Non-Performing Asset (NPA) in India – Meaning and Its Impact

NPA stands for Non-Performing Asset. It is an important indicator used to check the bank’s asset quality. Before investing in banking stocks, it is very important to check their gross NPA as well as the Net NPA. But what does that mean and why is it important? We will learn all about Non-Performing Assets (NPA) today.

In this article we cover

1. What is NPA?
2. Gross NPA and Net NPA
3. NPA levels in India – Public sector banks vs Private banks
4. Comparing India’s gross NPA with Asian peers
5. Comparing India’s gross NPA with European peers
6. Implications of pre and post mergers of banks with respect to NPA levels
7. Impact of High NPAs and how to interpret it

What is Non-Performing Asset (NPA)?

NPA is the most important data which needs to be compared amongst banks. NPAs of a bank can affect other ratios, operations and revenue. Correct analysis of NPA will give you a fair idea of which bank is performing better among its peers. So, straighten up and let’s understand NPA in detail! A bank’s primary source of income is the interest it receives on the loans it provides. When a bank loans money, they expose themselves to credit risk. It means that there are chances that the borrower might fail to repay bank’s loan.. When this happens, the loaned amount is classified as Non-Performing Asset. A loan is classified as a non-performing asset when the repayment is overdue for more than 90 days. It negatively affects bank’s ability to generate adequate income and profitability. A wise manager will always set aside some funds as reserves in case of such bad debts. In banking terms, this is called the Provisional Reserves. Such provisions eat into your profits because you can’t use this money elsewhere. But this is very important for banks to safeguard themselves from huge losses. The total defaults are classified as Gross NPAs (GNPA). The balance amount which remains after deducting the provision is classified as Net NPA (NNPA).

Gross NPA and Net NPA

Gross NPA is the total amount of NPAs without deducting the provisional amount. Net NPA is simply the gross NPA minus the provision left aside. It is used as a measure of the overall quality of the bank’s loan book. For example, a bank loans out Rs. 100 Crores and the provisional amount set aside is Rs. 30 Crores. By the end of the financial year, the bank manages to collect Rs. 45 Crores only. The total default of Rs. 55 Crores is the Gross NPA. The formula to calculate Net NPA is – Net NPA = Gross NPA – Provisional Reserves Gross NPA (total NPA) of Rs. 55 Crores – provision of Rs. 30 Crores = Net NPA = Rs. 25 Crores. Banks classify Gross NPAs further into three categories – substandard, doubtful, and loss assets. a. Sub standard assets Assets which are NPA for a period less than or equal to 12 months are sub standard assets. b. Doubtful assets An asset that remains NPA for a period exceeding 12 months is doubtful asset. They have a significantly higher risk level compared to substandard asset. c. Loss assets When a loss has been identified by an auditor and the amount has not yet been fully written off, it is classified as a loss asset. In other words, such an asset is considered uncollectible. Its record as an asset is not warranted although there may be some recovery value. You will find these details in the bank’s financial statement. Read their annual report and analyse their balance sheet to check the value of bad loans. It is very important to keep a track and analyse a bank’s NPAs as rising NPAs adversely affects a bank’s liquidity and growth abilities. This is a big red flag. We will understand this with the help of Yes Bank’s example further. But first, let’s have a look at the NPA levels of Indian Banks.

Gross NPA levels in India – Public Sector Banks vs Private banks vs Foreign Banks

Here is the gross NPA comparison between Public Sector Banks (PSUs), Private Banks, and Foreign Banks in India

Public Sector banks show  very high levels of NPA over the years. Private Sector banks’ NPA levels are rising but at a slow pace. . Whereas, Foreign Banks have lowest NPA levels compared to PSU banks and Private Banks. In 2015, PSU’s NPA level is almost as much as combined NPA levels of private and foreign banks in India. Overall, we can observe that Indian banks NPA amount kept increasing from 2014 to 2018. It reached a peak of 11.2% in FY-2018. This was when many big corporate companies defaulted on their loan repayment. One reason for growing NPAs is that the Indian economy enjoyed a boom phase from 2000-2008. Banks extensively issued loans to corporates with an expectation that the boom phase will benefit everyone. However, the sentiment didn’t last long. The 2008 financial crisis shook corporate profits pushing many corporates to bankruptcy and other crisis. This ultimately led to bad loans and further affected the NPA level, especially for public sector banks. So, can we conclude that PSU Banks are a bad investment option? Or is the overall Indian Banking sector a risky sector to invest in given the rising NPA levels? Comparison with our peers worldwide might give us an answer.

Comparing India’s Gross NPA with Asian Peers:

In 2016, the average NPAs for 135 countries was 7.39 %. In 2019, the average NPAs of 119 countries were 6.45%. During this period, Indian bank’s Gross NPAs were more than the average. Compared to other peers in Asia, India’s gross NPAs are very high. The rules and regulations in China and South Korea are very strict. We can say that this is a contributing reason to why their NPAs are almost negligible at 2% of their advances. India’s NPA levels are over double of NPA levels of European peers.

