Module 11. Risk Management
1. 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 ...
