4. Fixed Income Money Market Dealers Association of India (FIMMDAI).
• Indian Banks Association

The IBA established in 1946 as a voluntary association of banks, strove towards strengthening
the banking industry through consensus and co-ordination. Since nationalisation of banks, PSBs
tended to dominate IBA and developed close links with Government and RBI. Often, the reactive
and consensus and coordinated approach bordered on cartelisation. To illustrate, IBA had
worked out a schedule of benchmark service charges for the services rendered by member banks,
which were not mandatory in nature, but were being adopted by all banks. The practice of fixing
rates for services of banks was consistent with a regime of administered interest rates but not
consistent with the principle of competition. Hence, the IBA was directed by the RBI to desist
from working out a schedule of benchmark service charges for the services rendered by member
banks. Responding to the imperatives caused by the changing scenario in the reform era, the IBA
has, over the years, refocused its vision, redefined its role, and modified its operational
modalities.

• Foreign Exchange Dealers Association of India (FEDAI)

In the area of foreign exchange, FEDAI was established in 1958, and banks were required to
abide by terms and conditions prescribed by FEDAI for transacting foreign exchange business.
In the light of reforms, FEDAI has refocused its role by giving up fixing of rates, but plays a
multifarious role covering training of banks' personnel, accounting standards, evolving risk
measurement models like the VAR and accrediting foreign exchange brokers.
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• SROs Regulating Financial Markets

In the financial markets, the two SROs, viz., the PDAI and the FIMMDAI are of recent origin
i.e. 1996 and 1997. These two SROs have been proactive and are closely involved in
contemporary issues relating to development of money and government securities markets. The
representatives of PDAI and FIMMDAI are members of important committees of the RBI, both
on policy and operational issues. To illustrate, the Chairmen of PDAI and FIMMDAI are
members of the Technical Advisory Group on Money and Government Securities market of the
RBI. These two SROs have been very proactive in mounting the technological infrastructure in
the money and Government Securities markets. The FIMMDAI has now taken over the
responsibility of publishing the yield curve in the debt markets. Currently, the FIMMDAI is
working towards development of uniform documentation and accounting principles in the repo
market.

Composition of the Banking System as at the Beginning of New Millennium

At present the numbers of nationalised banks are 20. Several Foreign banks were allowed to
operate as per the guidelines of RBI. At present the banking system can be classified in
following categories:

PUBLIC SECTOR BANKS

• Reserve Bank of India

• State Bank of India and its 7 associate Banks
• Nationalised Banks (20 in number)
• Regional Rural Banks sponsored by Public sector Banks

PRIVATE SECTOR BANKS

• Old Generation Private Banks

• New Generation Private Banks
• Foreign Banks in India
• Scheduled Co-operative Banks
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• Non Scheduled Banks

CO-OPERATIVE SECTOR BANKS

• State Co-operative Banks

• Central Co-operative Banks
• Primary agriculture Credit Societies
• Land Development Banks
• Urban Co-operative Banks
• State Land Development Banks

DEVELOPMENT BANKS

• Industrial Finance Corporation of India (IFCI)

• Industrial Development bank of India (IDBI)
• Industrial Credit & Investment corporation of India (ICICI)
• Industrial Investment Bank of India (IIBI)
• Small Industries Development Bank of India (SIDBI)
• National Bank for Agriculture & Rural Development (NABARD)
• Export-Import Bank of India
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BANKING REGULATION ACT, 1949

The Banking Regulation Act enacted in 1949 provides a framework for regulation and
supervision of commercial banking activity. The provisions of this Act shall be in addition to,
and not, in derogation of the Companies Act, 1956 (1 of 1956), and any other law for the time
being in force. However the provision of the Companies Act applies to only the banks in the
private sector.

Provisions of the Act does not apply to-

a. a primary agricultural credit society;

b. a co-operative land mortgage bank; and
c. Any other co-operative society, except in certain cases.

Definition of Banking Business

‘Banking’ as defined in the Section 5 (b) of the Banking Regulations Act, 1949 is the business of
"Accepting deposits of money from the public for the purpose of lending or investment". These
deposits are repayable on demand or otherwise, and withdrawable by a cheque, draft, order or
otherwise.

The deposits accepted by Banking Company are different from those accepted by Non Banking
Finance Company or any other company in the nature in which these are repayable. Banks are
the only financial institutes which can accept demand deposits (Saving / Current) which can be
withdrawn by a cheque.

Section 6 of Banking Regulations Act, 1949 elaborately specifies the other forms of business
which a banking company may carry in addition to banking as defined in section 5. These
include in a nutshell

• Issuing Demand Drafts & Travellers Cheques

• Collection of Cheques, Bills of exchange
• Discounting and purchase of Bills
• Safe Deposit Lockers
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• Issuing Letters of Credit & Letters of Guarantee
• Sales and Purchase of Foreign Exchange
• Custodial Services
• Investment services
• doing all such other things as are incidental or conducive to the promotion or
advancement of the business of the company;
• Any other form of business which the Central Government may, by notification in the
Official Gazette, specify as a form of business in which it is lawful for a banking
company to engage.

No banking company shall engage in any form of business other than those referred to above

Use of words "bank", "banker", "banking" or "banking company"

No company other than a banking company shall use as part of its name or, in connection with
its business any of the words "bank", "banker" or "banking" and no company shall carry on the
business of banking in India unless it uses as part of its name at least one of such words. No firm,
individual or group of individuals shall, for the purpose of carrying on any business, use as part
of its or his name any of the words "bank", "banking" or "banking company".

However the following bodies are exempted from the above restriction to the extent
specified.

a. a subsidiary of a banking company formed for one or more of the purposes mentioned in
sub-section (1) of section 19, whose name indicates that it is a subsidiary of that banking
company;
b. Any association of banks formed for the protection of their mutual interests and
registered under section 25 of the Companies Act, 1956 (1 of 1956).

Prohibition of Trading
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No banking company shall directly or indirectly deal in the buying or selling or bartering of
goods, except in connection with the realization of security given to or held by it, or engage in
any trade, or buy, sell or barter goods for others otherwise than in connection with bills of
exchange received for collection or negotiation or with such of its business. However this
restriction shall not apply in respect of those functions or any other form of business which the
Central Government may, by notification in the Official Gazette, specify as a form of business in
which it is lawful for a banking company to engage.

Explanation: For the purposes of this section, "goods" means every kind of movable property,
other than actionable claims, stock, shares, money, bullion and specie and all instruments
referred to in clause (a) of sub-section (1) of section 6. The aforesaid clause reads as under:

"drawing, making, accepting, discounting, buying, selling, collecting and dealing in bills of
exchange, hundies, promissory notes, coupons, drafts, bill of lading, railway receipts, warrants,
debentures, certificates, scrips and other instruments, and securities whether transferable or
negotiable or not; the granting and issuing of letters of credit, travellers' Cheques and circular
notes; the buying, selling and dealing in bullion and specie; the buying and selling of foreign
exchange including foreign bank notes; the acquiring, holding, issuing on commission,
underwriting and dealing in stock, funds, shares, debentures, debenture stock, bonds, obligations,
securities and investments of all kinds; the purchasing and selling of bonds, scrips or other forms
of securities on behalf of constituents or others; the negotiating of loan and advances; the
receiving of all kinds of bonds, scrips or valuables on deposit or for safe custody or otherwise;
the providing of safe deposit vaults; the collecting and transmitting of money and securities;"

Disposal of Non-Banking Assets

No banking company shall hold any immovable property howsoever acquired, except such as is
required for its own use, for any period exceeding seven years from the acquisition thereof or
from the commencement of this Act, whichever is later or any extension of such period as in this
section provided, and such property shall be disposed of within such period or extended period,
as the case may be:
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PROVIDED that the banking company may, within the period of seven years as aforesaid, deal
or trade in any such property for the purpose of facilitating the disposal thereof:

PROVIDED FURTHER that the Reserve Bank may in any particular case extend the aforesaid
period of seven years by such period not exceeding five years where it is satisfied that such
extension would be in the interests of the depositors of the banking company.

