1. Internal Checks and Control
Since high level of NPAs dampens the performance of the banks identification of potential problem accounts and their close monitoring assumes importance. Though most banks have Early Warning Systems (EWS) for identification of potential NPAs, the actual processes followed, however, differ from bank to bank. The EWS enable a bank to identify the borrower accounts which show signs of credit deterioration and initiate remedial action. Many banks have evolved and adopted an elaborate EWS, which allows them to identify potential distress signals and plan their options beforehand, accordingly. The early warning signals, indicative of potential problems in the accounts, viz. persistent irregularity in accounts, delays in servicing of interest, frequent devolvement of L/Cs, units’ financial problems, market related problems, etc. are captured by the system. In addition, some of these banks are reviewing their exposure to borrower accounts every quarter based on published data which also serves as an important additional warning system. These early warning signals used by banks are generally independent of risk rating systems and asset classification norms prescribed by RBI.
The major components/processes of a EWS followed by banks in India as brought out by a study conducted by Reserve Bank of India at the instance of the Board of Financial Supervision are as follows:
- Designating Relationship Manager/ Credit Officer for monitoring account/s
- Preparation of `know your client’ profile
- Credit rating system
- Identification of watch-list/special mention category accounts
- Monitoring of early warning signals
Relationship Manager/Credit Officer
The Relationship Manager/Credit Officer is an official who is expected to have complete knowledge of borrower, his business, his future plans, etc. The Relationship Manager has to keep in constant touch with the borrower and report all developments impacting the borrowable account. As a part of this contact he is also expected to conduct scrutiny and activity inspections. In the credit monitoring process, the responsibility of monitoring a corporate account is vested with Relationship Manager/Credit Officer.
Know your client’ profile (KYC)
Most banks in India have a system of preparing `know your client’ (KYC) profile/credit report. As a part of `KYC’ system, visits are made on clients and their places of business/units. The frequency of such visits depends on the nature and needs of relationship.
Read More: Know Your Customer (KYC)
Credit Rating System
The credit rating system is essentially one point indicator of an individual credit exposure and is used to identify measure and monitor the credit risk of individual proposal. At the whole bank level, credit rating system enables tracking the health of banks entire credit portfolio. Most banks in India have put in place the system of internal credit rating. While most of the banks have developed their own models, a few banks have adopted credit rating models designed by rating agencies. Credit rating models take into account various types of risks viz. financial, industry and management, etc. associated with a borrowable unit. The exercise is generally done at the time of sanction of new borrowable account and at the time of review / renewal of existing credit facilities.
Watch-list/Special Mention Category
The grading of the bank’s risk assets is an important internal control tool. It serves the need of the Management to identify and monitor potential risks of a loan asset. The purpose of identification of potential NPAs is to ensure that appropriate preventive / corrective steps could be initiated by the bank to protect against the loan asset becoming non-performing. Most of the banks have a system to put certain borrowable accounts under watch list or special mention category if performing advances operating under adverse business or economic conditions are exhibiting certain distress signals. These accounts generally exhibit weaknesses which are correctable but warrant banks’ closer attention. The categorization of such accounts in watch list or special mention category provides early warning signals enabling Relationship Manager or Credit Officer to anticipate credit deterioration and take necessary preventive steps to avoid their slippage into non performing advances.
Early Warning Signals
It is important in any early warning system, to be sensitive to signals of credit deterioration. A host of early warning signals are used by different banks for identification of potential NPAs. Most banks in India have laid down a series of operational, financial, transactional indicators that could serve to identify emerging problems in credit exposures at an early stage. Further, it is revealed that the indicators which may trigger early warning system depend not only on default in payment of installment and interest but also other factors such as deterioration in operating and financial performance of the borrower, weakening industry characteristics, regulatory changes, general economic conditions, etc. Early warning signals can be classified into five broad categories viz.
(d) Management and
(e) External factors.
