WHAT IS BANK?

A bank is an institution that deals in money and its substitutes and provides other
financial services. Banks accept deposits and make loans and derive a profit from
the difference in the interest rates paid and charged, respectively.

Banks are critical to our economy. The primary function of banks is to put their
account holders' money to use by lending it out to others who can then use it to
buy homes, businesses, send kids to college etc. When you deposit your money
in the bank, your money goes into a big pool of money along with everyone else's,
and your account is credited with the amount of your deposit. When you write
checks or make withdrawals, that amount is deducted from your account balance.
Interest you earn on your balance is also added to your account.

Banks create money in the economy by making loans. The amount of money that
banks can lend is directly affected by the reserve requirement set by the Federal
Reserve. The reserve requirement is currently 3 percent to 10 percent of a bank's
total deposits. This amount can be held either in cash on hand or in the bank's
reserve account with the Fed.

What are the Functions of Banks?

These functions of banks are explained in following paragraphs of this article.

A. Primary Functions of Banks

The primary functions of a bank are also known as banking functions. They are
the main functions of a bank.
These primary functions of banks are explained below.

1. Accepting Deposits

The bank collects deposits from the public. These deposits can be of different
types, such as :-

1. Saving Deposits

This type of deposits encourages saving habit among the public. The
rate of interest is low. At present it is about 4% p.a. Withdrawals of
deposits are allowed subject to certain restrictions. This account is
suitable to salary and wage earners. This account can be opened in
single name or in joint names.

2. Fixed Deposits

Lump sum amount is deposited at one time for a specific period. Higher
rate of interest is paid, which varies with the period of deposit.
Withdrawals are not allowed before the expiry of the period. Those who
have surplus funds go for fixed deposit.

3. Current Deposits

This type of account is operated by businessmen. Withdrawals are

freely allowed. No interest is paid. In fact, there are service charges.
The account holders can get the benefit of overdraft facility.

4. Recurring Deposits

This type of account is operated by salaried persons and petty traders.

A certain sum of money is periodically deposited into the bank.
Withdrawals are permitted only after the expiry of certain period. A
higher rate of interest is paid.

2. Granting of Loans and Advances

 The bank advances loans to the business community and other members of
the public. The rate charged is higher than what it pays on deposits. The
difference in the interest rates (lending rate and the deposit rate) is its profit.
The types of bank loans and advances are :-

1. Overdraft

This type of advances are given to current account holders. No separate

account is maintained. All entries are made in the current account. A
certain amount is sanctioned as overdraft which can be withdrawn within
a certain period of time say three months or so. Interest is charged on actual
amount withdrawn. An overdraft facility is granted against a collateral
security. It is sanctioned to businessman and firms.

2. Cash Credits

The client is allowed cash credit upto a specific limit fixed in advance. It
can be given to current account holders as well as to others who do not
have an account with bank. Separate cash credit account is maintained.
Interest is charged on the amount withdrawn in excess of limit. The cash
credit is given against the security of tangible assets and / or guarantees.
The advance is given for a longer period and a larger amount of loan is
sanctioned than that of overdraft.

3. Loans

It is normally for short term say a period of one year or medium term say
a period of five years. Now-a-days, banks do lend money for long term.
Repayment of money can be in the form of installments spread over a
period of time or in a lumpsum amount. Interest is charged on the actual
amount sanctioned, whether withdrawn or not. The rate of interest may be
slightly lower than what is charged on overdrafts and cash credits. Loans
are normally secured against tangible assets of the company.

4.Discounting of Bill of Exchange

The bank can advance money by discounting or by purchasing bills of

exchange both domestic and foreign bills. The bank pays the bill amount
to the drawer or the beneficiary of the bill by deducting usual discount
charges. On maturity, the bill is presented to the drawee or acceptor of the
bill and the amount is collected.

B. Secondary Functions of Banks

The bank performs a number of secondary functions, also called as non-banking
functions.
These important secondary functions of banks are explained below.

1. Agency Functions

The bank acts as an agent of its customers. The bank performs a number of agency
functions which includes :-

1.Transfer of Funds

The bank transfer funds from one branch to another or from one place to
another.