INDIAN BANKING TODAY & TOMORROW

The future of Indian Banking represents a unique mixture of unlimited opportunities amidst
insurmountable challenges. On the one hand we see the scenario represented by the rapid process
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of globalisation presently taking shape bringing the community of nations in the world together,
transcending geographical boundaries, in the sphere of trade and commerce, and even
employment opportunities of individuals. All these indicate newly emerging opportunities for
Indian Banking. But on the darker side we see the accumulated morass, brought out by three
decades of controlled and regimented management of the banks in the past. It has siphoned
profitability of the Government owned banks, accumulated bloated NPA and threatens Capital
Adequacy of the Banks and their continued stability. Nationalised banks are heavily over-staffed.
The recruitment, training, placement and promotion policies of the banks leave much to be
desired. In the nutshell the problem is how to shed the legacies of the past and adopt to the
demands of the new age.

On the brighter side are the opportunities on account of -

1. The advent of economic reforms, the deregulation and opening of the Indian economy to
the global market, brings opportunities over a vast and unlimited market to business and
industry in our country, which directly brings added opportunities to the banks.
2. The advent of Reforms in the Financial & Banking Sectors (the first phase in the year
1992 to 1995) and the second phase in 1998 heralds a new welcome development to
reshape and reorganise banking institutions to look forward to the future with competence
and confidence. The complete freeing of Nationalised Banks (the major segment) from
administered policies and Government regulation in matters of day to day functioning
heralds a new era of self-governance and a scope for exercise of self initiative for these
banks. There will be no more directed lending, pre-ordered interest rates, or investment
guidelines as per dictates of the Government or RBI. Banks are to be managed by
themselves, as independent corporate organizations, and not as extensions of government
departments.
3. Acceptance of prudential norms with regards to Capital Adequacy, Income Recognition
and Provisioning are welcome measures of self regulation intended to fine-tune growth
and development of the banks. It introduces a new transparency, and the balance sheets of
banks now convey both their strength and weakness. Capital Adequacy and provisioning
norms are intended to provide stability to the Banks and protect them in times of crisis.
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These equally induce a measure of corporate accountability and responsibility for good
management on the part of the banks
4. Large scale switching to hi-tech banking by Indian Scheduled Commercial Banks(SCBs)
through the application of Information Technology and computerization of banking
operations, will revolutionalise customer service. The age-old methods of ‘pen and ink’
systems are over. Banks now will have more employees available for business
development and customer service freed from the needs of book-keeping and for casting
or tallying balances, as it was earlier.

All these welcome changes towards competitive and constructive banking could not however,
deliver quick benefits on account insurmountable carried over problems of the past three
decades. Since the 70s the SCBs of India functioned totally as captive capsule units cut off from
international banking and unable to participate in the structural transformations, the sweeping
changes, and the new type of lending products emerging in the global banking Institutions. Our
banks are over-staffed. The personnel lack training and knowledge resources required to compete
with international players. The prevalence of corruption in public services of which PSBs are an
integral part and the chaotic conditions in parts of the Indian Industry have resulted in the
accumulation of non-productive assets in an unprecedented level. The future of Indian Banking
is dependent on the success of its efforts as to how it shakes off these accumulated past legacies
and carried forward ailments and how it regenerates itself to avail the new vistas of opportunities
to be able to turn Indian Banking to International Standards.

PSBs in India can solve their problems only if they assert a spirit of self-initiative and self-
reliance through developing their in-house expertise. They have to imbibe the banking
philosophy inherent in de-regulation. They are free to choose their respective paths and set their
independent goals and corporate mission. The first need is management upgradation. We have
learnt prudential norms of asset classification and provisioning. More important now, we must
learn prudential norms of asset creation, of credit assessment and credit delivery, of risk
forecasting and de-risking strategies. The habit of looking to RBI and Government of India to
step in and remove the barriers in the way of the Banks should be given a go-bye. NPA is a
problem created by the Banks and they have to find the cause and the solution - how it was
created and how the Banks are to overcome it. Powerful Institutions can be nurtured by strong
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and dynamic management and not by corrupt and weak bureaucrats. These issues are discussed
with frankness and can dour in these pages, under titles listed in the Table of Contents(see Menu
Bar at the top), which provide you a direct access to any or all the topics of your choice.

Public sector ownership need not result in inefficiency and poor customer service. These are not
due to the ills of ownership, but due to failure to accept the correct "Mission" and "Goals" of
management. On the other hand unlike several private sector units, Public sector units have
specific plus points. They do not evade taxes, and do not accumulate unassessed wealth or
unaccounted money. They do not bribe controlling persons to get their way through. They do not
indulge in predatory "take over" of weaker rival units. In fact a public unit never competes
unethically with its rival-units.

Before the Sixties, banks in India were mainly lending to traders in agricultural commodities and
conventional agro-based industries, like textiles, Rice & Oil Mills, Cotton Ginning factories etc.
Indian Bankers actively entered the field of industrial finance from the mid-Sixties, when a
number of industrial projects were promoted as a result of the then ongoing process of
development planning in India. Industry was State controlled and State-protected from foreign
competition through the barrier of high walls of import tariffs. In an age of high inflation with
huge money supply, the demand for goods was always surging. Protection and lack of
competition enabled Industry to face little risks. Thumb rules for financing Term Loans and
Working Capital through memorized norms enabled Bankers to manage credit assessment,
delivery and monitoring, facing no more than normal risks. However after the Eighties the
position underwent a total transformation. The rupee was devalued in the early seventies and
Government had to seek massive assistance from the IMF and World Bank and as per their
prescription economic policies started progressively changing. Government Controls were being
withdrawn gradually. But far-reaching economic reforms were brought about only in the years
1991 and there after. In the year 1990-91 balance of payments position facing the country
became critical and foreign exchange reserves had been depleted to dangerously low levels.
Imports had to be severely curtailed in the course 1990-91 because of shortage of foreign
exchange. Importers were asked to deposit an amount equal to 200% of the L.C value with
Banks in advance to be eligible for getting the L.Cs opened. This affected the availability of
many essential items and also led to distinct slow down of industrial growth.
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The then urgent need of the hour was assessed as under: -

1. To aim at quick revival of the momentum of exports.

2. To create strong incentives to economise on imports, without resorting to proliferation of
licensing controls, which promote delay and inefficiency, generate arbitrariness and stifle
enterprise.
3. There was urgent need to create an environment free from bureaucratic controls in which
our exporters will be able to respond with speed and flexibility to changing international
conditions.
4. To recognise the change that is taking place in the world economy, where countries are
shedding isolation and getting increasingly integrated, and to shape our economic policies
as part of the prevailing global environment.