Financial related warning signals generally emanate from the borrowers’ balance sheet, income expenditure statement, statement of cash flows, statement of receivables etc. Following common warning signals are captured by some of the banks having relatively developed EWS.
Financial warning signals
- Persistent irregularity in the account
- Default in repayment obligation
- Devolvement of LC/invocation of guarantees
- Deterioration in liquidity/working capital position
- Substantial increase in long term debts in relation to equity
- Declining sales
- Operating losses/net losses
- Rising sales and falling profits
- Disproportionate increase in overheads relative to sales
- Rising level of bad debt losses Operational warning signals
- Low activity level in plant
- Disorderly diversification/frequent changes in plan
- Nonpayment of wages/power bills
- Loss of critical customer/s
- Frequent labor problems
- Evidence of aged inventory/large level of inventory
Management related warning signals
- Lack of co-operation from key personnel
- Change in management, ownership, or key personnel
- Desire to take undue risks
- Family disputes
- Poor financial controls
- Fudging of financial statements
- Diversion of funds
Banking related signals
- Declining bank balances/declining operations in the account
- Opening of account with other bank
- Return of outward bills/dishonored cheques
- Sales transactions not routed through the account
- Frequent requests for loan
- Frequent delays in submitting stock statements, financial data, etc. Signals relating to external factors
- Economic recession
- Emergence of new competition
- Emergence of new technology
- Changes in government / regulatory policies
- Natural calamities
2. Management/Resolution of NPAs
A reduction in the total gross and net NPAs in the Indian financial system indicates a significant improvement in management of NPAs. This is also on account of various resolution mechanisms introduced in the recent past which include the SRFAESI Act, one time settlement schemes, setting up of the CDR mechanism, strengthening of DRTs. From the data available of Public Sector Banks as on March 31, 2003, there were 1,522 numbers of NPAs as on March 31, 2003 which had gross value greater than Rs. 50 million in all the public sector banks in India. The total gross value of these NPAs amounted to Rs. 215 billion. The total number of resolution approaches (including cases where action is to be initiated) is greater than the number of NPAs, indicating some double counting. As can be seen, suit filed and BIFR are the two most common approaches to resolution of NPAs in public sector banks. Rehabilitation has been considered/ adopted in only about 13% of the cases. Settlement has been considered only in 9% of the cases. It is likely to have been adopted in even fewer cases. Data available on resolution strategies adopted by public sector banks suggest that Compromise settlement schemes with borrowers are found to be more effective than legal measures. Many banks have come out with their own restructuring schemes for settlement of NPA accounts. State Bank of India, HDFC Limited, M/s. Dun and Bradstreet Information Services (India) Pvt. Ltd. and M/s. Trans Union to serve as a mechanism for exchange of information between banks and FIs for curbing the growth of NPAs incorporated credit Information Bureau (India) Limited (CIBIL) in January 2001. Pending the enactment of CIB Regulation Bill, the RBI constituted a working group to examine the role of CIBs. As per the recommendations of the working group, Banks and FIs are now required to submit the list of suit-filed cases of Rs. 10 million and above and suit filed cases of willful defaulters of Rs. 2.5 million and above to RBI as well as CIBIL. CIBIL will share this information with commercial banks and FIs so as to help them minimize adverse selection at appraisal stage. The CIBIL is in the process of getting operationalised.
3. Willful Defaulters
RBI has issued revised guidelines in respect of detection of willful default and diversion and siphoning of funds. As per these guidelines a willful default occurs when a borrower defaults in meeting its obligations to the lender when it has capacity to honor the obligations or when funds have been utilized for purposes other than those for which finance was granted. The list of willful defaulters is required to be submitted to SEBI and RBI to prevent their access to capital markets. Sharing of information of this nature helps banks in their due diligence exercise and helps in avoiding financing unscrupulous elements. RBI has advised lenders to initiate legal measures including criminal actions, wherever required, and undertake a proactive approach in change in management, where appropriate.