2. Collection of Cheques

The bank collects the money of the cheques through clearing section of its
customers. The bank also collects money of the bills of exchange.

3. Periodic Payments

On standing instructions of the client, the bank makes periodic payments

in respect of electricity bills, rent, etc.

4. Portfolio Management

The banks also undertakes to purchase and sell the shares and debentures
on behalf of the clients and accordingly debits or credits the account. This
facility is called portfolio management.

5.Periodic Collections

The bank collects salary, pension, dividend and such other periodic
collections on behalf of the client.

6.Other Agency Functions

They act as trustees, executors, advisers and administrators on behalf of its

clients. They act as representatives of clients to deal with other banks and
institutions.

2. General Utility Functions

The bank also performs general utility functions, such as :-

1. Issue of Drafts and Letter of Credits

Banks issue drafts for transferring money from one place to another. It also
issues letter of credit, especially in case of, import trade. It also issues
travellers' cheques.

2.Locker Facility

The bank provides a locker facility for the safe custody of valuable
documents, gold ornaments and other valuables.

3. Underwriting of Shares

The bank underwrites shares and debentures through its merchant banking
division.

4.Dealing in Foreign Exchange

The commercial banks are allowed by RBI to deal in foreign exchange.

5. Project Reports

The bank may also undertake to prepare project reports on behalf of its
clients.

6.Social Welfare Programmes

It undertakes social welfare programmes, such as adult literacy

programmes, public welfare campaigns, etc.

7. Other Utility Functions

It acts as a referee to financial standing of customers. It collects

creditworthiness information about clients of its customers. It provides
market information to its customers, etc. It provides travellers' cheque
facility.
 Non-Performing Asset - NPA

What is a 'Non-Performing Asset - NPA '

A nonperforming asset (NPA) refers to a classification for loans on the books of

financial institutions that are in default or are in arrears on scheduled payments
of principal or interest. In most cases, debt is classified as nonperforming when
loan payments have not been made for a period of 90 days. While 90 days of non
payment is the standard period of time for debt to be categorized as
nonperforming, the amount of elapsed time may be shorter or longer depending
on the terms and conditions set forth in each loan.
Criteria
Loans don’t go bad right away. Most loans allow customers a certain grace
period. Then they are marked overdue. After a certain number of days, the loan
is classified as a nonperforming loan.
Banks usually classify as nonperforming assets any commercial loans which are
more than 90 days overdue and any consumer loans which are more than 180
days overdue.
For agricultural loans, if the interest and/or the installment or principal remains
overdue for two harvest seasons; it is declared as NPAs. But, this period should
not exceed two years. After two years any unpaid loan/installment will be
classified as NPA.

Categories
1. Sub-standard: When the NPAs have aged <= 12 months.
2. Doubtful: When the NPAs have aged > 12 months.
3. Loss assets: When the bank or its auditors have identified the loss, but it has
not been written off.

After a certain amount of time, a bank will try to recoup its money by foreclosing
on the property that secures the loan. The way money is recouped is a highly
contentious issue not just with banks but also with Micro-Finance Institutions
(MFIs). We will discuss it later in the article.

All of this can be explained in a much more technical manner, but that is not
required here. For example, we do not need to list all the conditions that make the
banks declare an asset as NPAs like ” In respect of derivative transactions, the
overdue receivables representing positive mark-to-market value of a derivative
contract, if these remain unpaid for a period of 90 days from the specified due
date for payment.”
Only understanding the basic concepts will suffice. UPSC is not going to ask you
these details, but about the impact and solutions of NPAs. Even in prelims, these
details will not be asked. So we avoid technicalities and jargons here. It is not
useful for a GS paper, even if some of it may be useful for Economics optional
paper.

BREAKING DOWN 'Non-Performing Asset - NPA '

Banks usually categorize loans as nonperforming after 90 days of nonpayment of
interest or principal, which can occur during the term of the loan or for failure to
pay principal due at maturity. For example, if a company with a $10 million loan
with interest-only payments of $50,000 per month fails to make a payment for
three consecutive months, the lender may be required to categorize the loan as
nonperforming to meet regulatory requirements. A loan can also be categorized
as nonperforming if a company makes all interest payments but cannot repay the
principal at maturity.