How Convertibility Was Achieved Through "LERMS"?

LERMS representing Liberalised Exchange Management System was introduced in the year
1992 as part of a package of reforms intended to secure instant and permanent remedies for the
problems ailing the Indian economy at that time. Some of the problems facing the country at that
timer were as under:-

1. The balance of payments position facing the country had become critical and foreign
exchange reserves had depleted to dangerously low levels i.e. $585 million, which was
sufficient for financing just one week of India's exports.
2. Export momentum built during 1986-87 to 1989-90 was lost and exports decelerated to
9% in U.S. Dollars
3. Imports had to be severely curbed in 1990-91 because of shortage of foreign exchange.
This affected the availability of many essential items and also led to a distinct slow down
in industrial growth.
4. Inflation was rocking the country and fiscal deficit was going uncontrolled, resulting
domestic prices unfavourable for export promotion.
5. The system of administered exchange allocations and rate fixation gave rise to parallel
markets in foreign exchange, trade mis-invoicing and capital flights. Persons who
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required foreign exchange were unable to get the same under the regulations in force, but
had recourse to the 'hawala' markets and brought the required foreign exchange at
premium rates
6. Exporters under-invoiced their export earnings and moved away foreign exchange abroad
or repatriated the same at a premium through the hawala route. There was considerable
leakage of accruals in foreign exchange earnings due to NRI remittances being routed
through these markets.
7. The unauthorised market also acted as conduits for financing smuggling operations into
and out of the country. The black market for foreign exchange was supported by the
unofficial gold movements into India.
8. There was urgent need to usher in a policy to end economic isolation of the country,
remove the controlled economic regime, and follow market oriented economic policy to
link India with the global economy

The package of urgent economic reforms not only to put an end to the above problems
facing the country, but could also permanently curbed their further occurrence. This
included the following:

• The Liberalised Exchange Control Management Scheme

• A liberal trade policy for both exports and imports
• Curbing fiscal deficit and government spending and to hold inflation under control

In March 1992 the Government announced the full convertibility of the Rupee in Current
Account. A fully convertible rupee provides full freedom to both residents and non-residents to
trade in goods, services and assets, thereby to integrate the domestic economy into the world
economy. Convertibility on current account along with trade liberalization measures has
enhanced the competitiveness of the domestic tradable and has made the world prices to prevail
in the domestic economy. The rupee convertibility process has been implemented since July
1991, involving several important elements:

• The relaxation of quantitative restrictions on imports by doing away with import quotas
and licensing.
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• The reduction of the level and dispersion of import tariff rates
• The elimination of several export subsidization schemes
• The liberalization of exchange restrictions on capital flows, particularly the inflow in
foreign direct investments and portfolio investments, and
• Introduction of the market-driven exchange rates of the rupee, instead of the administered
system through the mechanism of the basket-peg.

Financial features have registered a significant expansion in recent years with the expansion of
the existing futures market in certain centres, particularly London, Singapore and Amsterdam.
Interest and currency futures not only offer actual hedging facilities but also speculative
opportunities to market participants.

The search for banks for alternate non-funding business and also the means to retain valued
client relationship led to a spurt of off-balance sheet business, mainly in the form of underwritten
new facilities in the initial years and non-underwritten facilities

Similarly the quest, for shorter maturity and more liquid assets to counter balance the effectively
frozen medium and long term assets in the books of the Banks led to the growth of securitised
lending.

Growing deregulation in national financial markets and the revolution in telecommunication and
data processing technologies resulted in the better integration of financial markets in all countries
between the domestic financial system and the foreign Banking and non-banking institutions.

The development of new innovative products in the finance and credit market, though useful to
transfer risks to counter parties or hedge risks, have also increased the vulnerability of the banks
and other financial institutions to the vicissitudes of the market.

The problem of declining business opportunities faced by the Banks was further aggravated on
account of enormous debt servicing problems faced by a good number of developing countries
since 1982. This blocked sizeable assets of major international Banks as Non-productive or non-
performing. Investors reacted by disinvesting in bank equity shares and the Regulatory
authorities of Banks responded to the situation by pressing for adequate provisions for bad and
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non-performing assets and higher capital adequacy requirements. Thus the most conspicuous
change in the International financial market since 1982 has been displacement of direct bank
intermediation through the mechanism of syndicated loans, by a wide range of securities lending

By instinct the Banks attempted to counteract to the situation by searching for non-funding
business. Their efforts to retain valued client relationship led to spurt in their off-balance sheet
business, mainly in the form of underwritten new facilities in the initial years and later on to non-
underwritten facilities The quest for shorter maturity and more liquid assets to counterbalance
the sizeable fall in the medium and long term credit segment with the Bank, led to the growth of
securitised lending.

Overall on account of the changes that had taken place in the medium term credit market, several
major factors affected the Commercial Banks operating at the International level adversely.
These are listed as under:

1. International Debt Problem: The problem faced by developing countries and the
burden it loaded on the banks has already been referred.
2. Globalization of International Banking: Globalization has already resulted far reaching
changes in the Bank profile of the United States and the Banks in Europe are naturally to
follow suit. A number of mergers and other forms of consolidation have transferred
capital and power away from major money center banks towards new, efficient and
profitable regional and super regional banks.
3. Deregulation: The conservative era prohibiting Banks from venture into any other field
other than traditional banking is giving way to a liberalized thinking that banks should be
permitted to sell products hither to barred to them like property and insurance.
4. Securitisation ("Maturity transformation"): This concept has already been discussed
in detail.
5. Emergency of Japanese Banking: With the Dollar losing ground against major
currencies, and the U.S. Banks under severe strain arising mainly out of the debt crisis, it
is now the turn of the Japanese Banks to play an increasing role in the international
business. This is also supported by the growing current account surplus and the high
domestic savings rate of Japan
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6. The Stock Market Crash: With the stock market crash of 1987, banks have become
vulnerable to the decision of depositors regarding the banks.

A major concomitant of the above developments in the international financial markets in general
and the international banking arena in particular is to dramatically alter the conditions in which
banks will have to function. Banks are forced to accept as realities the following

• top-notch borrowers with excellent credit ratings are deserting the banks, and
• The borrowers with excellent credit ratings are tending to fail paying back loans, but also
find ways to attract and earn the capital that banks increasingly need.

THE EMERGENCE OF NPA IN INDIAN BANKING & FINANCIAL INSTITUTIONS

AND ITS DIMENSIONS

Non-performing Asset (NPA) has emerged since over a decade as an alarming threat to the
banking industry in our country sending distressing signals on the sustainability and endurability
of the affected banks. The positive results of the chain of measures effected under banking
reforms by the Government of India and RBI in terms of the two Narasimhan Committee
Reports in this contemporary period have been neutralised by the ill effects of this surging threat.
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Despite various correctional steps administered to solve and end this problem, concrete results
are eluding. It is a sweeping and all pervasive virus confronted universally on banking and
financial institutions. The severity of the problem is however acutely suffered by Nationalised
Banks, followed by the SBI group, and the all India Financial Institutions.

NPA statistics is executed through the following ways.

• Failure to identify an NPA as per stipulated guidelines: There were instances of `sub-
standard' assets being classified as `standard';
• Wrong classification of an NPA: classifying a `loss' asset as a `doubtful' or `sub-standard'
asset; classifying a `doubtful' asset as a `sub-standard' asset.
• Classifying an account of a credit customer as `substandard' and other accounts of the
same credit customer as `standard', throwing prudential norms to the winds.

