This blog s inscribed by Mudit Mandhana.
Banks are the financial intermediaries and play a vital role as a financial institution in the economy of the country. Theses financial institutions are exposed to a variety of the risks such as legal risk, liquidity risk, operational risk, credit risk, etc. This paper basically focuses on the credit risk faced by the banks in the form of Non – Performing Assets (NPAs). The banks in the recent times have faced a huge risk because of the increase in the percentage of loans turning into NPAs. According to the Financial Stability Report of RBI for December 2017, risks to the banking sector remained at an elevated level weighed down by further asset quality deterioration. It becomes necessary for the banks to have a diligent and efficient risk management system such that it can tackle the risks in a lucid manner. The banks have set up a Risk Management Committee under Regulation 21 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. The banks have also initiated the practice of Early Warning System (EWS) which enable the banks to manage the risks and mitigate the same. Thus, in a nutshell the paper deals with curbing of the NPA crisis through proper set up of risk management under the principles of corporate governance.
Keywords: Credit Risk, Non – Performing Assets (NPAs), Risk Management, Early Warning System (EWS).
Among the alluring attributes of the well defined financial system maintenance of NPAs can be considered as one of the important. Non Performing Assets (NPAs) are those assets which fizzle out to generate income through interest earned on the principal loan amount and the repayment of the principal loan amount. It is basically the result of the borrowers who deliberately default the re-payment of loan by citing poor economic condition affecting the business. Non – recovery or partial recovery of the loan creates a credit risk for the bank which affects the interest of the stakeholders.
Weakness in bank governance structures and failures in risk management is pointed by the lawmakers, regulatory bodies and research scholars as the vital causes of the financial crisis began in 2007. It is important for the banks to understand the importance of risk management as a corporate governance tool in order to overcome the risk of NPAs to which the Indian banks are miserably exposed. Considering the decentralized form of management in banks and the system of incentives on performance demands a stable and independent risk management function to completely erase out the scope any arbitrary action.
1.1 Non Performing Asset
An asset becomes non-performing when it ceases to generate income for the bank.
The sudden surge in the figures of NPAs in case of PSUs is because of the investment made in the non-viable projects which never take off or are delayed to multiple interferences by the governments. This failure in completion of the projects results in increasing the liability and thereby enhancing the credit risk. Thus, such is increase in the number of loans turning NPAs is a concern for banks and also for the financial system and the economy. Factors affecting the NPAs are divided into two broad categories firstly the internal factors and secondly the external factors. The internal factors includes loopholes in the policy, no proper SWOT analysis before grating of loan, deficiencies on part of the officers of the bank, poor lending process and no proper check on the security, and lack of diligence on part of managerial personnel. The external factors would include natural calamities, industrial sickness, wilful default on part of the menders, sudden change in government policies, ineffectiveness of the statutory provisions, lack of recovery procedure with some strict statues guiding them.
1.2 Risk Management
Risk management in simpler term means identification of the potential incertitude which needs to be determined and mitigated by the management of the entity in order to protect the interests of the entity and the stakeholders.
The definition of risk management was given by Committee of Sponsoring Organization of the Treadway Commission (COSO) as: “Risk management is a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.”
II. NPA crisis of banks in the light of Risk Management
2.1 Crisis and the factor of corporate governance
As already mentioned above the Non Performing Assets of a bank act as risk to the credit independence of the financial institutions and also affects the interest of the stakeholders in the bank. NPAs are the result of the wilful defaults on the part of the borrowers and in all sense is a risk to the bank because it’s the function of the bank to grant loan in order to generate income. The banks grant loan from the deposits received by it and investments. Thus, the responsibility on the bank is much more as it has to answerable to the stakeholders and if the loans will get converted into NPAs will result in bankruptcy and credit risk of the bank. During the economic recession it becomes more important for all the banks be it PSUs or private banks to have a well proof risk management policy. A well defined risk management policy will be need of the hour for the bank in order to sustain in the market and which will guide to the process of lowering the number of NPAs. Though, the Reserve Bank of India (RBI), the banking regulator issues circulars and guidelines to the banks in respect to the management of NPAs and measures to overcome the crisis.
