NPAs, stressed assets and the IBC: recognition, provisioning and resolution

India's bad-loan cycle of the 2010s shaped almost every banking reform that followed: the asset quality review, the IBC, the recapitalisation of public sector banks and tighter supervision. Paper III returns to it often, both as descriptive questions (assess the IBC) and as objective items on definitions, days and percentages. This guide gives you the life cycle of a bad loan, the arithmetic of provisioning, and each resolution tool with its strengths and limits.

How the stress built up

In the credit boom of roughly 2006–2011, banks, mostly public sector banks, lent heavily to infrastructure, power, steel and telecom. Then projects stalled because of land and environmental delays, fuel supply problems, falling commodity prices and a slowing economy. Instead of recognising losses, many loans were restructured and kept "standard", a practice often called evergreening.

The RBI's Asset Quality Review (AQR) of 2015–16 forced banks to classify these loans properly. Reported gross NPAs rose sharply, profits fell, and several public sector banks were placed under PCA. The recognition was painful but it was the start of the clean-up.

When is a loan an NPA?

A loan becomes a non-performing asset when it stops generating income for the bank:

• Term loan: interest or instalment overdue for more than 90 days.
• Overdraft or cash credit: the account stays "out of order" for more than 90 days.
• Bills purchased or discounted: overdue for more than 90 days.
• Agricultural loans: overdue for two crop seasons (short-duration crops) or one crop season (long-duration crops).

Before an account becomes an NPA, banks flag early stress as Special Mention Accounts:

Since the RBI's November 2021 clarifications, accounts are flagged on a day-end basis, and an NPA can be upgraded to standard only when all arrears of interest and principal are paid, not just part of them.

Ageing and provisioning

Once an account is an NPA, it moves through asset classes over time, and the provision the bank must set aside from profit rises.

The "secured portion" is the realisable value of the security; the rest is unsecured.

Worked example: a loan's journey

A borrower owes ₹10 crore. An instalment due on 31 March is not paid, and nothing is paid afterwards. The security (a factory) can realise ₹6 crore.

1. From the day after the due date the account is in SMA-0; after 30 days overdue it becomes SMA-1, after 60 days SMA-2, and once overdue for more than 90 days, around the end of June, an NPA.
2. For the next 12 months it is substandard. Provision = 15% of ₹10 crore = ₹1.5 crore (the loan is secured; for simplicity, treat it all at the secured rate).
3. It then becomes D1. Provision = 100% of the unsecured ₹4 crore + 25% of the secured ₹6 crore = 4 + 1.5 = ₹5.5 crore.
4. After a year in D1, it moves to D2. Provision = 4 + 40% of 6 = 4 + 2.4 = ₹6.4 crore.
5. After three years in doubtful (D1 plus two years of D2), it becomes D3: provision = ₹10 crore.

Each step up in provision reduces the bank's profit, and therefore its capital. This is why early resolution is worth so much.

Net NPA = gross NPA − provisions held. If gross NPAs are ₹5,000 crore and provisions ₹3,500 crore, net NPA is ₹1,500 crore, and the provision coverage ratio is 3,500 ÷ 5,000 = 70%.

The resolution toolkit

The IBC process

The Insolvency and Bankruptcy Code, 2016 replaced a patchwork of laws with one time-bound process. For companies, the adjudicating authority is the National Company Law Tribunal (NCLT); appeals go to the NCLAT and then the Supreme Court. The regulator is the Insolvency and Bankruptcy Board of India (IBBI).

1. Application: a financial creditor (Section 7), an operational creditor (Section 9) or the company itself (Section 10) applies once a default of at least ₹1 crore has occurred (the threshold was raised from ₹1 lakh in 2020).
2. Admission and moratorium: the NCLT admits the case and declares a moratorium (Section 14): no suits, recovery or enforcement against the company.
3. Insolvency professional: an interim resolution professional takes over management from the board; the promoters lose control.
4. Committee of creditors (CoC): made up of financial creditors, voting in proportion to their debt.
5. Resolution plan: bidders submit plans. Section 29A bars defaulting promoters and certain others from bidding. A plan needs 66% of the CoC's vote and NCLT approval.
6. Timeline: 180 days, extendable by 90, with an outer limit of 330 days including litigation (2019 amendment).
7. Liquidation: if no plan is approved, the company is liquidated and proceeds are shared in the order set by Section 53 (the "waterfall").

The Supreme Court has upheld the primacy of the CoC's "commercial wisdom", including in the Essar Steel case (2019). A pre-packaged insolvency route for MSMEs was added in 2021, and Section 227 lets the government notify financial service providers, such as large NBFCs, for insolvency on the RBI's application.

Worked example: recovery and haircut

Financial creditors have admitted claims of ₹1,200 crore. The approved plan pays ₹420 crore.

1. Recovery rate = 420 ÷ 1,200 = 35%.
2. Haircut = 100% − 35% = 65%.
3. If the liquidation value had been estimated at ₹300 crore, the plan gives creditors ₹120 crore more than liquidation, which is why the CoC may accept a large haircut.

Model answer outline (15 marks)

Question: Assess the impact of the Insolvency and Bankruptcy Code on the resolution of stressed assets in India.

1. Background: NPA build-up; earlier tools (BIFR, DRTs, SARFAESI, CDR) were slow or partial.
2. Features of the IBC: creditor-in-control, moratorium, time limits, Section 29A, NCLT and IBBI.
3. Positive effects: shift in creditor–debtor balance; settlements before admission; better recoveries than earlier tools; a market for stressed assets.
4. Problems: delays beyond 330 days; tribunal vacancies; deep haircuts in some cases; litigation.
5. Reforms: pre-packs for MSMEs; Section 227 for financial firms; proposals for group and cross-border insolvency.
6. Conclusion: a structural reform whose promise depends on tribunal capacity and time discipline.

Short model answer (10 marks)

Question: What is the difference between gross NPA and net NPA, and why does the provision coverage ratio matter?

Gross NPAs are the total outstanding amount of loans classified as non-performing, that is, loans with interest or principal overdue for more than 90 days. Net NPAs are gross NPAs minus the provisions the bank has already set aside against them. If a bank has gross NPAs of ₹5,000 crore and provisions of ₹3,500 crore, its net NPAs are ₹1,500 crore.

The provision coverage ratio (provisions ÷ gross NPAs) shows how much of the bad-loan problem has already been charged against profits. In this example it is 70%. A high ratio means future losses on these loans will hurt profits and capital less, so the bank is better protected. A low ratio means more pain may come.

For a supervisor, net NPA is the better measure of residual risk to capital, which is why the PCA framework uses the net NPA ratio. For a depositor or investor, a rising coverage ratio signals that a bank is recognising its problems rather than hiding them.

Practice questions

1. After how many days overdue does a term loan become an NPA?
   • More than 90 days.
2. Which SMA category covers 31–60 days overdue?
   • SMA-1.
3. A D2 loan of ₹8 crore has security worth ₹5 crore. What is the provision?
   • ₹5 crore. Unsecured ₹3 crore at 100% plus 40% of ₹5 crore = 3 + 2.
4. What is the minimum default for starting insolvency under the IBC?
   • ₹1 crore.
5. What share of the CoC vote approves a resolution plan?
   • 66%.
6. Under the SARFAESI Act, how long is the notice before enforcement?
   • 60 days.

What to do next

• Draw the loan life cycle: SMA-0, SMA-1, SMA-2, NPA, substandard, D1, D2, D3.
• Redo the provisioning example with security worth ₹3 crore.
• Read the banking regulation guide for PCA, which uses the net NPA ratio.
• Then read the risk management guide for credit risk measurement.