PRUDENTIAL NORMS INCOME RECOGNITION AND ASSET CLASSIFICATION 

1  INTRODUCTION 

As we have seen in earlier chapters, one of the main functions of banking is to make advances to the public; these are assets of the bank on which it earns interest. The banks make a major portion of their income through interest earned on loan and advances. However, the advances/assets of the bank are prone to deterioration due to various factors. As and when advances/assets of the bank stop generating income o, their repayment is not forthcoming to the bank as per terms of agreement, these assets become eligible for down gradation in quality and are called Non-Performing assets. The Reserve Bank of India has established norms for classification of Assets. 

2  NON-PERFORMING ASSETS 

An asset, including a leased one, becomes Non-Performing when it stops generating income to the bank. A Loan or Advance becomes NPA where: 

• Interest and/ or installment of principal remain overdue for a period of more than 90 days in respect of a term loan, 
• The account remains, out of order” in respect of an Overdraft/Cash Credit(OD/CC), e The bill (purchased and/or discounted) remains overdue for a period of more than 90 days 
• The installment of principal or interest thereon remains overdue for two crop seasons for short duration crops, 
• The installment of principal or interest thereon remains overdue for one crop season for long duration crops, 
• The amount of liquidity facility remains outstanding for more than 90 days in respect of a securitization transaction undertaken in terms of guidelines on securitization dated Feb 1, 2006. 
• In respect of derivative transactions, the overdue receivables representing positive market to market value of a derivative contract, if these remain unpaid for a period of 90 days from the specified due date for payment. 

As a consequence of above guidelines an account also becomes NPA if 

1. Irregular Drawings: The drawings permitted against DP of Stock statements older than 3 months are considered irregular drawings and if the irregular drawings are permitted for 90 days the account becomes NPA. Effectively drawings against stock statements older than 6 months makes an account NPA i.e. 3months + 3 months.
2. Renewal/Review is more than 6 months due. 

The accounts are classified Borrower wise and not facility-wise. It means if one account of a borrower is declared NPA, all other accounts should be declared NPA as well. However, please remember if a borrower has got bills discounted under LC and in the meantime his other accounts are classified NPA, the bills discounted under LC will not be treated as NPA till the date of realization of bills from LC issuing bank.

1. Out of Order: An account should be treated as ‘out of order’ if the outstanding balance remains continuously in excess of the sanctioned limit/drawing power. In cases where the outstanding balance in the principal operating account is less than the sanctioned limit/drawing power, but there are no credits continuously for 90 days as on the date of Balance Sheet or credits are not enough to cover the interest debited during the same period, these accounts should be treated as ‘out of order’. 

Exceptions: 

• However, advances granted against NSC/KVP/IVP etc. not to be classified NPA if there is Margin available. 
• Advances secured by Central Government Guarantee may not be classified NPA until the government repudiates the claim of guarantee. However, the same advantage is not applicable for advances secured by State Guarantee, such loans will be classified as per original terms. However, it must be remembered that the provision is not applicable for income recognition i.e. income cannot be booked if not paid despite Central Govt. guarantee. 

2. Overdue: Any amount due to the bank under any facility, if not paid on the due date will be classified as ‘Overdue’ 

3. Asset Classification: NPA assets (Loans and advances) are classified into three main categories: -

• Sub Standard: An asset remains in substandard category from its date of NPA to One year.
• Doubtful: An asset which has remained in Sub-Standard category for a period of 1 years becomes Doubtful thereafter.
• Loss Assets: a loan or advance where loss has been identified by bank or external/internal auditors is classified as Loss Assets. 