The Effects of NPAs

Carrying nonperforming assets, also referred to as nonperforming loans, on the
balance sheet places three distinct burdens on lenders. The nonpayment of interest
or principal reduces cash flow for the lender, which can disrupt budgets and
decrease earnings. Loan loss provisions, which are set aside to cover potential
losses, reduce the capital available to provide subsequent loans. Once the actual
losses from defaulted loans are determined, they are written off against earnings.

Recovering Losses
Lenders generally have four options to recoup some or all of the losses resulting
from nonperforming assets. When companies are struggling to service debt,
lenders can take proactive steps to restructure loans to maintain cash flow and
avoid classifying loans as nonperforming. When defaulted loans are
collateralized by assets of borrowers, lenders can take possession of the collateral
and sell it to cover losses to the extent of its market value.
Lenders can also convert bad loans into equity, which may appreciate to the point
of full recovery of principal lost in the defaulted loan. When bonds are converted
to new equity shares, the value of the original shares is usually wiped out. As a
last resort, banks can sell bad debts at steep discounts to companies that specialize
in loan collections. Lenders typically sell defaulted loans that are not secured with
collateral or when the other means of recovering losses are not cost-effective.

BANKS IN INDIA

The government has empowered the Reserve Bank of India (RBI) to help resolve
the issue of non-performing assets (NPAs). The RBI has also since directed the
banks that the joint lenders’ forums (JLFs) should implement the corrective action
plans (CAPs) within the prescribed timelines. So the big question is—will the bad
loans now get resolved more efficiently than was the case until a few weeks ago?
Let us look at the issue closely.
As per the RBI directive, banks will now have to agree to a common approach
for restructuring or recovery of each non-performing loan (NPL). The common
approach will be the one adopted by the lead bank, along with a few more banks
so as to meet the thresholds of 60% of lenders by value and 50% by number. The
desirability of this approach assumes that the interests of all banks need to be
aligned with or subsumed within the interest of the lead bank. It is doubtful that
the smaller banks would be happy with this measure for the simple reason that if
the same was true, all the members of the JLF would have anyway agreed with
the lead lender and a prescription by the RBI would not have been required in the
first place. Having said that, this seems to be a fair approach to the extent that the
JLF can now move forward with majority support.
However, we need to evaluate as to whether even after getting the JLF aligned,
will we face some other critical bottlenecks? In my view, the real problem has
been the absence of a reliable and coherent basis for JLF members to agree to a
common plan. Let us try and understand this.
When a troubled asset, like a power project, underlying an NPL, is to be revived
or transacted with an asset reconstruction company (ARC), the fundamental
requirement for an optimal decision process is the data on the costs and benefits
involved in the process. The parties involved would need to have reliable data to
put their money on the table. The required data would include the operational,
financial, and regulatory pay-offs from the power project, post-restructuring or
recovery actions. While the data is more easily available for an operational
project, it is not so for an under-construction project. For example, the projected
operational and financial performance for a thermal project depends on multiple
variables like the power purchase agreement (PPA), fuel supply agreement
(FSA), environmental clearance status, timelines for construction, etc. Each of
these variables is prone to uncertainties.
In the absence of reliable data regarding the elements of the pay-off to the banks,
each bank would adopt a stance that is aligned with its risk appetite and
preferences. It is known that the process of the bank getting back its dues through
the legal recovery process is usually slow, uncertain, and value destructive. There
is no market clearing mechanism to serve as a guide for the pricing decisions in
the restructuring or recovery to be done by the banks. This leads to a widening of
the bid-ask spreads, reflecting the uncertainty in the pricing of risk in the
transaction. As a result, the transaction either does not get consummated or if
forced to consummate, leads to a sub-optimal situation for certain stakeholders.
Till now the absence of an agreement within the JLF reflected the former and in
the revised circumstances, the forced agreement within the JLF will reflect the
latter.
Now the same logic will get extended when a buyer of the NPL (or the underlying
asset) is brought into the game. There is neither a junk bond market nor have there
been any significant transactions of impaired businesses to serve as a guide for
valuation. In the absence of any shadow pricing of the junk loans or the impaired
underlying assets, the potential buyers of the same are expected to quote low
prices to hedge their risk on account of high uncertainty, while buying the same
from the banks. While we may hope to count on competition among the buyout
funds, they would, in aggregate, be still expected to behave in their collective
interest and not be truly competitive.
So, what can we expect from the new paradigm? While the timelines for recovery
are expected to be more streamlined, there are caveats to the same.
For one, the banks will be under pressure to close the transactions soon and this
could at times lead to under-pricing of the loans, to the advantage of the buyers.
Second, the provisions made by the banks till now could turn out to be inadequate.
These provisions would, till now, have been based on expected losses from the
NPLs. But now we are talking of losses based on potentially lower realizations
than expected earlier. Third, it might turn out to be a case of missing the woods
for the trees. While the NPLs would be off the books of the banks, some of them
would still require significant recapitalization, as they would have lost a
significant amount of capital and credit-making capacities as well.
As a final thought, even as the process of JLF is being streamlined and
disciplined, it would be helpful if the government and the RBI can help create an
improved market for distressed assets at the
earliest.
In the long term, this is of course an imperative for the banking system as well as
the economy. In the short term, an increased flow of capital into the stressed assets
transactions should be encouraged with specific policy and tax incentives for a
limited time period. This will help in a more competitive market and better price
discovery. We have begun the journey of correction and must take it to the most
optimal conclusion.

