Banks generate a substantial amount of their income from the interest received upon the loans and advances provided to companies and individuals. As a consequence of the shrinking liquidity in the market and the current recessionary environment, more and more companies and individuals are unable to keep up with their repayment cycles and tend to default on their loans. Such defaulting loans are commonly referred to as Non-Performing Loans (“NPL”) or Non-Performing Assets (“NPA”). Rising NPLs are detrimental to the economy of any country and reflect poorly in respect of creditworthiness of banks that show a larger number of NPLs on their portfolios.
The present bulletin discusses the legal provisions governing NPLs in India, the reasons behind their rise, their effect on the economy and the plausible solutions available to banks to deal with them.
Simply put, NPL is a loan in default or one that is on the verge of default. NPA has been defined under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”)1 as an asset or account of a borrower which has been classified by a bank or financial institution as substandard, doubtful or loss asset.
To provide more clarity, India’s federal bank, the Reserve Bank of India (“RBI”) has laid down criteria to indicate whether a loan or advance constitutes a NPA 2 and classified NPAs into three broad categories:
- Substandard Assets: those that have remained NPA for a period less than or equal to 12 months.
- Doubtful Assets: those that have remained in the category of a substandard asset for 12 months.
- Loss Assets: where loss has been identified by the lending bank or internal or external auditors or by means of RBI inspection but the amount has not been written off wholly.
NPLs are a world-wide phenomenon and numerous causes have been attributed to their rise. In most cases the cause appears to be either “bad banking decisions” or “a
banking and financial crisis.” A bad banking decision is one where the bank makes an error of judgment while making an assessment of the borrower’s ability to repay a loan. A banking crisis on the other hand is caused by a shortage of capital in banks. The funds a bank receives in the form of deposits is usually lent out. As a consequence, if at a point of time, all or a majority of the depositors wish to withdraw all their money at the same time, the bank will not be in a position to make immediate repayment. This may cause a shortage of capital and lead to a banking crisis or even bankruptcy of the bank. When this crisis is widespread and simultaneously spreads to other banks, it may be referred to as a systemic banking crisis. Banking crisis may also be the outcome of prevailing economic policies, excessive lending by banks, a credit boom, etc. It impacts the financial and business sectors of a country, increasing the number of contractual defaults by individuals, corporates and financial institutions.
2. Consequences and solution
Increasing NPLs have a negative and a cascading impact on the economy of the country. When NPLs rise, banks not only hesitate in giving loans but are also compelled to divert their existing resources and manpower in resolving this problem. As a result, banks potentially lose out on their ability to capitalize on productive opportunities such as finding new and promising areas of investment that may yield higher returns.
Further, when there is an increase in NPLs, the entire capital of a bank gets tied up, giving rise to a credit crisis and a liquidity crunch in the economy. With lower liquidity in the market, the economy shows a downward trend, people take less financial risks, their purchasing power goes down and the economy is adversely affected as a whole. Banks begin to recall loans and companies and individuals who are unable to make repayments start defaulting, resulting in a further rise in NPLs.
In an attempt to recover and reduce the existing as well as accumulated NPLs, banks and financial institutions may:
- Take the assistance of an Asset Reconstruction Company (“ARC”)
- Seek redressal from the Debt Recovery Tribunal (“DRT”)
- Initiate winding up proceedings against defaulting companies
- Asset Reconstruction Companies3 and their role
3.Asset Reconstruction Companies3 and their role
ARCs provide an efficient mechanism to banks for dealing with their accumulated NPAs. With the enactment of the SARFAESI Act, the concept of ARCs came into formal existence, finally making way for an alternate means of redressal to litigation. To qualify as an ARC, a company must fulfill the eligibility criteria laid down under the SARFAESI Act4 and
must be registered with the RBI.5 The SARFAESI Act regulates the transfer of NPAs from banks to ARCs as well as the enforcement of security interests. Additionally, the RBI has also laid down guidelines governing the registration of ARCs, measures exercisable for asset reconstruction, functions of the ARC, prudential norms, acquisition of financial assets and matters related thereto.6
Based on their needs countries have adopted different models of ARCs across the globe with one common objective i.e., minimizing NPLs. In the US the government set up the Resolution Trust Corporation to deal with accumulated NPAs and was wound up once this purpose was achieved. In India, formation of ARCs is open to the private sector and here the ARCs function more like business entities attempting to make profits.
ARCs acquire NPAs from banks and financial institutions and manage them with a view to recover and liquidate the loans in default. Under the SARFAESI Act, an ARC can acquire NPAs from any bank or financial institution by either (a) issuing a debenture or bond or any other security in the nature of debenture, for a consideration agreed between them (on agreed terms and conditions), or (b) by entering into an agreement with such bank or financial institution for the transfer of such financial assets to such company on agreed terms and conditions.7 The board of the selling bank is required to formulate a policy for the sale of NPAs and ensure that the sale is carried out in accordance with such policy. This policy must specify the NPAs that are to be sold/purchased, the norms and procedure for the sale/purchase, the valuation procedure to be followed and also the accounting policy.8
Usually ARCs set up trusts to acquire NPAs. They acquire them at discounted rates and in return, issue security receipts to the selling banks/financial institutions. The ARCs then manage the acquired NPAs by providing for the management of the business of the defaulter/borrower, the sale or lease of a part or whole of the business of the defaulter/borrower, rescheduling payment of debts payable by the borrower, enforcement of security interest, settlement of dues payable by the borrower and possession of secured assets.9
4.Debt Recovery Tribunals
Under the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (“the RDBF Act”) another recourse available to lenders i.e., banks and financial institutions against defaulting borrowers is to move an application for recovery of debts.10 The RDBF Act provides for the establishment of the DRT which is empowered to adjudicate and decide recovery applications.
