How Does RBI Look At Default In NBFC ?

Default and Provisioning.

Asset Classification

Every non-banking financial company shall, after taking into account the degree of well defined credit weaknesses and extent of dependence on collateral security for realization, classify its lease/hire purchase assets, loans and advances and any other forms of credit into the following classes,  namely:

(i) Standard assets;

(ii) Sub-standard assets;

(iii) Doubtful assets; and

(iv) Loss assets.

The class of assets referred to above shall not be upgraded merely as a result of rescheduling, unless it satisfies the conditions required for the upgradation.

“Standard Asset” means the asset in respect of which, no default in repayment of principal or payment of interest is perceived and which does not disclose any problem nor carry more than normal risk attached to the business;

“Sub-Standard Asset” means:

(a) an asset which has been classified as non-performing asset (NPA) for a period not exceeding 18 months;

(b) an asset where the terms of the agreement regarding interest and / or principal have been renegotiated  or rescheduled or restructured after commencement  of operations, until the expiry of one year of satisfactory performance under the renegotiated or rescheduled or restructured terms.

“Doubtful Asset” means a term loan, or  a lease asset, or  a hire purchase asset, or any other asset, which remains a sub-standard asset for a period exceeding   18 months;

“Loss Asset” means:

(a) an asset which has been identified as loss asset by the non-banking financial company or its internal or external auditor or by the Reserve Bank  of India during the inspection of the non-banking financial company, to the extent it is not written off by the non-banking financial company; and

(b) an asset which is adversely affected by a potential threat of non- recoverability due to either  erosion in the value of security or non availability of security or due to any fraudulent act or omission on the part of the borrower;

‘Non-Performing Asset’ (referred to in these Directions as “NPA”) means:

a.        an asset, in respect of which, interest has remained  overdue for a period of six months or more;

b.       a term loan inclusive of unpaid interest, when the installment is overdue for a period of six months or more or on which interest amount remained overdue for a period of six months or more;

c.       a demand or call loan, which remained overdue for a period of six months or more from the date of demand or call or on which interest amount remained overdue for a period of six months or more;

d.       a bill which remains overdue for a period of six months or more;

e.       the interest in respect of a debt or the income on receivables under the head `other current assets’ in the nature of short term loans/advances, which facility remained overdue for a period of six months or more;

f.        any dues on account of sale of assets or services rendered or reimbursement of expenses incurred, which remained overdue for a period of six months or more;

g.      the lease rental and hire purchase installment, which has become overdue for a period of twelve months or more;

h.       in respect of loans, advances and other credit facilities (including bills purchased and discounted), the balance outstanding under the credit facilities (including accrued interest) made available to the same borrower/beneficiary when any of the above credit facilities becomes non-performing asset:

Provided that in the case of lease and hire purchase transactions, a non-banking financial company may classify each such account on the basis of its record of recovery;

Provisioning requirements

Every non-banking financial company shall,  after taking into account the time lag between an account becoming non-performing, its recognition as such, the realization of the security and the erosion over time in the value of security charged,  make provision against sub-standard assets, doubtful assets and loss assets as provided hereunder :-

(i)         Loss Assets: The entire asset shall be written off. If the assets are permitted to remain in the books  for  any  reason, 100% of the outstanding  should be provided for;

(ii)       Doubtful Assets:

(a)    100% provision to the extent  to  which  the advance is  not  covered  by  the  realizable value  of  the  security  to  which  the mortgage guarantee company has a  valid  recourse shall  be made. The realizable  value  is  to be  estimated  on a realistic  basis;

(b)   In regard to the secured portion, provision is to be made on the following basis  to the extent  of  20% to 100% of the secured portion depending upon  the period  for  which  the  asset has  remained doubtful:

     Period for which the asset has remained in doubtful category,

Up to one year,                                    20%

One to three years,                               30%

More than three years,                        100%

( iii)      Sub-standard assets: A general provision of 10% of total outstanding shall  be made

(iv)       Every Non Banking Financial Company shall make provision for standard assets at 0.25 percent of the outstanding, which shall not be reckoned for arriving at net NPAs. The provision towards standard assets need not be netted from gross advances but shall be shown separately as ‘Contingent Provisions against Standard Assets’ in the balance sheet.”

Classify To Bring Focus

Delinquencies need to be classified appropriately to bring the right focus. Different institutions use different type of delinquency/ collection reports. Each has its advantage and disadvantages.

Some foreign banks use collection reports based on ‘exposure given default’ – EGD. This gives a list in descending order of exposure. Here, the focus is on accounts with high exposure. Obviously, they do not want loss per account to be huge. Here, classification does not reflect neither level of delinquency or level of risk.

Some NBFCs use collection reports based on ‘past due amount’. This gives a list in descending order of default amount or past due amount. There is no clarity on delinquency and risk levels.

Most MNC lenders use collection reports based ‘days past due’ – DPD. This gives a list in descending order of number of days accounts in default. One can get ‘months past due’ by dividing DPD by 30. Months past due gives number of installments overdue.  Similarly, many credit card lenders use ‘buckets’ generally representing different months past due, say first bucket to mean account with past due from 1-30 days. This certainly indicates the level of delinquency and not fully the level of risk. Yes, default accounts with high DPD tend to be high risk; it gets increasingly difficult to collect with an increase in DPD.