EXTENT OF NPAs
Gross NPAs of domestic banks jumped to 4.2 % of total lending by the end of
September 2013 from 3.6 % six months before, according to the Reserve Bank
of India (RBI).
As per a recent warning by the RBI, bad loans (NPAs) could climb to 7% of
total advances by 2015.
In absolute terms, gross NPAs are estimated to touch Rs 2.50 lakh crores by the
end of March this year. This is equal to the size of the budget of Uttar Pradesh.
The biggest chunk of the soured debts is with state-run banks (Public sector
banks or PSBs), which account for two-thirds of loans but 80 % of the bad
assets.

WHY IT MATTERS?
The higher is the amount of non-performing assets (NPAs), the weaker will be
the bank’s revenue stream.
In the short-term, many banks have the ability to handle an increase in
nonperforming assets — they might have strong reserves or other capital that
can be used to offset the losses. But after a while, if that capital is used up,
nonperforming loans will imperil a bank’s health. Think of nonperforming
assets as dead weight on the balance sheet.
Here is the impact of the NPAs:
As the NPA of the banks will rise, it will bring a scarcity of funds in the Indian
security markets. Few banks will be willing to lend if they are not sure of the
recovery of their money.
The shareholders of the banks will lose a lot of money as banks themselves will
find it tough to survive in the market.
This will lead to a crisis of confidence in the market. The price of loans, i.e. the
interest rates will shoot up badly. Shooting of interest rates will directly impact
the investors who wish to take loans for setting up infrastructural, industrial
projects etc.
It will also impact the retail consumers like us, who will have to shell out a
higher interest rate for a loan.
All of this will lead to a situation of low off take of funds from the security
market. This will hurt the overall demand in the Indian economy. And, finally it
will lead to lower growth rates and of course higher inflation because of the
higher cost of capital.
This trend may continue in a vicious circle and deepen the crisis.
Total NPAs have touched figures close to the size of UP budget. Imagine if all
the NPA was recovered, how well it can augur for the Indian economy.
RBI governor Raghuram Rajan has recently said that NPAs must be
curbed before the problem becomes alarming.
WHY SUCH A SITUATION?
The rising incidence of NPAs has been generally attributed to the domestic
economic slowdown. It is believed that with economic growth slowing down
and rate of interest going up sharply, corporates have been finding it difficult to
repay loans, and it has added up to rising NPAs. Even finance minister P
Chidambaram stated that bad loans are a function of the economy and hence,
having bad loans during distressed times is very natural.
However, The NPA mess is not entirely because of the reversal of economic
cycles.
Here we look at the other reasons behind this mess. Basically the whole
problem can be divided into two parts – External problems and internal
problems as faced by the banks.