Once an application is made to the DRT, the DRT issues a summons to the defaulter requesting reasons as to why he should not be proceeded against. The defaulter submits a written statement specifying his defence and particulars of the debt sought to be set off if the case may be. After giving the applicant as well as the defaulter an opportunity to be heard, the DRT may pass a final order. The presiding officer then issues a certificate under his signature to the Recovery Officer for recovery of the amount specified in the certificate.11 As modes of recovery, the RDBF Act provides for the attachment and sale of movable or immovable property of the defaulter, the appointment of a receiver for the management of such property and finally his arrest and detention in prison.
An appeal against an order of the DRT lies with the Debt Recovery Appellate Tribunal only if the order passed by the DRT was passed without the consent of the parties. This remedy of seeking redressal from the DRT is available to banks and financial institutions only in recovery cases and not in case of other banking related disputes. It is also important to note that while the RDBF Act provides a mechanism to recover debts, the process itself is very lengthy and time consuming.
5.Winding up proceedings
As is common in the rest of the world banks have also been seen to seek redressal against defaulting companies by initiating winding up proceedings against them. This remedy is resorted to by banks and financial institutions all over the world. In India, the provisions for winding up of a company are contained in the Companies Act, 1956 (“the Act”). As per these provisions a company may be wound up either voluntarily or by an order of the Company Law Board (“CLB”). The CLB is empowered to pass an order of winding up for a number of reasons, including, the company’s inability to pay its debts.12 A petition for winding up a company can be filed by any creditor or creditors, any contributory or contributories or all of the aforesaid either together or separately, or by the Registrar of Companies, or any authorized person of the Central or State Government.13 However the lengthy, time consuming and protracted nature of a winding up proceeding in India generally tends to make it a less preferable option for making a recovery.
NPLs are a recurring phenomenon with which banks and financial institutions have to deal on an ongoing basis. In acknowledgment of the adverse impact of the increasing NPLs on the Indian economy, the government of India enacted the RDBF Act. A specialized body called the Credit Information Bureau of India Ltd. was setup in 2000, to disseminate important positive and negative credit information to member banks and financial institutions to enable them to form a clear assessment of the repaying capacity of prospective borrowers and being forewarned in case of regular defaulters.
Based on their respective needs and priorities, banks have to decide the recourse or solution best suited to them and deal with the ever increasing NPLs in their portfolios. Although the Central Government has provided remedies in the form of applications before the DRT and mechanisms for initiating winding up proceedings against defaulters, their time consuming and lengthy nature makes them less preferable as compared to ARCs. Further, an increasing number of NPAs on the balance sheets of a bank adversely impacts the banks credibility and image. By taking away a chunk of the NPAs an ARC is able to help maintain the banks credibility in the market, making it a preferred recourse.
Authored by: Tanya Mehta
1 Section 2 (o) of SARFAESI Act
2 In the Master Circular on Prudential Norms on Income recognition, asset classification and provisioning pertaining to advances dated July 01, 2009, some of the criteria laid down by the RBI include:
(i) where in case of a term loan the interest and/or installment of the principal remains overdue for a period of more than 90 days, (ii) the account remains out of order i.e., the outstanding balance remains continuously in excess of the sanctioned limit/drawing power, in respect of an Overdraft/Cash Credit (OD/CC), (iii) the bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted.
3 As per section 2 (v) of the SARFAESI Act, a reconstruction company means a company formed and registered under the Companies Act for the purpose of asset reconstruction
4 Section 3 (3)
5 Per the eligibility criteria (a) The Securitisation Companies (“SC”) or Reconstruction Companies (“RC”) must not have incurred losses in three preceding financial years, (b) made adequate arrangements for realization of the financial assets acquired for the purpose of securitisation or asset reconstruction and shall be able to pay periodical returns and redeem on the investments made in the company, (c) the directors of SC/RC have adequate professional experience, (d) the board of directors does not consist of more than half of its total number of directors as either nominees of any sponsor or associated in any manner with the sponsor or any of its subsidiaries, (e) any of its directors has not been convicted of any offence involving moral turpitude, (f) a sponsor is not a holding company of the CS/RC or does not otherwise hold any controlling interest in such SC/RC, (g) the SC/RC has complied with or is in a position to comply with prudential norms specified by the RBI.
6 (a) The SC and RC (Reserve Bank) Guidelines and Directions 2003 dated July 01, 2009, (b) Master Circular on directions/instructions issued to the SC/RC dated July 01, 2009, and (c) Master Circular on Prudential norms on Income Recognition, Asset Classification and provisioning pertaining to advances dated July 01, 2009 (this includes guidelines on sale/purchase of financial assets to SC/RC and guidelines on sale/purchase of NPAs
7 Section 5 of the SARFAESI Act
8 The SC and RC (Reserve Bank) Guidelines and Directions 2003 dated July 01, 2009
9 Section 9 of the SARFAESI Act
10 The RDBF Act is applicable to cases where the amount of debt recoverable by a bank or financial institution is more than INR 1 million or it is an amount notified by the Central Government and this notified amount is at least INR 100,000 ( Section 1 (4) of the RDBF Act)
11 Section 19
12 Section 433 of the Act
13 Section 439 of the Act