Essentially arising from the wrong classification of NPAs, there was a variation in the level of
loan loss provisioning actually held by the bank and the level required to be made. This practice
can be logically explained as a desperate attempt on the part of the bankers, whenever adequate
current earnings were not available to meet provisioning obligations. Driven to desperation and
impelled by the desire not to accept defeat, they have chosen to mislead and claim compliance
with the provisioning norms, without actually providing. This only shows that the problem has
swelled to graver dimensions.

The international rating agency Standard & Poor (S & P) conveys the gloomiest picture, while
estimating NPAs of the Indian banking sector between 35% to 70% of its total outstanding
credit. Much of this, up to 35% of the total banking assets, as per the rating agency would be
accounted as NPA if rescheduling and restructuring of loans to make them good assets in the
book are not taken into account. However RBI has contested this dismal assessment. But the fact
remains that the infection if left unchecked will eventually lead to what has been forecast by the
rating agency. This invests an urgency to tackle this virus as a fire fighting exercise.

Emergence of NPA as an Alarming Threat to Nationalised Banks

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7
NPA is a brought forward legacy accumulated over the past three decades, when prudent norms
of banking were forsaken basking by the halo of security provided by government ownership. It
is not wrong to have pursued social goals, but this does not justify relegating banking goals and
fiscal discipline to the background. But despite this extravagance the malaise remained invisible
to the public eyes due to the practice of not following transparent accounting standards, but
keeping the balance sheets opaque. This artificially conveyed picture of 'all is well' with PSBs
suddenly came to an end when the lid was open with the introduction of the prudential norms of
banking in the year 1992-93, bringing total transparency in disclosure norms and 'cleansing' the
balance sheets of commercial banks for the first time in the country.

Consequently PSBs in the post reform period came to be classified under three categories
as -

• healthy banks (those that are currently showing profits and hold no accumulated losses in
their balance sheet)
• banks showing currently profits, but still continuing to have accumulated losses of prior
years carried forward in their balance sheets
• Banks which are still in the red, i.e. showing losses in the past and in the present.

NPA has affected the profitability, liquidity and competitive functioning of PSBs and finally the
psychology of the bankers in respect of their disposition towards credit delivery and credit
expansion.
 4
8

CONCEPTUAL
ANALYSIS

The Indian Banking System

India’s banking sector is growing at a fast pace. India has become one of the most preferred
banking destinations in the world. The reasons are numerous: the economy is growing at a rate of
8%, Bank credit is growing at 30% per annum and there is an ever-expanding middle class of
 4
9
between 250 and 300 million people (larger than the population of the US) in need of financial
services. All this enables double-digit returns on most asset classes which is not so in a majority
of other countries. Foreign banks in India achieving a return on assets (ROA) of 3%, their keen
interest in expanding their businesses is understandable – even more so when compared with the
measly 1% average ROA for the Top 1000 banks in the world.

Indian markets provide growth opportunities, which are unlikely to be matched by the mature
banking markets around the world. Some of the high growth potential areas to be looked at are:
the market for consumer finance stands at about 2%-3% of GDP, compared with 25% in some
European markets, the real estate market in India is growing at 30% annually and is projected
to touch $ 50 billion by 2008, the retail credit is expected to cross Rs 5,70,000 crore by 2010
from the current level of Rs 1,89,000 crore in 2004-05 and huge SME sector which contributes
significantly to India’s GDP.

Indian Banking Sector: Strengths and Weaknesses

• Regulatory Systems (84.21%)

(84.2%)
• Economic Growth Rate (63.15%)
• Technological Advancement (52.63%)
• Risk Assessment Systems (47%)
• Credit Quality (42.1%)
Areas To Be Geared Up For Future Growth *
Diversification of markets beyond big cities
(84.2%)
HR Systems (63.15%)
Size of banks (52.63%)
High Transaction Costs (47.3%)
Banking Infrastructure (42%)
Labour Inflexibilities (42%)
 5
0

Indian
Banking
Sector

Turnaround success strategies

Strategies To Be Adopted For Creating World Class Banking System

Consolidation
Strict Corporate Governance Norms
Regional Expansion (Both within India as well as Outside)
Higher FDI limits
FTA with countries where India has comparative advantage in
banking sector

Some of the areas that need to be geared up for future growth, identified by the survey
respondents were Diversification of markets beyond big cities (84.2%), HR Systems
(63.15%), Size of banks (52.63%), High Transaction Costs (47.3%), Banking
 5
1
Infrastructure (42%) and Labour Inflexibilities (42%). Availability and reach of quality
products is confined to just big cities. Thus it is essential now to expand the gamut of banking
services both within India as well as outside. Size of the banks is also a critical element in the
chase for avenues for growth as it facilitates banks to attain new capabilities, technologies and
products at lower operating costs.

INDIA’S STEP TOWARDS GLOBAL COMPETIVENESS

Of the many Asia Pacific countries, China, Taiwan, South Korea and India will continue to
influence the development of the Asian markets. China and India are one of the fastest growing
economies in the world as evident from the graphs below.

Real GDP Growth Rate

%
12 10.5
10 8.3
7.5
8
5.6 5.5 5.3 5.1
6 4.5 4
4
2
0
g

a
na

nd
re

ea
a

an
si
on

si
di

po
hi

or

iw
ne

la
ay
In

K
C

ai
K
ga

Ta
do
al
g

Th
on

M
n

In
Si

Source: Morgan Stanley Research

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2

Loan Growth
%
30 27.6

25
20
15 13.4
9.9
10 8.1 7.7
6.4 6.4
5.1
5
0

g
na

re
nd
ea
a

an
on
si
di

po
hi

or

iw

la
ay
In

K
C

ai
K

ga
Ta
al

Th
on
M

n
Si
H

Source: Morgan Stanley Research

These above-mentioned countries, though at different stages of development, have the potential
to become major growth markets for traditional banking, investment banking, insurance, and
securities products. As a result, leading international and regional banks are interested to
establish their presence in these countries.

The Indian banking sector has scored over its counterparts not only in developing but even in
developed world such as Japan, Singapore and Australia on significant parameters. According to
Moody’s Investors Services data, Indian lenders have posted highest ROE of 20.38% (system
average of three years), closely followed by Indonesia at 20.19% and New Zealand 18.83%.
Japan, the biggest economy in Asia posted negative returns of 6.42%, implying that the banks
there made losses. Banks of Phillippines and Australia have posted an ROE of just 4.40% and
11.44% respectively.
 5
3

Regulatory Systems of India vis a vis other countries

100%
14.29
90% 17.65 17.65 17.65

80%
11.76
70% 17.65
58.82 Better
78.6
60% 35.29
71.43 At Par
50%

40% Below Par

52.94
30% 47.06
5.89
20% 7.1 29.41
17.65
10% 14.3 14.29
0%
China Japan Singapore Russia UK USA

Regulatory systems of Indian banks were rated better than China and Russia; at par with
Japan and Singapore but less advanced than UK and USA.

