Non-Performing Asset (NPA) simply means an asset that ceases to generate income.
Banks are the fundamental institutions for any economy. Amongst the various functions a bank performs, the function of acting as an intermediary between the depositor and borrower remains its most important function. Banks accept deposits from the public and pay interest on them. Banks further lend this amount to borrowing seekers at a rate higher than what they pay to depositors and the difference between the interest rates is what they earn. A very simple business model.
In the case of a normal business scenario, if a person does not pay our money back and there is no hope of getting it back, we write off that amount as ‘Bad debts’, a loss. But before that, unless it is certain that money will not be recovered, we create a provision or allowance for Bad debts. Provision is just simply a way of providing beforehand for foreseeable losses. This is based on the conservatism principle of accounting.
In the case of a bank, when the borrower ceases to pay interest on the loan taken, it becomes an NPA for the bank. RBI defines NPA as, “a credit facility in respect of which the interest and/ or installment of principal has remained ‘past due’ for a period of 90 days.” Now a bank does not write off an NPA as a loss immediately but instead creates a provision for these NPAs. Banks are required to classify non-performing assets further into the following three categories based on the period for which the asset has remained non-performing and the realisability of the dues:
- Sub-standard Assets
- Doubtful Assets
- Loss Assets
How does NPA affect banks?
Let us understand this by an example. Suppose you bought a machine worth ₹ 100,000 on credit to start your business. But after a few days, that machine gets stolen. Now since you don’t have any machine, your business will be going to get affected or I would say, will not take off from the ground itself. And you still need to pay Rs.100,000 to whom you bought the machine on credit.
In the case of NPAs, banks are also in the same situation. If a borrower does not pay them, it does not mean that they are not liable to pay the money to the depositors. Whether the borrower repays or not, banks have to pay the money taken from the depositors. Also, an increase in NPA affects the lending capacity of the bank, therefore, affecting it’s business and profitability. NPAs were the major reason which bought the Yes bank on the verge of failure, but then the Yes Bank was rescued by RBI.