Strategies for Managing Non-Performing Assets in Financial Institutions

Non-performing assets are a part and parcel of any institutional lending operation. The aim of lenders is to reduce non-performing assets as much as possible, however, it is easier said than done. 

An NPA can arise due to any of numerous reasons and lenders may not have any control over the situation. Most of the time, the lender has done everything right and taken care of everything in its power, however, NPAs still arise and can cost the lender heavy sums of money. 

Having said that, lenders still need to ensure that they are using the most effective strategies for managing NPAs so that they can reduce them and manage them more effectively.

Let’s take a look at what NPAs are and the most effective ways to reduce NPAs from occurring. 

What are NPAs?

Non-performing assets (NPAs) refer to loans or advances that are in default or have not been paid back by the borrower for a significant period of time. In other words, these are assets that have stopped generating income for the financial institution.

NPAs can arise due to a variety of reasons such as economic downturns, borrower default, industry-specific factors, or poor credit risk management. They can have a negative impact on the financial health of the institution, leading to reduced liquidity, lower profits, and potential regulatory penalties.

It is essential for financial institutions to have a clear understanding of NPAs and their implications in order to effectively manage them. This includes implementing strategies such as loan restructuring, loan recovery through legal means, and effective monitoring of NPAs. By doing so, financial institutions can mitigate the negative effects of NPAs and improve their financial performance.

Early Detection and Monitoring

We now have advanced technological capabilities that can help lenders to detect stress on loan accounts earlier than an event of default. Lenders can leverage data analytics and artificial intelligence to better predict which loan accounts are at higher risk of default. 

Once this data is available, the lender can take proactive steps to ensure that the default does not occur. For this data to be as accurate as possible, regular monitoring must be done by the lender. Regular reviews must be made and loan portfolios must be monitored and audited so that high-risk accounts can be identified as soon as possible.  

Robust Credit Appraisal Processes

The buck always stops with the lender. In case a borrower fails to repay a loan, it becomes the lender’s problem and the lender must deal with the consequences. That’s why lenders need to be especially careful before a loan is sanctioned and disbursed. 

Once a lender’s sales team detects a lead and finds potential borrowers, it is imperative for the concerned loan officers to conduct a thorough credit appraisal. The credit appraisal needs to detect the financial health of the borrower, their overall credit worthiness, the health of the industry in which the borrower is operating or the job security of the borrower, and so on. Every factor must be looked into so that the lender can rest assured that no stone has been left unturned before a loan is sanctioned. 

This process ensures that only the healthiest of borrowers enter the books of the lender which automatically reduces the risk of non-performing assets. 

Effective Risk Management

There are two primary ways in which NPA-risk can be mitigated by lenders. 

The first way involves diversification. The lender needs to create a loan portfolio that constitutes many different types of borrowers that earn from various different sectors in the market. This type of diversification reduces sector risk and concentration risk. 

Diversification ensures that even if a particular sector does not perform well, the risk that it poses to the lender is limited. For example, if a lender only lends money to farmers, then it may face significant challenges in case the monsoon fails. 

The second way in which such risk can be reduced is through a dynamic risk assessment process. Lenders need to use stress testing and scenario analysis to ensure that the overall risk of NPAs remains as low as possible in a diverse range of circumstances. 

Financial institutions should assess the creditworthiness of borrowers before lending to them. This includes analyzing their financial statements, credit history, and other relevant information to determine the likelihood of default.

Financial institutions can implement strategies to mitigate credit risk such as collateral requirements, loan covenants, and insurance.

Effective credit risk management can help financial institutions identify potential NPAs early on and take proactive measures to mitigate the risk of default. This can help improve the financial health of the institution and reduce the impact of NPAs on their overall performance.

Loan Restructuring and Recovery

Once an event of default has occurred, it’s essential for lenders to approach the situation in a collaborative way rather than a combative way. 

No borrower commits a default with the intention of committing a default (apart from wilful defaulters who need to be treated differently). That’s why lenders need to work with borrowers to ensure that borrowers can pay back as much as money as they can to the lender. 

It’s important for lenders to maintain a positive relationship with the borrower so that healthy negotiations can take place. This will help the lender recover a higher amount and even recover all their dues. 

Loan restructuring can take several forms, such as extending the loan tenure, reducing the interest rate, or rescheduling the repayment schedule. The specific type of restructuring depends on the borrower’s financial position, the reason for the default, and other relevant factors.

Loan restructuring can benefit both the borrower and the financial institution. For the borrower, it provides an opportunity to repay the loan and avoid default, which can have negative consequences such as damage to their credit score. For the financial institution, loan restructuring can help reduce the number of NPAs on their books, improve their asset quality, and reduce the risk of future defaults.

It is important for financial institutions to have a clear policy on loan restructuring and to implement it in a transparent and consistent manner. This can help ensure that loan restructuring is used as a tool for managing NPAs effectively and not as a means to provide undue relief to certain borrowers.

Loan Recovery Through Legal Means

Loan recovery through legal means is another strategy that financial institutions can use to manage NPAs. This involves taking legal action against defaulting borrowers to recover the outstanding loan amount.

The legal action can take several forms, such as filing a suit in court, invoking the arbitration clause in the loan agreement, or initiating recovery proceedings under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act.

While loan recovery through legal means can be an effective strategy for managing NPAs, it is also important for financial institutions to exercise caution and follow the legal process carefully. This includes ensuring that the borrower’s rights are protected and that the legal action is taken in accordance with the applicable laws and regulations.

In addition, financial institutions should also consider the costs and time involved in legal proceedings and weigh them against the potential benefits of loan recovery. It is important to strike a balance between recovering the loan amount and maintaining a positive relationship with the borrower.

Clear and Transparent Loan Classification System

A clear and transparent loan classification system is essential for effective NPA management in financial institutions. A loan classification system is a framework that classifies loans based on their level of risk and the likelihood of default.

The loan classification system enables financial institutions to identify potential NPAs early on and take proactive measures to mitigate the risk of default. A clear and transparent loan classification system provides a common understanding of the level of risk associated with different loans and ensures that loans are classified consistently across the institution.

There are several loan classification systems that financial institutions can adopt, such as the Basel III framework or the Indian banking system’s asset classification norms. These frameworks typically classify loans into different categories based on their level of risk, such as standard assets, sub-standard assets, doubtful assets, and loss assets.

A clear and transparent loan classification system enables financial institutions to identify potential NPAs early on and take proactive measures to mitigate the risk of default. It also provides clarity to regulators, investors, and other stakeholders on the level of risk associated with the institution’s loan portfolio.

How Can Legodesk Help?

Legodesk offers an intuitive software solution meant for lenders that can help with debt recovery. 

Our software platform has a wide range of features such as legal notice automation, case management, contact management, and our unique Feet-on-Street app that all work together to help ease the debt collection burden on lenders. The aim of Legodesk is to help make debt collection as easy as possible and reduce the costs associated with debt collection. 

We are trusted by banks, NBFCs, and even enterprises with lots of credit on their books.  

Wrapping Up

It is important for lenders to take the necessary steps to reduce the occurrence of non-performing assets as much as possible. 

While they cannot always be prevented completely, the lender can take several steps to reduce their impact. Even if a default occurs, how the lender chooses to manage NPAs can make a world of difference in how easily they manage to recover their dues. 

Lenders need to keep abreast with the latest emerging technology to ensure that their operations are as efficient as any. Many new tools are deployed every year which can help streamline the debt collection and overall lending process. 

Such strategies are the best bet lenders can make against NPAs on their books.