MANAGEMENT OF NON PERFORMING ASSETS (NPA)
IMPORTANCE OF APPRAISAL AND ASSESSMENT OF LOAN FACILITY
Any business preposition, be it a manufacturing industry, a trading business or a service enterprise, is a process of realisation of a vision through proper planning and execution of the project to implement it through a study on technical feasibility and economic viability of the project. Whereas the technical feasibility depends upon the location of the project and its advantage, infrastructure available which includes utilities, manpower, logistics and marketing also, the economic viability is based on the earning capacity to fulfill the financial, socio economic commitments and obligations of the business. The success depends upon how the factors of production and business are utilized effectively and efficiently to realize the objectives of the enterprise and how the enterprise raises funds for the implementation of the projects and managing it successfully. Hence, Appraisal and assessment of loan requirement plays a very important role to meet the financial commitment of the business enterprise.
Accepting deposits from the public and lending for productive purposes are the two primary functions of the banks. Since they are the custodians of the public money, the responsibility of the banks to safe guard the interest of the public is paramount. The basic principles of lending are the following.
Borrower: Borrower’s character, capacity and credit worthiness play an important role which should be ascertained by the banks and financial institutions through various sources. In this connection credit rating of borrowers by credit rating companies and the bank can be a tool to assess the borrower’s background. Character of the borrower and his integrity and honesty are the most important and valuable assets of the borrower. Besides, the core management team on whom the borrower is going to depend for the veritable realisation of the objectives of business also plays a vital role in the assessment process.
Purpose of loan and nature of business: Nature of business dictates the purpose of loan. Loan is given to meet the capital needs like land and building and plant and machinery and other assets by way of term loan to be paid over a period of time depending upon the cash generation and to meet day to day expenses by way of working finance to be renewed after a particular period of time which is normally one year from the date of availing the finance. Besides, loans can also be categorised into fund based loans and non-fund based loans like bank guarantee, letter of credit etc. The banks are expected to grant loans in accordance with the policy and norms declared by Reserve Bank of India in terms of section 21of Banking Regulation Act, 1949. The banks should also ensure that the loans granted by them are used for the purpose for which they are granted and are not misused or diverted.
Amount of loan: Adequate amount and appropriate type of loan are required to be sanctioned to meet the purpose of the loan without any impediment. Any under financing of the project may lead to non-completion, cost escalation and delay in commissioning of the project which may affect the repayment and other financial commitment of the borrower. Similarly over financing also is not good as funds may be misused and diverted by the borrower affecting the profitability of the main activity.
Duration of the loan: The duration of the loan is very important for the banks because the liquidity factor of the banks to meet the demands of the depositors has to be taken into consideration which is based on the asset liability matching. Long term finance blocks up funds where as working capital funds are short term realisable on demand. Long term finance also involves more risk as the socio economic situation can change drastically particularly in international trade and commerce during the term finance period which may affect the financial position of the banks and financial institutions. Hence, care has to be taken to meet any unforeseen contingencies.
Security: Loans are sanctioned against securities because in case of default the banks can take recourse to sale of security to realise their dues. There are two types of securities. Primary securities are those securities which are procured out of bank finance and collateral securities consist mostly of immovable properties or any other tangible securities not connected with bank finance and which are already in the possession of those who offer their personal assets as security. More often the banks overlook performance and insist more collateral securities with the result the facilities become more security oriented and not purpose oriented. It may lead to complacency and callousness among the bank’s credit monitoring authorities because of the high value of collateral securities due to which their credit monitoring is likely to suffer.
Risk Assessment: Risk may be defined as ‘possibility of loss’, which may be financial loss or loss to the image or reputation. Banks like any other commercial organisation also intend to take risk, which is inherent in any business. Higher the risk taken higher the gain would be. But higher risks may also result into higher losses. However, banks are prudent enough to identify measure and price risk, and maintain appropriate capital to take care of any eventuality. The major risks in banking business or ‘banking risks’, as commonly referred, are (i) Liquidity Risk (ii) Interest Rate Risk (iii) Market Risk (iv) Credit or Default Risk (v) Operational Risk. Considering the importance of study of risks involved, the banks and financial institutions have to undertake a thorough analysis and assessment of risks involved to avoid incidents of account turning into NPA.
Cash Flow Analysis: The health and liquidity of banks depend upon timely recovery of their investments with their expected return on their investments. Recovery consists of two important components namely servicing of interest on loans in case of working capital and its timely renewal and timely payment of installments and servicing of interest in the case of term loans. Hence it is imperative on the part of banks to appraise and assess the capacity of the borrowers to meet their financial commitments and obligations not only towards servicing of interest and repayment of loans and advances sanctioned by the bank but also to meet other business commitments which depends upon the liquidity position of the enterprise. Liquidity position is determined by the cash flow being generated out of business activities. Operating any business in today’s economic environment means managing cash flow. Companies looking only at their earnings and not managing cash flow cannot and will not survive in today’s economy where short term operational loans are not often readily available. Hence managing a very positive cash flow is an essential and an inevitable necessity for any business organisation.