4. Provisioning: 

Substandard Assets                                             

• 15% of total outstanding backed by security
• 25% of unsecured Debt   
• 20% for unsecured Infra Project Debt

Doubtful Assets

• Doubtful 1 : Secured portion -25%; Unsecured portion- 100%
• Doubtful 2 : Secured portion - 40%; Unsecured portion - 100%
• Doubtful 3 : Secured + Unsecured portion : 100%

Loss Assets

• 100%                   

An Example: Let us assume a loan account with a balance of Rs.1.00 lakhs. The security has diminished and is available for Rs.60000.00. So the secured portion of loan is Rs.60000.00 and unsecured is also Rs.40000.00. Since loss is identified as less than 50% the asset will be Substandard in the first year and provision during 18 years will be 15% on 60000.00 and 25% on 40000.00 i.e. 9000+10000=19000.00.

Next year, the account will become Doubtful and provision will be 100% for loss identified plus 25% of secured portion i.e. 40000+25% of 60000.00 total being 40000.00+15000.00=55000.00. Next year and next to that year (i.e. 3% year and 4” year) it will attract provisions of Rs.40000.00+40% of 60000.00 i.e. total 64000.00. After 4 years since NPA declaration the account will be attracting 100% provisions irrespective of security. 

However, please note that if an asset is in doubtful category and ECGC guarantee is available, the Provisioning is provided as under: 

i) Amount Outstanding  : Rs 100.00

ii)Less: Value of security  : Rs 40.00

iii)Less: ECGC Guarantee percentage : 50%

so value of ECGC is 50% of Rs.60 =Rs 30

iv)Now unsecured portion after ECGC cover is Rs.30.00

v)Provision      

i) 25% on secured amount 25% of Rs.40 =Rs. 10.00

   ii). 100% provision on unsecured value =Rs. 30.00

Total Provision =Rs. 40.00

3.  PROVISIONING REQUIREMENT FOR FRAUD CASES 

In case of fraud cases, the entire amount due to the bank (irrespective of the security held against such fraud assets) is required to be provided with four quarters starting from the quarter the fraud is identified. However, in case the fraud is not reported to RB! As per guidelines, the banks are required to make 100% Provisions immediately. 

4.  PROVISIONING REQUIREMENT ON STANDARD ASSETS 

It is required that provision be made on all standard assets. The provisions are to be made on following Rates: 

• Farm Credit to agriculture and SME   : 0.25%
• Commercial Real Estate    :                 1.00%
• Commercial Real Estate Residential Housing sector : 0.75%
• All other loans and advances    :             0.40%

  (Please note Medium Enterprises fall under this category)

The provision on Standard Assets is not to be netted for the purpose of calculation of Net NPA. The provisions should also not be netted from Gross Advances but should be shown as ‘Contingent Provisions Against Standard Assets’ under ‘Other Liabilities and Provisions Others’. 

Provision Coverage Ratio: is the ratio of provisions to gross non-performing assets and shows the extent of funds a bank has kept aside for non-performing assets. 

5.  EXAMPLES ON CALCULATION OF PROVISIONING REQUIREMENT: 

Advances Covered by ECGC Guarantee: In the case of advances classified as doubtful and Guaranteed by ECGC, provision should be made only for the balance in excess of the amount guaranteed by the Corporation. Further, while arriving at the provision required to be made for doubtful assets, realizable value of the securities should first be deducted from the outstanding balance in respect of the amount guaranteed by the Corporation and then Provision made as illustrated hereunder: 

            Examples

              Provision required to be Made

Advance Covered by CGTMSE Or (CRGFTLIH) Example

              Provision required to be Made

6.  INCOME RECOGNITION 

Income, is generally recognized on accrual basis, however for all accounts which have been classified as NPA income has to be recognized on cash realized basis. Funded Interest: In NPA cases where interest has been funded and already booked as income, provision for full amount should be made. 

Conversion of Interest into Equity or other Instruments: In case the interest portion is converted into equity or other such instruments and income is booked, full provision should be made for the income so recognized. 

7.  CREDIT CARD NPA 

The minimum credit card dues, as mentioned on the statements, if not paid within 90 days from the payment due date mentioned on the statement will render the credit card dues as NPA.