External Factors
REASONS RELATED TO THE CORPORATE SECTOR
Apart from the slowdown in India, the global economy has also slowed down.
This has adversely impacted the corporate sector in India. Continuing
uncertainty in the global markets has lead to lower exports of various products
like textiles, engineering goods, leather, gems etc. It can be noted that imports
and exports combined equal to around 40% of India’s GDP!
A hurt corporate sector is finding it difficult to pay loans
The ban in mining projects, delay in environmental related permits affecting
power, iron and steel sector, volatility in prices of raw material and the shortage
in availability of power have all impacted the performance of the corporate
sector. This has affected their ability to pay back loans.

OTHER SECTORS
Banks in India are highly regulated. Priority sector lending (PSL) is one of these
regulations which require the banks to give a certain % of their loans to certain
sections of society. These are farmers, SCs, STs, IT parks, MSMEs etc.
Naturally one would assume that the weaker sections covered under PSL are the
ones to be blamed for the situation. However, it is not the case.
As per recent news reports, the Standing Committee on Finance will be now
examining the reasons for high NPAS in PSBs.
The data, shared with the Standing Committee, shows that NPAs in the
corporate sector are far higher than those in the priority or agriculture sector.
Within the priority sector, incremental NPAs were more in respect to micro
small and medium enterprises followed by agriculture.
However, even the PSL sector has contributed substantially to the NPAs.
As per the latest estimates by the SBI, education loans constitute 20% of its
NPAs!

The sluggish legal system (Judiciary in India) and lack of systematic and
constant efforts by the banks make it difficult to recover these loans from both
corporate and non-corporate.

Internal Factors

1. Indiscriminate lending by some state-owned banks during the high growth

period (2004-08) is one of the main reasons for the deterioration in asset quality.

2. Bankers say there is a lack of rigour in loan appraisal systems and monitoring
of warning signals at state-run banks. This is particularly true in case of
infrastructure projects, many of which are struggling to repay loans. Besides,
these projects go on for 20 to 30 years.
3. Poor recovery and use of coercive techniques by banks in recovering loans

4. The wait and watch approach of banks have been often blamed as the reason
for rising NPAs as banks allow deteriorating asset class to go from bad to worse
in the hope of revival and often offer restructuring option to corporates.
A Parliamentary panel, examining increasing incidents of NPAs, has observed
that state-owned banks should stop “ever-greening” or repeated restructuring of
corporate debt to check the constant bulging of their non-performing assets.
Members of the panel were of the view that NPAs are the result of bad
economic situation, but there were also management issue of every-greening of
loans, which could be avoided by “not renewing loans, particularly of
corporate”.

Therefore, it can be clearly seen that it is only the economic slowdown that is
behind the NPAs. There are a whole range of factors.

WAY OUT
The simplest approach to cut down NPAs is to recover the bad loans.
Apart from the regular guidelines released by the RBI, to strengthen further the
recovery of dues by banks and financial institutions, Government of India
promulgated:
1.The Recovery of Debts Due to Banks and Financial Institutions Act, 1993
2. The Securitization Reconstruction of Financial Assets and Enforcement of
Security Interest (SARFAESI) Act, 2002.
So, how can the banks legally recover their loans?

(i) The Securitization and Reconstruction of Financial Assets and Enforcement

of Security Interest (SARFAESI) Act, 2002 – The Act empowers Banks /
Financial Institutions to recover their non-performing assets without the
intervention of the Court, through acquiring and disposing of the secured assets
in NPA accounts with outstanding amount of Rs. 1 lakh and above. The banks
have to first issue a notice. Then, on the borrower’s failure to repay, they can:
Take possession of security and/or
Take over the management of the borrowing concern.
Appoint a person to manage the concern.

(ii) Recovery of Debts Due to Banks and Financial Institutions (DRT) Act: The
Act provides setting up of Debt Recovery Tribunals (DRTs) and Debt Recovery
Appellate Tribunals (DRATs) for expeditious and exclusive disposal of suits
filed by banks / FIs for recovery of their dues in NPA accounts with outstanding
amount of Rs. 10 lac and above. Government has, so far, set up 33 DRTs and 5
DRATs all over the country.