2.2 Risk Management Structure
It is important for every bank to have a robust risk management structure in order to identify, analyze and mitigate the risks. The major concern of the banks should be on choosing the appropriate structure to be established to counter the risks. There are basically two risk management structures: centralised structure and decentralised structure whereas the former one is globally accepted because it makes reporting to the top management easier. The primary responsibility of the understanding the risk should be of the Board of Directors. In order to respond to the risks the Board of Directors should set up a Risk Management Committee which should be independent in letter and spirit that will directly report to the Board of Directors. The function of the risk management committee will be to identify the overall risks, determine the effect of that risk, to tackle the risk and to monitor the same. Credit Risk is the risk which the bankers have to face resulting from the process of lending. The unwillingness of the customers to repay the loan and default in such payments enhances the risk for the bank and therefore it becomes more important for the banks to efficiently tackle such risks. It is important for the banks to establish a high level Credit Risk Committee to monitor the risk by adhering to the policies and also coming up with loan policies.
2.3 Instruments of Credit Risk
The RBI has laid down in its notification some of the instrument which might help in countering the risks and its adverse impacts on all the stakeholders and the bank itself:
2.3.1 Credit Approving Authority
Bank should have a well defined delegation of powers. This instrument suggest a credit approving authority, the basic job of which will be to approve the loan after scrutinizing each and every factor which comes in question before approving the loan. There must be an approving grid established which helps the executives to carry out the process of lending smoothly. So if the credit worthiness is well evaluated at this stage then the probability of the loan becoming a NPAs. In order to completely curb the NPA risk the bankers have to strictly follow the policies and act in adherence of all the instruments.
2.3.2 Prudential Limits
In a decision to lower down the degree of credit risk, it is necessary for the bank set some prudential limits on various aspects to bring down the surging numbers of NPAs. Some limits can be:
- To establish or frame a single and group borrowings limit;
- To fix the substantial exposure limit of the banks;
- To set up an exposure limit of the banks in every industry and to lay down the policies to deal in sensitive industries. The adjustments have to be done by the banks before exposing it to any industry. The banks should identify the high risks industries and manage the loans in a feasible and controlled manner in these sectors because volatility of the industry acts as a catalyst to convert loans into NPAs.
Thus, if banks successfully set up the prudential limits it becomes easier for them to the monitor the loan because the risk is well evaluated. Thus, considering the recent example of Kingfisher Airlines, the exposure of the leader of the consortium, i.e., SBI was more than a thousand crore even when the Airlines were in a struggling phase. In order to curb such practices, prudential limits are to be set up by the banks and adhered in word and spirit.
2.3.3 Risk Pricing
This instrument suggests that the bank to price the loan as per the credibility of the borrower. If the borrower falls under high credit risk category should be granted loan at a high price. This practice will help the bank to minimize the default resulting in the creation of NPAs. It is the duty of the risk management committee to identify and monitor the probable high risk borrowers and even do a periodical loan reviews such that there is a check on the security of the loan. In case of Kingfisher Airlines the amount summed up to thousand crores because of multiple borrowings and had been the banks concerned about the risk pricing keep in purview the history would have helped bank save a lot of money from becoming NPAs.
2.3.4 Portfolio Management
It is pertinent for the banks to recognize the creditworthiness or the risk well in advance, the tracking or reconciling the NPAs with the dates of the balance sheet will not be a systematic solution to efficient minimization of the credit risk. It becomes the duty of the credit risk management committee to determine and keep the track of the portfolio in order to avoid unnecessary default in repayment of the loan. There has to periodic monitoring of the portfolio. Thus, in the time when the NPAs have increased drastically and the bulk of matters pending before the Debt Recovery Tribunal highlights the urgent need of the bank to necessitate surveillance on the high risk credit.