Risk Assessment Systems of India vis a vis other countries

100%
21.43 21.43 21.43
35.71
80%
14.29 14.29
78.57 78.57
60% 14.29 Better
64.29 At Par
40% Below Par
64.29 64.29
50
20%
21.42 21.43
14.29
0%
China Japan Singapore Russia UK USA
 5
4
Risk management framework is a key strength for sustainable growth of banks. How have we
performed in this area? Respondents rated India’s Risk management systems more advanced than
China and Russia; at par with Japan, and less advanced than Singapore, UK and USA. This
shows we need to work out this but we are not too far. It is with this confidence we are going ahead
with the challenge of implementing Basel II by April 2007. 83% of our respondents highlighted
that Basel II implementation would take us a step ahead in global competitiveness.

Technological Systems of India vis a vis other countries

100% 14.29 21.43 21.43 21.43

80% 42.86 7.14
54 14.29
42.9 Better
60%
At Par

40% 35.71 78.57 Below Par

23 64.29 71.43
42.9
20%
23 21.43
0%
China Japan Singapore Russia UK USA

Technology has given birth to a new era in banking. Technology can be the key differentiator
between two banks and a major factor to attain competitive edge. Though slow in the beginning,
Indian banks seem to have paced up in adoption of advanced technology, as is evident from our
survey results. Technological systems of Indian banks have rated more advanced than China
and Russia; at par with Japan, but less advanced than Singapore, UK and USA.
 5
5

Credit Quality of India vis a vis other countries

100%
21.43
90% 35.71
80%
42.86
57.14 Better
70% 71.43
78.57
60% 50 At Par
50%
Below Par
40% 14.28
64.29
30%
57.14
14.29
20% 28.57 28.57
21.43
10% 14.29
0%
China Japan Singapore Russia UK USA

While enhancement of credit is an important function of the Banks, it is equally imperative to

keep a check on the quality of credit to ensure good health of the banking system and effective
functioning of market for distressed assets.

One of the key fundamentals of Indian banking sector – Credit Quality too has been rated fairly
well in comparison with other countries. Majority of respondents quoted credit quality of
Indian banks better in comparison with China, Japan and Russia; at par with Singapore
but below par with UK and USA. As a percentage of GDP, the Net NPA of Indian banks
stands mere to just 1.4% as on March 2006 as compared with 3.1% in 2004-05. As a percentage
of GDP, gross NPA in India is just 1.9 % compared with 6.7% in China as on March 2005.

It is evident that India fares well on these critical parameters. But are the existing International
banks happy doing business here? Well, our foreign bank respondents seem to be happy here and
wish to expand further. 75 per cent of the foreign bank’s respondents rated their working
experience in India as “extremely good”. Given India’s potential over the next decade and
beyond, all the foreign banks respondents stated that they have formulated strategies for
future expansion in India.
 5
6

The fundamental business of lending has brought trouble to individual banks and entire banking
system. It is, therefore, imperative that the banks are adequate systems for credit assessment of
individual projects and evaluating risk associated therewith as well as the industry as a whole.
Generally, Banks in India evaluate a proposal through the traditional tools of project financing,
computing maximum permissible limits, assessing management capabilities and prescribing a
ceiling for an industry exposure. As banks move in to a new high powered world of financial
operations and trading, with new risks, the need is felt for more sophisticated and versatile
instruments for risk assessment, monitoring and controlling risk exposures. It is, therefore, time
that banks managements equip them fully to grapple with the demands of creating tools and
systems capable of assessing, monitoring and controlling risk exposures in a more scientific
manner.

THE PROBLEM OF NON-PERFORMING ASSETS

Liberalization and Globalization ushered in by the government in the early 90s have thrown open
many challenges to the Indian financial sector. Banks, amongst other things, were set on a path
to align their accounting standards with the International standards and by global players. They
had to have a fresh look into their balance sheet and analyze them critically in the light of the
prudential norms of income recognition and provisioning that were stipulated by the regulator,
based on Narasimhan Committee recommendations.

Loans and Advances as assets of the bank play an important part in gross earnings and net profits
of banks. The share of advances in the total assets of the banks forms more than 60 percent7 and
as such it is the backbone of banking structure. Bank lending is very crucial for it make possible
the financing of agricultural, industrial and commercial activities of the country. The strength
and soundness of the banking system primarily depends upon health of the advances. In other
words, improvement in assets quality is fundamental to strengthening working of banks and
improving their financial viability. Most domestic public sector banks in the country are
expected to completely wipeout their outstanding NPAs between 2006 and 2008.
 5
7

NPAs are an inevitable burden on the banking industry. Hence the success of a bank depends
upon methods of managing NPAs and keeping them within tolerance level, of late, several
institutional mechanisms have been developed in India to deal with NPAs and there has also
been tightening of legal provisions. Perhaps more importantly, effective management of NPAs
requires an appropriate internal check and balances system in a bank.

In this background, this chapter is designed to give an outline of trends in NPAs in Indian
banking industry vis-à-vis other countries and highlight the importance of NPAs management.
NPA is 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 90 days10

The issue of Non-Performing Assets (NPAs) in the financial sector has been an area of concern
for all economies and reduction in NPAs has become synonymous to functional efficiency of
financial intermediaries. From the early nineties till date, the regulators in India, under the
general recommendations of the Narasimhan Committee Reports (1 & 2), Verma Committee
Report, Basle 1 & 2 and insights and findings of scholars, have continuously provided guidelines
and directives addressed at reducing NPAs. A perusal of the Reserve Bank of India (RBI)
circulars in this regard will give the reader a comprehensive idea about the extent of detail in
which norms and guidelines have been formulated to arrest the growth in NPAs. It started off
with introduction of prudential norms and has delved into adoption of a risk based management
system. The Indian financial sector has responded well and adopted the directives given, and the
overall health has shown considerable improvement.
Although NPAs are a balance sheet issue of individual banks and financial institutions, it has
wider macroeconomic implications and the literature, while discussing financial sector reforms,
has gone into a discussion on NPAs also. The reasons can be observed from the following flow
diagram:
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8

Presence of NPAs indicates asset quality of the balance sheet and hence future income
generating prospects. This also requires provisioning which has implications with respect to
capital adequacy. Declining capital adequacy adversely affects shareholder value and restricts the
ability of the bank/institution to access the capital market for additional equity to enhance capital
adequacy. If this happens for a large number of financial intermediaries, then, given that there
are large inter bank transactions, there could be a domino kind of effect. Low capital adequacy
will also severely affect the growth prospects of banks and institutions.
With weak growth outlook and low functional efficiency, the sector as a whole will not be able
to perform its role and will adversely affect the savings investment process. Once we realize this,
it is evident that a micro problem of a bank translates into a macro problem.
 5
9
With weak growth outlook and low functional efficiency, the sector as a whole will not be able
to perform its role and will adversely affect the savings investment process. Once we realize this,
it is evident that a micro problem of a bank translates into a macro problem of the economy.
Capital market development takes a back seat and GDP growth rate weakens. The adverse
effects of fiscal deficit loom large and a balance of payments crisis also cannot be ruled out.
Banking crisis and foreign exchange crisis get interlinked.

REASONS FOR AN ASSET TURNING NPA

The various reasons, either singly or jointly, behind an asset turning NPA can be classified as
follows
1 • Reasons from the economy side
2 • Reasons from the industry side
3 • Reasons from the borrower’s side
4 • Reasons from the banking system side
5 • Reasons from the loan structuring side
6 • Reasons from the security side – collateral vs cash flow
7 • Reasons from the regulatory side

From the above, it may be surprising to many that only the borrower is not always at fault. At
times, systemic faults can also adversely affect the profitability of financial intermediaries. The
following discussion will clarify our position.

