When a borrower is unable to repay the money lent by a lender, such a type of the loan becomes non-performing in the accounts of financial firms. It is also not certain if a lender will receive the money loaned to the borrower. They are the banks’ investments that don’t offer any returns.
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What is a Non-Performing Asset?
When the asset stops generating revenue for the bank, it is a non-performing asset. An NPA is a loan or an advance wherein:
- Interest and/or installment of principal remain overdue for a period of quite 90 days in respect of a term loan,
- The account remains ‘out of order’ in respect of an Overdraft/Cash Credit (OD/CC)
- The bill remains overdue for a period of more than 90 days within the case of bills purchased and discounted.
More precisely, if customers do not repay the principal amount and interest after a specified period of time, these loans are deemed to be non-performing assets or NPAs. The non-performing asset does not yield any income to the lender in the form of interest payments.
Classification of NPA: Banks further categorize NPAs into the following:
- Standard Assets: The assets that continue to remain in NPA for 12 months or less than 12 months are known as the Standard Assets and the risk of these assets is normal.
- Substandard assets: They are the assets that have remained an NPA for a period less than or equal to 12 months.
- Doubtful assets: Refer to those are the assets that would be classified as doubtful if it has remained in the substandard category for a period of 12 months.
- Loss asset: As per RBI, “Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted anymore, although there may be some salvage or recovery value.”
Impact of NPA:
High NPAs are not favorable for a bank, because they are assets that are not performing. High NPAs mean that banks have too many loans that have become non-functional which are not rendering any interest income to the bank. Banks can either keep the NPAs in their books in the hope that they may recover them or make provisions for it. If not, the banks can write off the loans entirely as bad debt. However, there are many other factors that are required to assess a bank apart from NPA.
Both the borrower and the lender should be aware of the difference between performing and non-performing assets. As for the borrower, if the asset is non-performing and interest payments are not made, it will affect their credit and growth possibilities negatively. Which will hamper their ability to obtain borrowing in the future.
As the bank or lender is concerned, the interest earned on loans will act as a main source of income. Therefore, non-performing assets will affect their ability to generate adequate income negatively and thus, their overall profitability as well. Banks should track the status of their non-performing assets, as too many NPAs have a negative impact on their liquidity and growth capabilities.
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Example of Non-Performing Assets (NPA):
ABC Ltd. has borrowed $10 million from Bank XYZ and must pay $1,000 of interest for 5 years per month. Now, for 3 consecutive months, i.e. 90 days, if the borrower defaults on the payment, then the bank has to mark the loan as a non-performing asset on its balance sheet for that financial year.
How banks can prevent further creation of NPAs:
Non-performing assets are manageable, but it depends on their quantity and how far they are past due. In the short term, most banks usually take on a fair amount of NPAs. However, if the volume of NPAs continues to build over time, it threatens the financial health and future success of the lender. For non-performing assets, the banks should have an adequate framework and prohibitions, and limited credits should be made accessible only to entities that are worthy of them.
Author: Mahek Medh
About the Author: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.