It would be unjust to compare a developing country to other developed countries. But the above charts shows that India’s high NPA level pose a threat to future growth. It slows down the cash flow if the assets continue turning bad at this rate. The problem of NPAs in India is deep rooted. Does this mean that there is no hope that India’s NPA level would ever go down? No, it is possible. Earlier, PSU banks’ gross NPA used to be less than 2% of their advances. By the end of 2018, it rose to about 16%. As for private banks, gross NPA before 2008 was less than 2% of their advances. By the end of 2018, it went up to 5%. Major contributors to the increase in PSU banks’ NPA rise were frauds, bankruptcy, lenient management, and corruption. Strict rules and regulations are being implemented to improve this situation. To save this sinking boat, major steps were taken in the previous years like mergers and amalgamation of many poorly-performing banks.

Implications of pre and post mergers of banks in respect to NPA Level

In 2020, the government announced the amalgamation of 10 PSU banks into four big banks. The merger was effective from April 1, 2020. Oriental Bank of Commerce and United Bank of India were merged into Punjab National Bank. Allahabad Bank into Indian bank, Syndicate Bank into Canara Bank, and Andhra and Corporation Bank into Union Bank of India. Including the past mergers, total number of PSU banks have reduced from 27 to 12. This was a huge step by the government. As an analyst, your duty is to understand how this merger affects the performance the overall banking sector. Mergers results in a bigger capital base and higher liquidity. This reduces government’s burden of recapitalising the public sector banks time and again. Historically, mergers have given great results in terms of saving weak banks. They are crucial for the country’s economy.. Let’s have a look at our recent pre and post-merger data as of March 2020.

Mar-20	Net NPA Ratio (%)
	Pre-Merger	Post-Merger
Punjab National Bank	5.8	5.39
Oriental Bank of Commerce	5
United Bank	4.88
Canara Bank	4.18	4.08
Syndicate Bank	4.61
Union Bank of India	5.49	4.75
Andhra Bank	4.92
Corporation Bank	5.14
Indian Bank	3.13	3.76
Allahabad Bank	5.66
Bank of Baroda	5.4	5.71
Vijaya Bank	4.1
Dena Bank	11.04

Two major state-run banks – Dena Bank and Vijaya Bank were merged with Bank of Baroda in 2019. This merger directly benefitted Dena Bank. Its NPA of 11.04% was 22% of the total advances. The NPA’s of Dena bank was the 5th largest in the banking sector. The Reserve Bank of India (RBI) stepped in to take corrective measures and Dena bank was prohibited from lending in the market. The merger solved this problem and pulled out Dena Bank from this problem. However, mergers are not a long-term solution to decaying financials. It does not solve problems like bad loans and bad governance in PSU banks.  This also leads to poor employee morale. Also Read: Best banking stocks to buy in India right now. Let’s understand how high NPAs can affect investors and stakeholders of a bank.

Impact of High NPAs and how to interpret it

High NPA’s are a red flag for investors. It suggests that the particular bank is not viable. This immediately impacts the banks’ cash flow and future earnings. If these NPAs were paid on time, they would’ve generated additional capital for the banks. This could have been used further by the banks to extend more loans. In fact, banks have to create additional provision if their NPA percentage keeps on increasing. Funds kept aside as provision could have been sourced from the future profits of the bank which otherwise could have been used to maintain stable growth. In simple words, high NPA stops possible future revenue generation.

NPA Case Study – Yes Bank’s Rise & Fall

Let’s understand Yes Bank’s scenario. The bank’s stock price fell by almost 90% when the news of its poor financials broke out.

Out of panic, customers rushed to withdraw their deposits. To control the situation, all the withdrawals were capped at Rs. 50,000. This further impacted many businesses’ cash flow.The devil is in the detail. If we analyse Yes bank’s NPA scenario further, we will find that about 67.9% of Yes Bank’s loans were offered to large corporates.

So even if a couple of such large borrowers default on their repayment, it could result in a very stressful situation for banks and investors. Yes Bank had financed couple of huge loans which ended up as an NPA. This includes IL&FS, Jet Airway, Anil Ambani Group, Essel Group, DHFL etc. This led to a substantial rise in Yes Bank’s NPA. Watch our case study on the entire Yes Bank saga –

So, when you are reading a bank’s annual report, check their loan issuing pattern. This will give you an idea about the risk they are facing or might face in the future.

End Note

High NPAs endanger the financial health of a bank. Investing in such banks is a bad idea. But in order to improve the economy, it is necessary for banks to provide loans to businesses. This makes them prone to risk of NPAs. However,  NPA is just one important factor to understand bank’s asset quality. There are multiple factors which you need to consider before buying a bank stock. Analysing NPA in isolation will not suffice. Capital adequacy ratio, Liquidity coverage, Qualitative analysis are few other factors you need to analyse. To save your time, we have written a detailed guide explaining every fundamental factor one needs to check before investing in banks. By reading this guide, you will understand the ins and out, from understanding how banks earn money to how can they generate returns for us. You will be able to analyse any bank of your choice. Read Next: How to Analyse Banking Stocks – A Complete Guide Conduct your own independent analysis today! Take your first step towards stock market trading by opening a FREE Demat account with Samco.