1 • Reasons from the economy side

2
0 Political – mindset regarding paradigm, proactive, fiscally responsible (national income
accounts)
1 b. Economic – growth, distribution, efficient allocation of resources
2 c. Social – acceptability, mobility, education
3 d. Technological – advances in use of IT
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0
4 e. Legal – Enforceability of loan contracts
5 f. Environmental – liberalization & globalisation
If loan contracts are not easily enforceable, there will naturally be a tendency to default. Opening
up of the economy can render companies uncompetitive. Lack of adaptation of IT will make data
processing difficult and information dissemination will be impossible. Objective analysis of risk
would be difficult and appraisal would remain a subjective matter. Similarly, directed programs
of lending can be counterproductive.

1 • Reasons from the industry side

2
1 a. Global competition
2 b. Cyclical downswing
3 c. Sunset industry
4 d. Frequent changes in regulatory norms
3 • Reasons from the borrower’s side
4 a. Misconceived project
5 b. Poor governance
6 c. Product failure
7 d. Inefficient management
8 e. Diversion of funds
9 f. Dormant capital market
10 g. Regulatory changes

11 • Reasons from the banking system side

1 a. Parameters set for their functioning were deficient: incorrect goal perception and
identification – lazy banking
2 b. Directed banking and lack of freedom to choose products and pricing
3 c. Being unexposed to international marketing methods and products, people lacked
training and knowledge resources
 6
1
4 d. Ownership and management were not distinguished – composition of Board of
5 Directors.
6 e. Lack of systems and procedures – audit and inspections
7 f. Banks lacked the ability to handle enormous growth in liabilities and assets
8 g. Lack of a mechanism of credit information dissemination
9 h. Lack of an effective judicial system for recovery from defaulters
10 i. Collateral based lending leading to idle assets
11 j. Fixing of price and quantum of loans
12 k. Lack of an effective IT system and MIS
13
12 • Reasons from the loan structuring side
13
1 a. High debt equity ratio
1 b. Timing of raising equity
2 c. Discrepancy between the rate of interest charged and the realistic rate of return
3 d. Inconsistency between revenue generation and the loan repayment schedule
4 e. Lack of binding penal clauses and performance guarantees
5 • Reasons from the security side – collateral vs. cash flow
6
There is a tendency among banks and institutions to depend excessively on collateral for
advancing of loans. While this is important, it presumes from the very beginning that the
borrower would default and the security would need to be enchased for recovery of the loan.
Clearly, this logic is unacceptable. Emphasis should then be on cash generation and a charge
on this should be built into the loan contract through some escrow mechanism.

1 • Reasons from the regulatory side

Frequent regulatory changes can turn assets non-performing. Accounting reason like reduction in
income recognition norms from 180 days to 90 days could be one such reason. Pollution related
issues could be the other reason. Distance between two sugar mills could be a third.
 6
2
3. Recovery Strategies

The various resolution strategies for recovery from NPAs include financial restructuring, change
in management, one time settlement, merger, sale to an asset reconstruction

Company, securitisation of receivables and filing of legal suit. Under each option there are
options, which can be exercised either singly or jointly. The details under each strategy are given
in the following.

TRENDS IN NPA LEVELS:

• Capital to Risk-weighted Assets Ratio (CRAR)

The capital to risk weighted assets ratio (CRAR) is an indicator for assessing soundness and
solvency of banks. Out of 92 scheduled commercial banks, 75 banks could maintain the CRAR
of more than 8 per cent during the year 1995-96, when the prescribed CRAR was 8 per cent.
During 1999-2000, 96 banks maintained CRAR of 9 to 10 per cent and above when the
prescribed rate was 9 per cent. In 2004-05, out of 88 scheduled commercial banks, 78 banks
could maintain CRAR of above 10 per cent and 8 banks between 9 and 10 per cent.
All banks in the State Bank group maintained capital to risk weighted assets ratio of more than
10 per cent in 2004-05. In the nationalised bank group, 17 banks reached more than 10 per cent
CRAR level except two banks who’s CRAR during 2004-05 was between 9-10 per cent. During
2004-05, there were 2 banks in the old private sector category whose CRAR was less than 9 per
cent
 6
3

The measure of non-performing assets helps us to assess the efficiency in allocation of resources
made by banks to productive sectors. The problem of NPAs arise either due to bad management
by banks or due to external factors like unanticipated shocks, business cycle and natural
calamities (Caprio and Klingebiel, 1996). Several studies have underscored the role of banks’
lending policy and terms of credit, which include cost, maturity and collateral in influencing the
movement of non-performing assets of banks (Reddy, 2004, Mohan 2003, 2004).

The ratio of gross non-performing assets (NPAs) to gross advances of all scheduled commercial
banks decreased from 14.4 per cent in 1998 to 5.1 per cent in 2005. Bank group-wise analysis
shows that across the bank groups there has been a significant reduction in the gross non-
performing assets. With respect to public sector banks (State Bank group and nationalised bank
group together), NPAs have decreased from 16.0 per cent in 1998 to 5.4 per cent in 2005. In the
 6
4

Case of foreign banks group, gross NPAs as a percentage to gross advances, which was the
lowest among all the groups at 6.4 per cent in 1998, decreased to 2.9 per cent in 2005. With
regard to domestic private sector banks group, gross NPAs decreased from 8.7 per cent to 3.9 per
cent during the same period. The ratio of net NPAs to net advances of different bank groups also
exhibited similar declining trends during the period from 1998 to 2005. The net NPAs of all
scheduled commercial banks declined from 7.3 per cent in 1998 to 2.0 per cent in 2005
The decline in NPAs is more evidenced across bank groups especially since 2003. This reflects
on the positive impact of the measures taken by the Reserve Bank towards NPA reduction and
specifically due to the enactment of the Securitisation and Reconstruction of Financial Assets
and Enforcement of Security Interest (SARFAESI) Act, ensuring speedier recovery without
intervention of courts or tribunal.
The composition of NPAs of public sector banks brings to light certain interesting aspects. It is
observed that in 1995 for State Bank group, the share of NPAs was 52.5 per cent for the priority
sector, 41.4 per cent for the non-priority sector, and 6.1 per cent for the public sector. These
percentages were 47.4 per cent, 51.5 per cent and 1.1 per cent, respectively in 2005. Similarly in
the case of nationalised banks also, the NPA composition for non-priority sector has increased,
whereas, that for priority sector and public sector, there is a marginal reduction. This shows that
not only advances to the priority sector are going non-performing, but more than that, nonpriority
sector lending is the area where the bankers need to cautiously examine the possibilities of loans
becoming non-performing. Here the question of moral hazard, adverse selection and credit
rationing comes to the fore. These issues are to be addressed face on. This also goes to explode
the commonly held myth that the problem of NPAs is caused mainly due to the credit allocation
to priority sectors.