2.3.5 Loan Review Mechanism
LRM is a mechanism adopted by the Credit Risk Management Committee to identify the loan loss borrower, to maintain the integrity of the credit grading process and others areas as well. It is foremost for the banks to evaluate the risk through this mechanism to understand the probable loan loss and to take the corrective measures at that stage to reduce the losses to the maximum. If the LRM is followed properly then the number of the NPAs would come down and if there is periodical review of the loan, it will make the bank understand the tendencies of the borrowers in the matter who are interested and not interested to repay the loan. It is the responsibility of the bank to initiate and implement a loan review policy and to review it in regular intervals. This practice of the banks will help them improve their credit standing and the credit advanced will be secured and there will be no encumbrance at the time of repayment.
III. Critical Comment
As we all know that banks are financial intermediaries and they are exposed to the risks relating to its day to day business of lending and trading. It becomes necessary for the banks to identify, analyze, evaluate and monitor the risks in order to survive in this risk borne sector. There are a lot of risk to which the bank is exposed to like the legal risk, operational risk, market risk and liquidity risk but amongst all in order for the bank to survive, the most important risk is the credit risk. The bank does not generate money; it is the interest on the credit and the deposits accepted becomes the principal amount for the loan to the borrowers.
In order to reduce the NPAs the banks has to evaluate the risk efficiently and have a strict approval mechanism. The banks should keep a regular check on the loans granted by it. As mentioned in the project, the establishment of the Risk Management Committee is a measure to improve the corporate governance. Regulation 21 of the Securities Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 states that board of directors to constitute Risk Management Committee, thus it becomes clear that the regulators are also concerned by the increasing number of the NPAs and the need of an efficient risk management.
The problem of NPAs has to be tackled properly by the bank because it might lead to organizational restructuring sometimes. It has also opened the eyes of the banker to do a proper assessment on the basis of the standard procedure to check the creditworthiness on any intending borrower or existing borrower in order to assess the risk involved. Considering my opinion it is necessary to avoid NPAs at the nascent stage of credit consideration by putting in rigorous and appropriate credit appraisal mechanism.
The borrowers in recent times are facing huge difficulties in raising funds through banks because of the increased number of NPAs. This increase in the number of NPAs is having a drastic affect on the balance sheet of the banks and as a result the banks are not enthusiastic in sanctioning loans to genuine borrowers even. The banks have made the loans costly in order to compensate the loss to the banks through NPAs which itself makes it difficult for the borrowers to borrow the money. However, the banks have taken measures to lower the numbers of NPA by taking strategic approach which comes with a time limit and which bring the banking sector in India par with the International norms of the banking sector.
 Regulation 21 of SEBI(Listing Obligations and Disclosure Requirements), 2015.
 An OECD report argues that “the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements” (Kirkpatrick (2008)). Similarly the Commission on the Causes of the Financial and Economic Crisis in the U. S. concluded its work by stating that the “dramatic failures of corporate governance…at many systematically important financial institutions were a key cause of this crisis.”
 For example, the then Chairman of the Federal Reserve, Ben Bernanke, argued that “The failure to appreciate risk exposures at a firm-wide level can be costly. For example, during the recent episode, the senior managers of some firms did not fully appreciate the extent of their firm’s exposure to U.S. subprime mortgages” (May 2008).
 Andrew Ellul, Introduction, The Role of Risk Management in Corporate Governance (Apr.05, 2020, 04:38 PM).
 Pricewaterhouse Coopers LLP, Enterprise Risk Management – Integrated Framework, Executive Summary (Apr.05, 2020, 2:05 PM), https://www.coso.org/Documents/COSO-ERM-Executive-Summary.pdf
Risk Management System in Banks, Reserve Bank of India (Apr. 08, 2020, 12:36 PM) https://rbidocs.rbi.org.in/rdocs/notification/PDFs/9492.pdf
 Regulation 21 of SEBI(Listing Obligations and Disclosure Requirements) Regulations, 2015.