Any asset we posses has to 'perform'. Otherwise it becomes a dead asset. In banks the loans they give to the customers are the assets. The assets should bring regular return-mainly the interest- to say they are performing. Moreover if there is any repayment schedule, the repayment also should come regularly as per schedule.
If in any such loan account (called by general term advances or whatever name or subcategory) if the interest is not serviced or paid on due date, or any instalment of repayment is not paid on its due date, and even within three months(90 days) then the loan or asset has to be treated as Non-performing asset.
Such accounts has to be monitored specially and to be brought back to performing level as early as possible. The banks have to assess all such non-performing assets periodically(generally quarterly). Banks are mandated to earmark and keep separate as provision an amount equal to a stipulated percentage of the total NPAs as on particular date(say end of each quarter) as provision.
Further, the banks cannot account further profit from the NPAs until the dues of interests and instalments are recovered in full. So a bank is affected in more ways by an NPA.
1. They do not get any profit or income from NPAs.
2. Banks have to take from their already earned profits and keep it aside as provision.
3.Depending on the age of the NPAs , the banks have to keep provision almost hundred percent of the NPAs. That affects profitability and dividend to shareholders.
4. NPAs are money blocked, and the banks do not get funds turned over for further lending. That will again affect their business and profitability.
5. If NPAs go more than the accumulated profit, then they affect the capital itself and erode the capital base. It is to avoid such capital erosion that there is a stipulation of Capital Adequacy Ratio for banks.
If a certain sum is to be lent, then a certain percentage of that is to be added to the capital. When profit flows regularly, this additional capital comes from profit. But with huge NPAs, the profit is less and banks have to find additional capital for further lending.
The more the lending, the more capital adequacy amount is needed. As public sector banks owner is government, the government has to infuse capital. Had it been private, they should have taken i from shareholders as share issue (rights or preference). In any way NPAs affect the stakeholders directly or indirectly.
However banks are supposed to monitor every account and take remedial action even when there is just first minor default. But due to the large number of accounts this is not done hundred percent effectively. Sometimes the borrowers go on promising and asking for some time but default ultimately. However the experience is that the high amount NPAs are the shockers and not the small ticket loans. It takes many thousand small loan accounts to make a single big borrower NPA.
Banks and bank officials also are subject to various pressures and influences that they cannot take all the supposed measures against big ticket defaults. There are many legal hurdles and loopholes which are well exploited by the big defaulters. Above all, there is the political influence and name taking by the big borrowers.
As the big loans immediately affect the bank's/branch's business, bank higher ups also lend more time to see if they are brought to performance.
The more effective way to avoid NPA is to give business targets very realistically and not arbitrarily, announce and publish all big loans of public sector banks and their details to he knowledge of the public-either in balance sheets or as media announcements. The names and photos of the defaulters should be published.
Apart from all these, there should be a change in our laws to make the directors personally responsible to all the liabilities of the company(which is not now). The state of things now is, director and company are different. Director's personal assets cannot be attached for the default or liability of a company, unless agreement is taken specifically for the purpose. Even then there can be disputes and directors can escape.
Ironically in the case of a small proprietary firm, the firm and proprietor are one and same.
The company director should be held responsible and punishable for the defaulted liabilities of a company. Then the big NPAs will come down.