Then, how do we measure risk, delinquency level and classify them broadly based on delinquency and risk, to bring the right focus by allocating and assigning resources to mitigate losses?

It is important to have accounts classified in the following matrix.

I High Delinquency - High Risk	III Low Delinquency - High Risk
II High Delinquency - Low Risk	IV Low Delinquency - Low Risk

Collection reports rak ordered by delinquency rate would help classify, based on risk.

Delinquency rate is, as defined elsewhere in my blogs, the rate of amount past due as compared to amount billed so far for the contract.

Top 20% of accounts on the list are certainly high risk accounts; balance can be classified as low risk accounts. These can be further classified based on DPD. Accounts with DPD higher than 90 may be classified as high delinquent and remaining low delinquent.

Now, we have 4 quadrants which constitute Debt Lifecycle as follows:

I        High delinquent – High risk

II       High delinquent – Low risk

III      Low delinquent -  High risk

IV      Low delinquent – Low risk

It is clear that the focus needs to be on high risk accounts and more on Quadrant I accounts which are High delinquent – High risk. Different quadrants require different levels of curing like calling, field visits, repossession, agency collection, legal actions, etc.

Try them; you will see results. Losses will come down.

Collection analytic will help further classify to bring razor sharp focus; I will write on collection analytics on different pages in near future.

Reduce Losses

Losses are a function of mindless orientation towards sales numbers and lack of credit management.

It is true that sales are important in any business, so is in finance business. Sales bring profits.

In many a bank, more so in MNC banks, I have heard that the top guy with orientation of marketing or credit is named alternatively for any branch. The first guy would show result in terms of sales and credit guy would clean up. It may be true because a country head or a product head in MNCs are normally for a three years term and they are under stress to show results to get a ‘better position’. Lest, they would be shown door.

In a competitive business like finance business, every thing gets measured by the boss, except the credit quality which shows up after an average period of 1-2 years. Losses occur after the term is over and the horse is bolted. It is important that banks and NBFCs have adequate credit analytics to show and even predict the quality of credit and portfolio regularly, at an interval not less than 3 months.

Probability of loss is 100% when there is lack of credit management in finance or banking business. They have a very high correlation with losses.

Credit losses arise because of:

1. External fraud by crime groups
2. Internal fraud by sales guys jointly with or without Direct Marketing Agents
3. Lack of credit history of customers
4. Bad credit policy
5. Too many subjective and qualitative assessment of credit
6. Too many exceptions because of interference of the top guy/ seniors.

Strong collection mechanism and strong credit management would deter crime groups and internal employees attempting to defraud by falsifying the application and documents. There are agencies like Experian is available, whose services will help avoid frauds in application stage to a large extent, at least in retail finance business, where number of applications is huge.

CIBIL

Credit history is made available by CIBIL in India; I believe they also offer credit score/ rating. They have done a commendable job of getting about 90 % of lenders to share the credit history of their customers. My experience, at least about 5 years ago, was that not many banks could share the right data in full, and from across India. More computerization of banks had happened since then and I am sure the data provided currently would be highly reliable. My suggestion would be to avoid all customers whose credit history is not traceable in CIBIL.

Should one use exclusively CIBIL credit scoring in approval process?

Rather not. CIBIL score is based on assessment of the ability of the customer to pay on the existing loans. It has no recourse to any other vital information that would be required to fully assess “ability and intention” of the customers and to quantify the credit risk of the customer more accurately.

Most of credit policies are made by "cut & paste" of competitor policies. It must be simple, clear and purposeful, supported by an internal credit scoring model, giving weight to credit history, credit score offered by CIBIL. Credit policy must be company specific and must be internal. There could be enough discussion on formulating the policy among heads of all departments including collection, sales & marketing. But, the interference must not be allowed with the policy till the next review meeting; feedbacks are welcome. Collection analytics like early default analysis, standard deviation of payments, ratio of high-risk accounts sourced in the last one year may be the bases for tinkering the policy and the norms like LTV, etc.

Strong collection department, and preferably internal recovery & legal vertical under collection department will go a long way in achieving better recovery ratio. Of course, the collection analytics will  help to direct efforts appropriately to achieve better collection and the right focus to mitigate losses.

Repossession of underlying asset is the most important activity to reduce or even mitigate losses. Why do you have an underlying asset as security, if you cannot have recourse to?

It is normal and easy to blame that collections are poor and losses are higher, because of inefficiency of collection department. May be. I recall here the famous statement of one my vice-president Carlos who once said, “Best of collections will not solve collections problem, but better credit will”.

Currently, the profit margins are 5-6% in retail finance business. Net margins are as low as 3-4%. It is clear that no bank or company can afford losses beyond this. What is important is that for, every 1% loss, the company's sales will have to be 33% more,  to have the same level of risk adjusted return.

Is it easy to do sales? Even if you can, is capital easily available? Even if capital is available, can you assure “return”? O boy! losses are too costly.

Is there an option? Reduce Losses.