An analysis of NPAs of different banks groups indicates, the public sector banks hold larger
share of NPAs during the year 1993-94 and gradually decreased to 9.36 percent in the year 2003.
On the contrary, the private sector banks show fluctuating trend with starting at 6.23 percent in
the year 1994-95 rising upto 10.44 percent in year 1998 and decreased to 8.08 percent in the year
2002-03.
 6
5
NPAs of Scheduled Commercial Banks

COMPOSITION OF NPAS OF PUBLIC SECTOR BANKS

Across the bank groups, there has been a significant reduction in the non-performing assets
(NPAs). The composition of NPAs of public sector banks interestingly reveals that NPAs
connected to nonpriority sector has increased, whereas, NPAs relating to priority sector advances
exhibited a decline. This goes to explode the commonly held myth that the problem of NPAs is
caused mainly due to the credit allocation made to priority sectors.
The share of non-interest income in the total income has been increasing across the different
bank groups.
 6
6

COMPARISON OF NPAs IN YEAR 2005 & 2006

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7
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8
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9

FINDINGS &
CONCLUSIONS
 7
0

FINDINGS

• IMPACT ON PROFITABILITY

The enormous provisioning of NPA together with the holding cost of such non-productive assets
over the years has acted as a severe drain on the profitability of the PSBs. In turn PSBs are seen
as poor performers and unable to approach the market for raising additional capital. Equity issues
of nationalised banks that have already tapped the market are now quoted at a discount in the
secondary market. Other banks hesitate to approach the market to raise new issues. This has
alternatively forced PSBs to borrow heavily from the debt market to build Tier II Capital to meet
capital adequacy norms putting severe pressure on their profit margins, else they are to seek the
bounty of the Central Government for repeated Recapitalisation.

NPA is not merely non-remunerative. It is also cost absorbing and profit eroding.

In the context of severe competition in the banking industry, the weak banks are at disadvantage
for leveraging the rate of interest in the deregulated market and securing remunerative business
growth. The options for these banks are lost. "The spread is the bread for the banks". This is the
margin between the cost of resources employed and the return there from. In other words it is
gap between the return on funds deployed (Interest earned on credit and investments) and cost of
funds employed (Interest paid on deposits). When the interest rates were directed by RBI, as
heretofore, there was no option for banks. But today in the deregulated market the banks decide
their lending rates and borrowing rates. In the competitive money and capital Markets, inability
to offer competitive market rates adds to the disadvantage of marketing and building new
business.

In the face of the deregulated banking industry, an ideal competitive working is reached, when
the banks are able to earn adequate amount of non-interest income to cover their entire operating
 7
1
expenses i.e. a positive burden. In that event the spread factor i.e. the difference between the
gross interest income and interest cost will constitute its operating profits. Theoretically even if
the bank keeps 0% spread, it will still break even in terms of operating profit and not return an
operating loss. The net profit is the amount of the operating profit minus the amount of
provisions to be made including for taxation. On account of the burden of heavy NPA, many
nationalised banks have little option and they are unable to lower lending rates competitively, as
a wider spread is necessitated to cover cost of NPA in the face of lower income from off balance
sheet business yielding non-interest income.

• Impact of NPAs on Development Financial Institutions Health:

The efficiency of any Development Financial Institutions is not always reflected only by the size
of its balance sheet but by the level of return on its assets. NPAs do not generate any income for
DFIs but at the same time DFIs are required to make provisions for such NPAs from their current
profits.
Following are the deleterious effect on the return on assets in several ways:
1 They erode current profits through provisioning requirements
2 They result in reduced interest income
3 They require high provisioning requirements affecting profits
4 They limit recycling of funds, set in asset- liability mismatches, etc.

THE FOLLOWING ARE THE PRIMARY CAUSES FOR TURNING THE ACCOUNTS
INTO NPA:

1. Diversion of funds, mostly for the expansion/ diversification of business or for promoting
associate concern.
2. Factors internal to business like product/ marketing failure, inefficient management,
inappropriate technology, labour unrest
3. Changes in the Macro-environment like recession in the economy, infrastructural bottlenecks
etc.
4. Inadequate control/ supervision, leading to time/cost over-runs during project
 7
2
Implementation.
5. Changes in Government policies e.g. Import duties.
6. Deficiencies like delay in the release of limits/ funds by banks/FIs

7. Willful defaults, siphoning of funds, frauds, misappropriation, promoters/ management’s

disputes, etc.

SECONDARY CAUSES ARE AS FOLLOWS:

1. Selection of the project.

2. Implementation of the project- time over-run, cost over-run, under-financing technology
involved
3. Intention of the borrower.
4. Industrial/ Economic trend.
5. Absence of the up gradation of the unit/ ploughing back of the profit.

• DIFFICULTIES WITH THE NON-PERFORMING ASSETS:

1. Owners do not receive a market return on their capital. In the worst case, if the bank fails,
owners lose their assets. In modern times, this may affect a broad pool of shareholders.

2. Depositors do not receive a market return on savings. In the worst case if the bank fails,
depositors lose their assets or uninsured balance. Banks also redistribute losses to other
borrowers by charging higher interest rates. Lower deposit rates and higher lending rates repress
savings and financial markets, which hampers economic growth.

3. Non performing loans epitomize bad investment. They misallocate credit from good projects,
which do not receive funding, to failed projects. Bad investment ends up in misallocation of
capital and, by extension, labour and natural resources. The economy performs below its
production potential.
 7
3
4. Non performing loans may spill over the banking system and contract the money stock, which
may lead to economic contraction. This spillover effect can channelize through illiquidity or
bank insolvency; (a) when many borrowers fail to pay interest, banks may experience liquidity
shortages. These shortages can jam payments across the country, (b) illiquidity constraints bank

in paying depositors e.g. cashing their paychecks. Banking panic follows. A run on banks by
depositors as part of the national money stock become inoperative. The money stock contracts
and economic contraction follows (c) undercapitalized banks exceeds the banks capital base.

Lending by banks has been highly politicized. It is common knowledge that loans are given to
various industrial houses not on commercial considerations and viability of project but on
political considerations; some politician would ask the bank to extend the loan to a particular
corporate and the bank would oblige. In normal circumstances banks, before extending any loan,
would make a thorough study of the actual need of the party concerned, the prospects of the
business in which it is engaged, its track record, the quality of management and so on. Since this
is not looked into, many of the loans become NPAs.

The loans for the weaker sections of the society and the waiving of the loans to farmers are
another dimension of the politicization of bank lending.

Most of the depositor’s money has been frittered away by the banks at the instance of politicians,
while the same depositors are being made to pay through taxes to cover the losses of the bank.

KEY STRUCTURAL CHANGES

Phasing out of statutory pre-emption - The SLR requirement have been brought down from
38.5% to 25% and CRR requirement from 7.50% to 5.75%. (Presently 4.5%)
• Deregulation of interest rates - All lending rates except for lending to small borrowers and a
part of export finance has been de-regulated. Interest on all deposits is determined by banks
except on savings deposits.
• Capital adequacy - CAR of 9 % prescribed with effect from March 31, 2000.
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• Other prudential norms - Income recognition, asset classification and provisioning norms has
been made applicable. The provisioning norms are more prudent, objective, transparent, and
uniform and designed to avoid subjectivity.
• Entry of new private sector banks - 9 new private sector banks have been set up with a view
to induce greater competition and for improving operational efficiency of the banking system.
Competition has been introduced in a controlled manner and today we have nine new private
sector banks and 36 foreign banks in India competing with the public sector banks both in retail
and corporate banking
• Functional autonomy - The minimum prescribed Government equity was brought to
51%. Nine nationalised banks raised Rs.2855 crores from the market during 1994-2001. Banks
Boards have been given more powers in operational matters such as rationalization of
branches, credit delivery and recruitment of staff
• Debt Recovery Tribunals - 22 DRTs and 5 DRATs have already been set up and 7 more
DRTs will be set up during the current financial year. Comprehensive amendments in the Act
have been made to make the provisions for adjudication, enforcement and recovery more
effective.
• Transparency in financial statements - Banks have been advised to disclose certain key
parameters such as CAR, percentage of NPAs, provisions for NPAs, net value of investment,
Return on Assets, profit per employee and interest income as percentage to working funds.

