NBFC Asset Classification

Monisha Chaudhary

30 Mar, 2024

The RBI clarified income recognition, asset classification, and provisioning criteria for banks, NBFCs, and all-India financial institutions in a note as part of its initiative to update the regulations of NBFCs. The important elements include categorizing special mention accounts (SMA) and non performing assets (NPAs) based on day-end positions and only upgrading an NPA to a standard category after clearing all outstanding overdue.

ICRA states that while banks won’t be affected by the new regulations because they currently adhere to them, NBFCs typically upgrade NPA accounts even with partial overdue payment as long as the total overdue as of the reporting date was less than 90 days. Let us discuss the asset classification as per the RBI Master Circular on Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining to advances.

Categorization of Assets

Based on the length of time an asset has been nonperforming and the ability to collect on the debt, financial institutions are required to further categorize nonperforming assets into the following three groups:

• Substandard Assets
• Doubtful Assets
• Loss Assets

Sub-Standard Assets – Accounts that have been in the NPA category for less than or equal to 12 months. In terms of realisability, these accounts exhibit inadequate credit, and the Bank will likely suffer a loss if the defects are not fixed.

Doubtful Assets – Accounts that have been in the NPA category for longer than 12 months. A loan that is marked as doubtful contains all the flaws that come with Sub-Standard assets, plus the additional quality that the full recovery of the advance is highly improbable because of the deterioration of the security value or other factors.

Loss Assets – Assets with a loss that has been discovered by the Bank, internal or external auditors, or an RBI inspector that has not been written off. Even though there may be some salvage or recovery value, the item is regarded as being uncollectible.

Guidelines for Asset Classification

In general, the degree of clearly identified credit weakness should be taken into consideration when classifying assets into the aforementioned categories. The classification of assets is as follows:

Appropriate internal systems for proper and timely identification of NPAs – Banks and financial institutions should put in place the required infrastructure and appropriate internal mechanisms (including technology-enabled processes) for the accurate and timely detection of NPAs.

Accounts with Temporary Deficiencies

Based on the record of recovery, an asset should be classified as an NPA. In order to classify accounts with certain defects, financial institutions may adhere to the following rules:

• Given that current assets are the first to be appropriated in times of trouble, banks should make sure that withdrawals from working capital accounts are supported by adequate current assets. It is necessary to calculate drawing power using the most recent stock statement. 
• Even if the unit is operational or the borrower’s financial situation is sound, a working capital borrowed account will become NPA if such irregular drawings are permitted in the account for a continuous period of 90 days.
• Credit limits, both regular and ad hoc, must be reviewed and regularised no later than three months after the payment deadline or the date of the ad hoc penalty. The branch shall provide proof that the renewal or review of credit limits is already underway and will be finished soon in the event of restrictions like the non-availability of financial statements and other data from the borrowers.

Upgradation of loan accounts classified as NPAs – In the event of loan accounts designated as NPAs, the account should no longer be classed as nonperforming and may be categorized as “standard” accounts if arrears of interest and principal are paid by the borrower.

Accounts regularised near the balance sheet date – When a single or a small number of credits are recorded before the balance sheet date, the asset classification of borrower accounts should be handled carefully and objectively. According to the facts available, an account should be considered an NPA if it shows inherent vulnerability. 

Asset Classification to be borrower-wise and not facility-wise

• It is challenging to imagine a circumstance in which only one loan to a borrower or one investment in any securities issued by the borrower develops into a problematic loan or investment and not others. 
• The balance in that account should also be treated as a part of the borrower’s principal operating account for the purposes of applying prudential norms on income recognition, asset classification, and provisioning if the debits resulting from the devolvement of letters of credit or invoked guarantees are parked in a separate account.
• If any other facility provided to the borrower is labelled as a nonperforming asset (NPA), the discounted bills under the LC benefitting the borrower may not be labelled as an NPA.

Advances under consortium arrangements – Accounts under a consortium should be classified as assets based on the history of recoveries of the individual member and other factors affecting the recoverability of the advances. 

Accounts where there is erosion in the value of security/frauds committed by borrowers

• It will not be prudent to classify assets at various stages for accounts where there are potential threats to recovery due to deterioration in the value of the security or non-availability of security, as well as the existence of other factors like fraud committed by borrowers.
• When the realizable value of a security is less than 50% of the value determined by the Bank or accepted by the RBI at the time of the most recent inspection, as applicable, it can be said that there has been a considerable erosion in its value. Such NPAs may be categorized as questionable assets right away, and provisioning should be applied to those assets.
• The existence of the security shall be disregarded, and the asset should be immediately labelled as a loss asset if the realizable value of the security, as determined by the financial institutions/approved valuers/RB, is less than 10% of the outstanding borrower accounts. Either the Bank will cover the whole cost, or it will be written off.

Advances against Term Deposits, NSCs, KVPs/IVPs, etc. – If sufficient margin is present in the accounts, advances against term deposits, NSCs that are eligible for surrender, IVPs, KVPs, and life insurance should not be classified as NPAs. This exemption does not apply to advances against gold ornaments, government securities and all other securities.

Loans with a moratorium for payment of interest – When financing is provided for industrial projects and others, there is a moratorium on interest payments; the interest is not considered “due” until the moratorium or gestation period has passed. Accordingly, with respect to the date of interest debit, such amounts of interest do not become past due and, as a result, do not become NPA. If they are not collected, they become overdue after the interest payment deadline.

Interest on housing loans or other advances given to employees that are repayable after recovering the principal need not be regarded as past due as of the first quarter. Such advances/loans should only be labelled as NPA when there is a failure to make principal or interest payments by the due dates as specified.

Government-guaranteed advances

• Credit facilities backed by a Central Government guarantee, even though overdue, may only be classified as NPA if the Government renounces its guarantee when it is invoked. This exemption from the requirement that government advances be labelled as NPA is not intended to allow for the recognition of income.
• To determine the asset classification and provisioning requirements for State government-guaranteed exposures, the requirement of invoking the guarantee has been delinked.
• Date of Commencement of Commercial Operations’ (DCCO) – The DCCO of the project should be made explicit at the time of financial close for all projects financed by FIs or banks and should be legally documented. When the financial institution approves the loan, it should additionally record this in the appraisal note.

Conclusion

The adoption of new asset classification standards and the early detection of stressed loan portfolios may eventually result in an improvement in asset quality as well as a culture of prudent borrowing and upholding loan servicing obligations. The financial sector would benefit most from these measures, and NBFCs will need to adjust their asset management ecosystem to comply with the strict requirements.

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