Asset Classification and Provisioning Norms in Banks

Asset quality refers to the health of a bank’s loan and asset portfolio. Strong asset quality means most loans are performing (being repaid on time), which keeps banks profitable and stable. When many loans turn into Non-Performing Assets (NPAs) (loans where the borrower has stopped repaying), the bank faces losses. The bank must use its profits to cover these bad loans, eroding its capital and limiting its ability to give new loans.

High levels of NPAs make banks risk-averse (hesitant to lend) and can even threaten a bank’s survival. In extreme cases, if bad loans pile up across many banks, it can destabilize the entire economy. Thus, maintaining good asset quality (low NPAs) is crucial for a bank’s profitability, depositor confidence, and overall financial system stability. Regulators like the Reserve Bank of India (RBI) place strong emphasis on NPA management through clear classification norms, provisioning requirements, and recovery mechanisms to ensure banks remain healthy.

Asset Classification

Banks classify their loans and advances based on asset quality. RBI has defined standard criteria for classifying assets, especially identifying NPAs. An asset is considered an NPA if interest or principal payments are overdue for more than 90 days (for term loans), or if an overdraft is ‘out of order’ for over 90 days. (For agricultural loans, the norms are slightly different – e.g. one or two crop seasons overdue, depending on crop duration.) Once an asset is an NPA, it falls into one of three sub-categories based on the duration of non-payment. Overall, banks classify assets into four broad groups:

1. Standard Assets

These are performing loans that do not have any issues and carry only normal business risk. A standard asset is not an NPA. Essentially, the borrower is paying interest/principal on time, and the loan is considered healthy.

2. Sub-Standard Assets

A sub-standard asset is a loan that has remained NPA for 12 months or less. These loans have clear weaknesses – the borrower’s financial condition or the value of the security (collateral) is not adequate to ensure full recovery of the loan. There is a distinct possibility of some loss to the bank if issues are not corrected, so the asset is weak but hasn’t been non-performing for long.

3. Doubtful Assets

A doubtful asset is one that has remained an NPA for more than 12 months. In other words, after one year as a sub-standard NPA, the loan gets classified as doubtful. Doubtful assets have all the weaknesses of sub-standard ones, but with even greater risk that the bank may not be able to recover the full amount. The longer a loan remains doubtful, the less likely the full recovery becomes – collection of dues is “highly questionable and improbable” in such cases.

4. Loss Assets

Loss assets are loans where loss has been identified by the bank or auditors or by RBI inspectors, but the amount has not yet been written off fully. These are loans considered uncollectible or of such little value that they should no longer be kept on the balance sheet as assets. In practical terms, a loss asset is nearly 100% bad – the bank expects no meaningful recovery (perhaps only salvage value), yet for some reason the loan has not been formally written off. Often, banks directly classify loans as loss assets when there is fraud or when collateral value has severely eroded, without waiting through sub-standard or doubtful stages.

Provisioning Norms

When loans turn bad, banks are required to set aside money from their profits to cover expected losses. This is called provisioning. RBI prescribes standard provisioning percentages for each category of assets based on how risky they are. The idea is to build a cushion so that even if the NPA ultimately doesn’t pay, the bank has already accounted for that loss. Key provisioning norms are:

Standard Assets

Even for performing loans, banks keep a small general provision as a precaution. This is usually around 0.25% to 1% of the outstanding amount (the exact percentage varies by type of loan – for example, it may be 0.25% for secured retail or SME loans, higher for riskier loans). Some special standard assets like restructured loans carried even higher provision (e.g. up to 5% or more) as per past RBI norms. These provisions on standard assets are not due to any default, but just a buffer for unexpected losses.

Sub-Standard Asset

For loans in the sub-standard category (NPAs for ≤12 months), banks must make a provisioning of 15% of the outstanding amount. However, if a sub-standard loan is unsecured (no collateral) or has an unsecured portion, a higher 25% provision is required on the unsecured portion. The higher percentage reflects the greater loss risk when there is no security. This means the bank anticipates it might lose about a quarter of unsecured sub-standard loans, and hence provides accordingly.

Doubtful Assets

Doubtful loans require more aggressive provisioning since the chance of loss increases with time in default. Any unsecured portion of a doubtful asset is provided for at 100% (fully provided, as it’s likely to be lost). For the secured portion, provisioning is staged by how long the loan has been doubtful:

• Up to 1 year in doubtful: provide 25% of the secured portion.
• 1 to 3 years in doubtful: provide 40% of the secured portion.
• More than 3 years doubtful: provide 100% of the secured portion (essentially treating it as a loss). So, a doubtful asset that has been NPA for, say, 2 years would have 100% provision on whatever part isn’t backed by collateral, and 40% provision on the part backed by collateral. As time goes on, banks increase provisions, anticipating that prolonged NPAs will result in most of the loan not being recovered.

Loss Assets

These loans are considered virtually unrecoverable. Loss assets are to be provided for at 100% of the outstanding amount (if they haven’t already been written off). In practice, banks usually write off loss assets (remove them from books), but if any remain on the books, the bank must hold an equivalent amount of provision because it does not expect to recover any money from these loans.

The above requirements are prudential norms – they ensure banks recognize potential losses early and set aside funds accordingly. The sum of all provisions a bank carries reflects how much of its bad assets are already accounted for. A key metric is the Provisioning Coverage Ratio (PCR), which is the ratio of total provisions to gross NPAs. For example, a PCR of 70% means the bank has provisioned 70% of its total NPA amount. A higher PCR indicates the bank has buffered for most of its bad loans and is less likely to suffer unexpected losses, whereas a low PCR means the bank could be vulnerable if NPAs don’t recover. In general, regulators and analysts prefer a PCR above around 70% for a bank, meaning a large share of potential losses are already covered.