Operating Cycle: Cash flow in business depends upon the Operating cycle of the business. It is also known as cash operating cycle or cash conversion cycle or asset conversion cycle, which establishes how many days it takes for a company to turn purchases of inventory into cash receipts from its eventual sale. Operating cycle has three components of payable turnover days, Inventory Turnover days and Accounts Receivable Turnover days. These come together to form the complete measurement of operating cycle days. To be more specific, the payable turnover days are the period of time in which a company keeps track of how quickly they can pay off their financial obligations to suppliers. The next step, inventory turnover, is the ratio that indicates how many times a company sells and replaces their inventory over time. The final step, the accounts receivable turnover days, encase the period of time in which the company is evaluated on how fast they can receive payments for their sales. As said before, when all of these steps are put together the operating cycle is complete. The lesser the operating cycle, the better is the cash flow. Hence, the liquidity of the business is governed by its operating cycle.
Industry Study: A comparative study of similar industries / business would give an insight into the past performance, current market situation and future prospects of such industries so that a better and pragmatic view can be taken about such industries to predict the likely trend that may set in. Trend analysis is the process of comparing business data over time to identify any consistent results or trends. Then a strategy can be developed to respond to these trends in line with the business goals. Trend analysis helps to understand how the business has performed and predict where current business operations and practices of the business will lead to. Done well, it will give ideas about decisions to be taken to move the business in the right direction to prevent the business becoming non performing asset. Trend analysis can be used to help improve the business by (i) Identifying areas where the business is performing well so it can duplicate success. (ii) Identifying areas where the business is underperforming and (iii) providing evidence and information to facilitate decision making.
Delivery of credit: After having undertaken a quality assessment and appraisal and taking into account all aspects of risks involved and after ensuring adequate cash flow to meet the financial commitments of the business enterprise, the banks issue their sanction letter with all terms and conditions. But the terms and conditions should be easily and fairly implementable without any hassles. Credit is delivered on executing banking and legal documents after complying with the terms and conditions of sanction. It is pertinent to note that the success or failure of any commercial business venture is determined by flow of credit in adequate quantity at the right time so that business project can be implemented as per the schedule of implementation to start commercial operations to create adequate cash flow so as to enable the business entity to fulfill its financial commitment to the bank as well as to the other business commitments.
Understanding the Borrower and his requirements: Presently the attitude of the bank and that of the borrower has created a divide between them leading to misunderstanding and distrust. The prudential norms introduced on account of the banking reforms have generated more pressure on the performance and profitability of the banks. The basic problem is that while the bank thinks that the borrower is responsible for the account becoming NPA, the borrower on the other hand believes that the many wrong doings of the bank are the reasons for his account becoming NPA. Thus there is a stalemate and an aberration in the respective thinking. What are the reasons for such divergent views? The basic reason is lack of effective communication between the bank and the borrower. Communication can make or mar a relationship. The purpose of effective communication is to understand and to be understood and the result is the creation of trust between the bank and the customer which is the key that opens all doors. In any relationship, the essence of trust is not in its “bind”, but in its “bond”. Communication, if effective, leads to co-operation that is to say to understand each other creating an intimate relationship valuing each other views. So it is with the bank and its customer. Acceptance comes out of understanding and acceptance can lead to better customer banker relationship. The banker customer relationship is complimentary to each other and not contradictory. If only the banker and the borrower can understand their respective roles and duties and responsibilities and how are they interconnected with their mutual welfare in their correct perspectives, then only can there be an everlasting enduring and endearing relationship. In the ultimate analysis, the bank has to reorient their attitude towards their customers to match the habits of the customer. The banker has to take decisions to serve the customer with a delightful service and improve upon further on the basis of feedback and through innovation. The customers particularly the borrowers can match and reciprocate the proactive borrower friendly good gesture of the banks by understanding their role and duties in their correct perspectives so that the bank can become the friend, philosopher, and guide to the borrowers which can produce excellent economic results. The perceptions, culture, values, and business ethics of the bank and that of the customers should be complimentary to each other and if united will not only lead to excellence in business but also ensure an adoring relationship between the bank and the customers.
It is thus obvious that the first and the foremost step to be taken by the banks to arrest the deteriorating trend in the management of NPA is to implement an efficient and effective management system and procedure for the assessment and appraisal of credit proposal by knowledgeable professionals with pragmatic and practical outlook and a visualizing capacity to anticipate any unforeseen eventuality and to find remedial measures to tackle purposefully and effectively such incidents. Besides, understanding the various problems and predicaments faced by the borrowers and finding remedies for them along with educating the borrowers with regard to good governance, financial discipline and effective financial management would create trust and confidence to produce a congenial relationship and conducive working environment between the bank and the borrower which will pave the way for the prevention of slippage of NPA accounts. But banks seldom provide their assessment and appraisal report to the borrowers under the guise of being their internal matter and not being transparent with the result the borrowers cannot articulate their grievances regarding their views on the assessment and appraisal of their loan requirement and most of the time the banks impose their views on the borrowers without considering their observations and also without any consultation with them overlooking RBI guidelines contained in their circular on Fair Practices Code for Lenders DBOD. Leg. No.BC. 104 /09.07.007/2002-03 dated May 5, 2003 and also DBOD.No.Leg.BC.65 /09.07.005/2006-07 dated March 6, 2007.If the banks fail to undertake such an exercise, then it leads to creation of non performing accounts from the beginning itself and such accounts can be termed as “Born Sick” and there are many such accounts.