(iii) Lok Adalats: Section 89 of the Civil Procedure Code provides resolution of
disputes through ADR methods such as Arbitration, Conciliation, Lok Adalats
and Mediation. Lok Adalat mechanism offers expeditious, in-expensive and
mutually acceptable way of settlement of disputes.
Government has advised the public sector banks to utilize this mechanism to its
fullest potential for recovery in Non-performing Assets (NPAs) cases.
Among the various channels of recovery available to banks for dealing with bad
loans, the SARFAESI Act and the Debt Recovery Tribunals (DRTs) have been
the most effective in terms of amount recovered.
The recent controversy surrounding loan recovery in India – Views of the SC
Banks have been alleged to engage in coercive practices to recover the loans.
Recently, there have been some judicial pronouncements by the apex court
determining the scope of powers of enforcement of securities without the
intervention of the courts, by the banks and FIs under the SARFAESI Act. The
apex court has reiterated the need to protect the interest of borrowers, and
emphasized that the exercise of extraordinary powers of recovery, by banks and
FIs must be in compliance with the provisions of the SARFAESI Act.

As per the Supreme Court (SC) – “”Liquidity of finances and flow of money is
essential for any healthy and growth oriented economy. But certainly, what must
be kept in mind is that the law should not be in derogation of the rights which are
guaranteed to the people under the Constitution. The procedure should also be
fair, reasonable and valid, though it may vary looking to the different situations
needed to be tackled and object sought to be achieved.”

But, these are steps which cure the disease of NPAs. “The issue of NPAs needs
to be tackled at the level of prevention rather than cure.”
Therefore, the steps that can prevent the piling up of NPAs are as follows:

1. CONSERVATISM:
Banks need to be more conservative in granting loans to sectors that have
traditionally found to be contributors in NPAs. Infrastructure sector is one such
example. NPAs rise predominantly because of long gestation period of the
projects. Therefore, the infrastructure sector, instead of getting loans from the
banks can be funded from Infrastructure Debt Funds (IDFs) or other specialized
funds for infrastructural development in the country.

2. IMPROVING PROCESSES:
The credit sanctioning process of banks needs to go much more beyond the
traditional analysis of financial statements and analyzing the history of
promoters. For example, banks rely more on the information given by credit
bureaus. However, it is often noticed that several defaults by some corporate are
not registered in their credit history.
3. RELYING LESS ON RESTRUCTURING THE LOANS:

Instead of sitting and waiting for a loan to turn to a bad loan, and then
restructure it, the banks may officially start to work to recover such a loan. This
will obviate the need to restructure a loan and several issues associated with it.
One estimate says that by 2013 there will be Rs 2 trillion worth of restructured
loans.

4. EXPANDING AND DIVERSIFYING CONSUMER BASE BY

INNOVATIVE BUSINESS MODELS:
Contrary to popular perceptions,the NPA in non-corporate sector is less than
that in the corporate sector. Hence, there is a need to reach out to people in
remote areas lacking connectivity and accessibility. More and more poor people
in rural pockets should be brought under the banking system by adopting new
technologies and electronic means. Innovative business models will play a
crucial role here. Otherwise, the NPAs may increase instead of decreasing.
As said by the new M.D. of SBI, Mr. Viswanathan proposed ideas such as a
single demat account for all investments and credit cards for school students
(above class 8th) to make them aware with the banking system.
 CONCLUSION

Looking at the giant size of the banking industry, there can be hardly any doubt
that the menace of NPAs needs to be curbed. It poses a big threat to the macro-
economic stability of the Indian economy. An analysis of the present situation
brings us to the point that the problem is multi-faceted and has roots in
economic slowdown; deteriorating business climate in India; shortages in the
legal system; and the operational shortcoming of the banks. Therefore, it has to
be dealt at multiple levels. The government can’t be expected to rescue the
state-run banks with tax-payer’s money every time they fall into a crisis. But,
the kind of attention with which this problem has been received by
policymakers and bankers alike is a big ray of hope. Right steps, timely and
concerted actions and a revival of the Indian economy will put a lid on NPAs.
Prevention, however, has to become a priority than mere cure.