PROVISIONING NORMS

• In conformity with the prudential norms, provisions should be made on the non-
performing assets on the basis of classification of assets into prescribed categories as
detailed earlier.
• Taking into account the time lag between an account becoming doubtful of recovery, its
recognition as such, the realisation of the security and the erosion over time in the value
of security charged to the bank, the banks should make provision against loss assets,
doubtful assets and substandard assets as below:
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• REPORTING FORMAT FOR NPAs

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CONCLUSION

Asset quality is one of the important parameters based on which the performance of a bank is
assessed by the regulation and the public. Some of the areas where the Indian banks identified to
for better NPA management like credit risk management, special investigative audit, negotiated
settlement, internal checks & systems for early indication of NPAs etc

The response to Basel Accord II reforms world over is not uniform and spontaneous. Basel-II is
known for complicated risk management models and complex data requirements. Big
international banks, as those in the US, prefer this new version, as they perceive that their
superior technology and systems would make them Basel compliant and provide an edge in the
competitive environment, in the form of lower regulatory capital.

Indian banks do not perceive any immediate value in the new norms as they are globally
insignificant players with simple and straight forward balance-sheet structures. This is clearly
vindicated by the sample study according to which 57 per cent of the executives of public sector
banks are sceptical about Basel Accord II norms, particularly in respect of investment cost and
the complexity of proposed internal rating system. As against this, the private sector banks with
supposedly more investment in technology related infrastructure are in favour of the proposals
under New Basel Capital Accord as vindicated by the sample study according to which 67
percent of executives of private sector banks are in-favour for New Basel Capital Accord.

However, putting Basel II in place is going to be far more challenging than Basel I. The adoption
of Basel II will boost good Risk Management practices and good corporate governance in banks.
However, the cost of putting in place robust system today is viewed in an increasingly number of
countries as a price worth paying to prevent such crisis. Assuming that the banks can get over the
technological and operational hurdles, switching over to Basel II norms can no doubt turn the
Indian banks, mainly the public sector banks, more efficient and competitive globally. This, in
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turn, will help strengthen the financial sector to undertake further reforms including capital
account convertibility more confidently.

It is realized that if a resolution strategy for recovery of dues from NPAs is not put in place
quickly and efficiently, these assets would deteriorate in value over time and little value would
be realized at the end, except may be its scrap value. That is why; asset securitisation has gained
popularity among financial sector players. The literature, however, has not specifically discussed
about the various resolution strategies that could be put in place for recovery from NPAs, and in
particular, in which situation which strategy should be adopted. The purpose of this paper is to
indicate the various considerations that one has to bear in mind before zeroing on a resolution
strategy. The details of the strategy would follow after that.

It is important to note that it is difficult to get data from banks and institutions regarding the
decision process that leads to a specific resolution strategy for a particular NPA. This is so as
there is no fixed formula on the basis of which a recovery strategy for a NPA is undertaken.
Broad parametric guidelines can be given like vintage of plant and machinery and current market
value, future revenue generating potential of the assets, extent of provisioning in the books of the
lender, asset classification as per prudential norms, the nature of the industry etc. But to arrive a
specific figure for a one time settlement or sale of a second hand asset or financial restructuring
involves subjective elements in bargaining, the extent to which the borrower is conscious of
his/her social status, financial strength of the incumbent promoter etc. For example it is difficult
to substantiate as to why a bank, for a particular company, went it for settlement for 50% of the
principal amount waiving all other dues. Two NPAs of the same vintage in the same industry
may be resolved in two ways. This is why, although Reserve Bank of India (RBI) has given
some guidelines in this regard, it has left it to the discretion of the Board of Directors of a
bank/institution to take decisions outside the guidelines of RBI.
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RECOMMENDATIONS
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RECOMMENDATIONS

The various resolution strategies for recovery from NPAs include financial restructuring, change
in management, one time settlement, merger, sale to an asset reconstruction company,
securitisation of receivables and filing of legal suit. Under each option there are options, which
can be exercised either singly or jointly. The details under each strategy are given in the
following.

• Early recognition of the problem

• Early Alert System – determine threshold for proactive intervention before account
becomes a NPA
• Identify borrowers with genuine intent
• Restructuring should be attempted only after an objective assessment of the viability and
the promoter’s intent. Banks should be convinced of a turnaround within a scheduled
timeframe
• Timeliness and adequacy of response
• Focus on Cash flows
• Management Effectiveness
• Consortium / Multiple Financing

1 A. FINANCIAL RESTRUCTURING
2
0 • Reschedulement of the principal repayment
1 • Reduction in the rate of interest
2 • Funding of past due interest into loan or instruments (debt or equity or quasi equity)
3 • Funding of future interest
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4 • Waiver of past simple interest, compound interest or liquidated damages
5 • Conversion of loan into equity or quasi-equity
6 • Reduction in equity
7
8 • Debt write-off
9 • Funds infusion by way of equity or debt for project completion
10 • Funds infusion for working capital purposes
11 • Escrowing of receivables – Trust & Retention Account
Under this strategy, the company is in operation, but requires some relief. However, along with
relief’s, some additional fund infusion by the promoter should be a must.

B. CHANGE IN MANAGEMENT

1 • Change in the promoters

2 • Induction of professionals

1 C. ONE TIME SETTLEMENT (OTS)

2
3 • Full principal with all past interest and future interest with prepayment
premium
4 • Full principal with all past interest
5 • Full principal with part interest
6 • Full principal with full or part interest converted to equity or quasi equity
instrument
7 • Part principal with the remaining part converted to some equity or quasi
equity instrument
8 • Part principal and remaining part written off
9
10 D. MERGER WITH ANOTHER COMPANY

11 �Nature
 of the industry – sunrise or sunset
12 �Synergy issues
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13 �Valuation
14 �Share swap ratio
15 �Tax implications
16

CHART FOR ASSESSING CORRECTIVE STEPS IN DIFFERENT CIRCUMSTANCES:

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LIMITATIONS

LIMITATIONS

• The scope of the research report is very wide but the information available
on the internet sites and magazines and others are very limited.
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• The other limitation of my report is that the project should not be more than
80-90 pages therefore I had to restrict my contents.
• Due to the wide scope of the topic I have done the analysis only on one
segment i.e. banking sector.
• Data taken is secondary so many requirements of the readers might not be
fulfilled.
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BIBLIOGRAPHY

BIBLIOGRAPHY:

• “Non-Performing Loans and Terms of Credit of Public Sector Banks in India: An

Empirical Assessment”, Reserve Bank of India Occasional Papers,
• Personal website of R Kannan
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• K Raghavan, Manager, Bank of Baroda
• Maximising Value of NPAs, World Bank
• A study of NPAs in India, Prashanth K Reddy
• www.geocities.com/kstability/content/index.html
• www.rbi.org.in